Declining Propane Demand Will Eventually Threaten AmeriGas' Dividend

| About: AmeriGas Partners (APU)


AmeriGas loses customers every year.

Its MLP structure means it is heavily dependent on the healthy functioning of the capital markets.

The entity's ~8% annual distribution yield is not backed by growing end-market (propane) demand.

For younger investors, dividend growth investing is a long-term strategy. To achieve a yield on cost of 10% or more on a strong corporate payer, for example, it could take years, sometimes decades. That's why the sustainability of a company's future free cash flows is so critical to dividend growth investing--and by extension, why end market demand is so vital to assessing the prospects of dividend growth entities. If a firm's end markets are declining or if the firm is steadily bleeding customers, it will become increasingly more difficult to raise the dividend over the long haul. In this piece, let's put all of these thoughts together and evaluate AmeriGas (NYSE:APU) dividend growth prospects.

Image Source: AmeriGas

But first, let's start with framing this analysis for readers. Most dividend assessments tend to be backward-looking -- meaning, the evaluation rests more on what the company has done in the past: how long it has raised its dividend, for example. Don't misunderstand. We think analyzing historical trends is important, but investors should understand that for a cash-rich, growing company to raise its dividend by a reasonable amount in each of the past 20, 30 or more years isn't much to write home about.

Imagine, for example, giving your grandson $1 for his age on each consecutive birthday. Though you'll effectively be raising his "dividend" each year, the payout isn't necessarily tied to your income stream, nor is it very taxing on your lifestyle (even if he lives to 100 years or older). In a similar manner, a dividend payment is not explicitly tied to a firm's earnings stream, nor is it very taxing on a firm to raise its dividend each year. For one, firms with substantial earnings don't have to pay a dividend, and companies can report declining earnings and still raise their dividend in the same earnings release.

Over the long haul, earnings growth will have to support dividend growth, but in instances where the payout ratio is low, earnings don't necessarily have to expand for the company to raise its dividend for years and years. A company can double its payout ratio by raising its dividend for 50 consecutive years, for example, but the payout ratio at the end of the period could still only be 50% of earnings at the beginning of the 50-year period. Fascinating, no?

With all of this said, it becomes obvious that assessing the future capacity of growth of the dividend is really what matters most for dividend growth investors. After all, dividend growth investors are investing for the next 5, 10, 20 years, not the past 5, 10, 20. And they want their dividends to increase by a material amount. This forward-looking perspective that assesses the potential magnitude of future dividend growth is all the difference in the world. That is why we created a forward-looking assessment of dividend growth through the innovative Valuentum Dividend Cushion methodology.

For those that may not be familiar with our boutique research firm, we generate a discounted cash-flow analysis for all firms in our coverage. We use these future forecasts of free cash flow (cash flow from operations less capital expenditures) and expected cash dividend payments, and consider the company's net cash position to evaluate just how much capacity a firm has to keep raising its dividends long into the future.

The Dividend Cushion is a forward-looking ratio (with a numerator and a denominator). It tells investors how many times future free cash flow (cash from operations less capital spending) will cover future dividend payments after considering the net cash on the balance sheet, which is also a key source of dividend strength. It is purely fundamentally-based, and driven from items taken directly off the financial statements.

Let's now take a look at AmeriGas' investment highlights and then its dividend report to see how all of the analysis comes together.

AmeriGas' Investment Highlights

• AmeriGas Partners is a master limited partnership. It is the nation's largest retail propane marketer (15% share), serving approximately 2 million customers in all 50 states from approximately 2,100 distribution locations. The entity conducts business principally through its subsidiary AmeriGas Propane.

• AmeriGas boasts a number of competitive advantages. Its customer density results in efficient distribution, while geographic diversity reduces regional weather risk. The company's end-use diversity is notable (commercial/industrial), and its scale via the largest sales force in the industry offers benefits.

• AmeriGas Partners' cash flow generation is robust, but its financial leverage could potentially be concerning down the road. If cash flows begin to weaken, we'd become more cautious on the firm's overall financial health. Declining propane demand (2-3% per annum) is a more relevant risk, however. The firm loses 2,500 customers per year due to natural gas.

Image Source: AmeriGas

• AmeriGas' distribution yield is elevated, but we note its safety is dependent on the healthy functioning of the capital markets (the entity's dividend payout is greater than its earnings). MLPs are inherently risky enterprises in this respect. They pay out significantly more in distributions than they earn, and this means that without being able to issue new equity or issue new debt, the distribution would collapse. This is just a fact of an MLP's business structure.

