Sprague Resources: Very High Yield, But Still Very Risky After Disappointing End To 2020
Summary
- Sprague Resources once again sustained their distributions for another quarter but they remain very risky.
- Despite seeing good fortune during most of 2020, this seems unlikely to repeat again during 2021.
- Their operating cash flow turned negative during the fourth quarter of 2020 and even without working capital movements, it was still disappointing very low.
- It seems likely that without further good fortune, their very high leverage and weak liquidity will see a significant distribution reduction during 2021.
- Given their very risky distributions offsetting the appeal of their very high yield, I believe that my neutral rating is appropriate.
Introduction
Even though Sprague Resources (NYSE:SRLP) managed to sustain their distributions amidst the turmoil of 2020, this feat was primarily accomplished due to temporary good fortune, as my previous article discussed. A follow-up analysis is provided within this article that reviews the sustainability of their very high 14% distribution yield during 2021 along with their recently released fourth quarter of 2020 results.
Executive Summary & Ratings
Since many readers are likely short on time, the table below provides a very brief executive summary and ratings for the primary criteria that was assessed. This Google Document provides a list of all my equivalent ratings as well as more information regarding my rating system. The following section provides a detailed analysis for those readers who are wishing to dig deeper into their situation.
Image Source: Author.
*There are significant short and medium-term uncertainties for the broader oil and gas industry, however, in the long-term they will certainly face a decline as the world moves away from fossil fuels.
Detailed Analysis
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Instead of simply assessing distribution coverage through distributable cash flow, I prefer to utilize free cash flow since it provides the toughest criteria and best captures the true impact on their financial position. The main difference between the two is that the former ignores the capital expenditure that relates to growth projects, which given the very high capital intensity of their industry can create a material difference.
On the surface, it initially appears that 2020 was a blockbuster year with their operating cash flow surging towards approximately equalling their four-year high at $154m, which stands in stark contrast to the negative $65m they generated during 2019. This ultimately left with $136m of free cash flow, which was ample to cover their distribution payments and thus provide very strong coverage at 201.82%.
Whilst in a way 2020 was a blockbuster year, when viewed in another light it was merely just a continuation of 2019 and as to be explained, their underlying ability to cover their distributions was very weak. Following the historic oil price crash during the first half of 2020 they were able to benefit immensely from the extreme contango oil price curve, whereby longer-dated oil prices were massively above the shorter-dated prices that at one point even turned negative, as quoted below.
"Sprague's Adjusted EBITDA increased by 50% over last year as our extensive storage assets enabled us to capture attractive contango opportunities".
-Sprague Resources Third Quarter Of 2020 Results Announcement.
If interested in further details regarding this aspect of their operations, please refer to my previously linked article. This was naturally just a temporary benefit that cannot realistically be expected again during 2021 with management expecting a fairly normal oil price curve, as quoted below.
"But what we see in front of us today is a -- what I'd characterize as a normal curve. It's got a few months in which there's very mild backwardation and a few months in which there's very mild contango. So, in the aggregate, it's a pretty flat forward curve today."
-Sprague Resources Q4 2020 Conference Call.
The other arguably even bigger variable that made 2020 seem like a blockbuster year was simply their lumpy operating cash flow stemming from working capital movements, which has been common across the years. Once removing these impacts their operating cash flow drops to only $68m for 2020, which is down a small $2m from their results for 2019 and thus indicates essentially flat performance year on year.
This underlying operating cash flow excluding working capital movements provides a clearer insight into what they can more consistently have available to fund their distribution payments. After subtracting their capital expenditure and miscellaneous cash expenses they were left with only $49m of underlying free cash flow and thus versus their distribution payments of $67m, thereby providing very weak distribution coverage of 72.69%.
It should also be considered that their distribution payments of $67m virtually equal their underlying operating cash flow excluding working capital movements during 2020 of $68m. This points to particularly severe pressure to reduce their distributions since there would be no margin of safety even if their capital expenditure was to fall to zero forever, which is naturally impossible.
If zooming down into their results for the fourth quarter of 2020 alone it becomes apparent that they were clearly quite weak year on year, which explains their earnings per share miss that sent their unit price plunging by double-digit percentages on the 4th March. Their operating cash flow during the first nine months of 2020 was $224m versus the $154m for the full year, thereby meaning that the fourth quarter saw their operating cash flow turn to negative $70m. Even though they ended 2020 with a large working capital build, this shows how it was even larger back at the end of the third quarter of 2020, although this alone does not completely explain their weak operating cash flow performance during the fourth quarter.
Whilst this lumpy cash flow performance could just initially appear as simply business as usual, their underlying performance was still quite disappointing even after removing the impacts from working capital movements. During the first nine months of 2020 their underlying operating cash flow that excluded these was $63m, which given their equivalent results for the full year of only $68m indicates that the fourth quarter saw a measly $5m of operating cash flow excluding working capital movements. This compares quite unfavorably to the fourth quarter of 2019, when they generated underlying operating cash flow of $22m and thus marks a negative end to a tumultuous year.
When looking further ahead into 2021 and the situation does not appear likely to improve materially given their guidance for adjusted EBITDA of $113m at the midpoint versus their result of $117m for 2020, as per their fourth quarter of 2020 results announcement. Generally speaking, there should be a strong correlation between adjusted EBITDA and operating cash flow excluding working capital movements and thus it appears that their very weak distribution coverage is set to continue during 2021, along with the associated risks of a reduction.