AmeriGas' Dividend Report

AmeriGas' distribution yield is nice, offering nearly an 8% annual payout at current price levels. When we say nice at this point, we mean that the firm's distribution yield is above the average dividend yield of S&P 500 companies and most bellwethers across different industries. When we say nice, we don't mean the firm's dividend is safe or that it will grow at a fast rate. The bottom right of the table in the image below reveals our expectations for the MLP's future pace of dividend expansion (~3%-5% per annum). Please have a look.

Image Source: Valuentum

Let's now dig into AmeriGas' qualitative ratings for dividend safety, dividend growth potential, and risk of capital loss. As we mentioned previously, the Dividend Cushion ratio not only informs our opinion of the safety of the dividend, but also of its capacity for future growth. The higher the Dividend Cushion score above 1, the more capacity a firm has for future dividend increases.

For MLPs, we make a number adjustments to the Dividend Cushion ratio to account for their dependence on the capital markets. The largest adjustment is that we add future proceeds from forecasted equity issuance to the numerator. This provides an artificial boost relative to corporates and makes the interpretation of the Dividend Cushion score for all MLPs in our coverage heavily dependent on the healthy functioning of the capital markets. Still, even with this boost, AmeriGas' dividend health isn't that spectacular.

Dividend Safety / Cushion -- POOR / 0.9

We assess the safety of the MLP's dividend by adding the company's net cash to our forecast of its free cash flows over the next five years (we also add proceeds from future equity issuance to the numerator for MLPs). We then divide that sum by the total expected dividends over the next five years. This process results in our Dividend Cushion™ ratio. A Dividend Cushion™ above 1 indicates a firm can cover its future dividends with net cash on hand and future free cash flow, while a score below 1 signals trouble may be on the horizon. And by extension, the greater the score, the safer the dividend, as excess cash can be used to offset any unexpected earnings shortfall. AmeriGas Partners scores a 0.9 on our Dividend Cushion™, which is POOR.

Dividend Growth Potential -- VERY POOR

We judge the future potential growth of the dividend by evaluating the capacity for future increases, as measured by the Dividend Cushion™, and management's willingness to consistently raise the
dividend, as measured by the firm's dividend track record. AmeriGas Partners registers an VERY POOR rating on our scale, but we think the firm's annual dividend will be $4.08 per share within the next several years (by the end of fiscal 2018). How can we say that the firm has VERY POOR dividend growth prospects but still say the dividend will grow?

We typically assign the quantitative dividend growth forecasts to firms on the basis of their qualitative Dividend Growth rating, but we also make adjustments to account for a firm's track record and other considerations. For example, in the case of AmeriGas, the company has been raising its distribution at a mid-single-digit annual pace in recent years, and we would expect the board to continue doing so, even in the face of declining end market demand. It's important for readers to understand that the actions by boards and management teams are not always rational on an economic-value (or sustainability) basis, especially as boards seek to serve their income investor constituency base and support the equity.

For those interested in dividend growth forecasts, we have dividend growth forecasts for every company in our 1,000+ firm coverage universe. The scale we generally use is shown below, though actual forecasts are tweaked to reflect the unique dividend growth characteristics of each firm.

Dividend Growth Potential Scale

Excellent: 8% or higher
Good: 4%-8%
Poor: 2%-4%
Very Poor: 0%-2%

Risk of Capital Loss -- MEDIUM

Though the dividend certainly can impact a company's share price, we assess the risk of capital loss within the valuation context. We assess the risk of capital loss based on our analysis of a firm's intrinsic value at this point in time. If the stock is undervalued (based on our DCF process), we think the risk of failing to recoup one's original capital investment (ex dividends) is relatively LOW. If the stock is fairly valued (it falls within our fair value estimate range), we think the likelihood of losing capital (ex dividends) is MEDIUM. If the stock is trading above our estimate of its intrinsic value, we think the likelihood of losing at least a portion of one's original investment (ex dividends) is HIGH. AmeriGas Partners registers a score of MEDIUM on our scale, as shares are trading within our fair value range.

Wrapping This Up

There's not much to like about AmeriGas other than it pays out an extravagant yield. Though this will attract some income investors regardless of the entity's future prospects, AmeriGas' MLP structure coupled with declining end market demand and a payout ratio that exceeds earnings, we think long-term dividend growth investors can find better ideas. We prefer ideas held in the Dividend Growth portfolio.

The following provides the definitions of the terms you may have read in the dividend report (image) above. Thank you for reading!

Dividend Methodology Note: For oil and gas pipeline firms, which operate different business structures, and utilities (including waste firms) we employ a different methodology such that comparisons with general operating firms remain meaningful. For oil and gas pipeline firms, we add equity issuance in the future to the numerator and use 0.2 of the firm's total debt load. For utilities, we use 0.5 of the firm's total debt load.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.