A final point of interest to consider before moving onto their financial position is that since the beginning of 2017 they have invested a total of $76m through their capital expenditure net of divestitures, plus a further $107m of acquisitions. This combined equals approximately 60% of their total operating cash flow during this same four-year-long period of time, however, disappointingly they have seemingly seen no reward from these investments. Their adjusted EBITDA guidance for 2021 of $113m actually sits only $4m above their adjusted EBITDA results for 2016, as per their fourth quarter of 2016 results announcement.
Needless to say that this performance is rather lackluster and thus highlights a prime example of why my analyses focus on utilizing free cash flow not their distributable cash flow since the growth portion of these investments has not seemingly produced any material earnings growth. Given the continued outlook for very weak distribution coverage during 2021, their financial position will continue playing an important role.
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Following their largely disappointing fourth quarter of 2020 it was not surprising to see their net debt increase, however, the extent was surprising with 13.39% during the quarter alone being a very large jump for such a short period of time. Their already low cash balance edged even lower to an almost invisible level of only $4m and thus both of these factors set a negative precedence for their overall financial position.
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Whilst their leverage at the end of 2020 was an improvement since the end of 2019, it nevertheless is only a small change and thus still clearly sits in the very high territory. This is primarily evidenced by their net debt-to-EBITDA of 6.49 sitting well above the threshold of 5.01, not to mention their very high gearing ratio of 92.63%. Their net debt-to-operating cash flow of 4.77 should largely be ignored since it was materially boosted their previously discussed working capital movements.
Given this very high leverage, it would have been very difficult to see their distributions having survived 2020 if not for their previously discussed good fortune that temporarily saw their operating cash flow surge. Even if their distribution coverage was to somehow consistently remain modestly above 100% perpetually into the future, this level of leverage would still pose significant risks to its long-term sustainability. In fact, due to their lumpy cash flow performance this level of leverage could even threaten their ability to remain a going concern if anything unforeseen eventuates since their liquidity also leaves quite a bit to be desired. Sadly there are reasons to expect that this situation cannot be improved without a very large distribution reduction given the previously discussed flat outlook for 2021 and questionable returns from their investments.
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Despite their cash balance edging even lower during the fourth quarter of 2020, nothing material changed overall regarding their liquidity with their current ratio of 0.99 being essentially the same as the previous result of 1.00. Although this would often be considered positive, this is negated by the fact that it is already rated as weak due to their virtually non-existent cash balance and very lumpy cash flow performance.
When conducting the previous analysis it was commented that they would likely face the less than ideal situation of becoming reliant on their credit facilities once their good fortune passes, which sadly transpired during the fourth quarter given their negative operating cash flow. This becomes particularly concerning because financial institutions are unlikely to extend materially more funding than already committed due to their very high leverage, even if their debt covenants are not necessarily breached.
During the fourth quarter of 2020 alone they drained a staggering 43.63% of their working capital credit facility, thereby leaving the available balance at $106m versus $189m previously. Unless they see another fortunate surge in operating cash flow in the short-term, this will soon be depleted along with their ability to sustain their distributions. It would be very surprising to see financial institutions extending further credit without wanting a compromise in return, the quickest and most effective method is heavily reducing their distributions.
It was interesting to see that the entirety of their debt structure is completely comprised of the facilities provided through their credit agreement, as the table included below displays. This credit agreement matures on May 2022 and even if they avoid any issues until this date, it will obviously require refinancing and thus support from financial institutions.
Image Source: Sprague Resources 2020 10-K.
Conclusion
Their underlying ability to cover their distributions appears very weak and they have very high leverage and arguably weak liquidity, thereby creating a toxic combination for income investors and thus they should continue bracing for a large distribution reduction. Given their business as usual outlook for 2021, it appears these problems will persist and thus so will my neutral rating as the attractiveness of their very high yield is offset by its very risky fundamentals.
Notes: Unless specified otherwise, all figures in this article were taken from Sprague Resources' 2020 10-K (previously linked), 2019 10-K and 2017 10-K SEC Filings, all calculated figures were performed by the author.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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Comments (7)
But the author is missing the trigger for the distribution cut -- IMO the first step will be to have SRLP buy out the incentive distribution rights by issuing to the parent a huge number of units, THEN they'll cut the distribution -- they need the current high distribution to justify the biggest possible buyout price. This is the standard playbook that GPs have followed in the past to "simplify" and get rid of IDRs -- see Enbridge, etc. At that point they'll own so many of the units that they can buy in the rest for a song, like they tried to do last year for $13. I don't think there's any way they end 2021 as a public company.
I think you missed the IDR reset. In February, the GP agreed to reset the IDR thresholds at much higher levels, and SRLP issued 3.1 million new units to them to make up for the lost IDR payments. Today, the IDRs have no intrinsic value, only the opportunity for IDR payments in the future if SRLP can raise the distribution. And the old IDRs were in the 50/50 splits. Under the new thresholds the distribution has to exceed $ 1.00 per quarter before the 50/50 splits are reached.After receiving the 3.1 million new units, the GP owns 61% of all the common units. And I agree with you that a buyout is coming. But not until operating results decline a bit, and (probably) the distribution is cut.