AmeriGas purchase of Heritage raises eyebrows, questions

In late October, AmeriGas Partners L.P. reached an agreement to acquire Heritage Propane, the propane operations of Energy Transfer Partners L.P., for a staggering $2.9 billion.

Under the terms of the deal, the country’s largest propane distributor will pay $1.5 billion in cash and $1.3 billion in shares, as well as assume $71 million in debt from two Energy Transfer Partners subsidiaries, Heritage Operating and Titan Energy Partners.

Energy Transfer conducts its propane operations in 41 states through the subsidiaries including Heritage Operating L.P. and Titan Energy Partners L.P. The acquisition of Heritage Propane will add more than 1 million retail propane customers and more than 500 million gallons to AmeriGas’ nationwide propane distribution operations, which already included 1.3 million retail customers and more than 893 million gallons of annual propane sales.

News of the blockbuster deal made big waves in the consolidating propane industry. There were some red flags on the investment front, however. Some ratings firms put the credit ratings of AmeriGas Partners on watch for possible downgrade due to expectations that the deal will result in increased leverage at AmeriGas. They also cited possible execution risks, including challenges related to integration, financing and greater-than-anticipated customer loss.

LP Gas Editor in Chief Patrick Hyland asked industry analyst Ronald Londe to evaluate the mega-deal from both a competitive and operational standpoint. Londe is managing director of equity research for energy master limited partnerships with Wells Fargo Securities LLC.

How does the deal strengthen the AmeriGas portfolio?

LONDE: From the standpoint of AmeriGas, it makes them much larger, obviously, and probably more diversified geographically from a competitive standpoint. It will allow them to be a little more residential-oriented; I think they go from 40% residential to about 44% residential. Obviously, residential gallons have a somewhat higher margin associated with them, and that is a positive.

The company feels it can gain some productivity through what they call improved density, which has to do with more efficiency of supply and logistics as they blend locations.

Are their customer makeups much different from each other? Are there any specialty areas that one is particularly good at or does more than the other?

LONDE: No, I don’t think so. Heritage traditionally had higher margins just because of their orientation toward residential. It’s hard to calculate what benefit AmeriGas will get on the ACE (cylinder exchange) side of the equation – the barbeque tank cylinders that they sell. They seem to think that they would be able to get some benefit by Heritage locations being able to supply other locations around the country that are now supplied by third parties.

What has the reaction been in the market?

LONDE: The reaction has been fairly subdued. If you look at the performance of AmeriGas when it was announced versus where the stock is selling now, it’s pretty close to even. I think the market viewed this as a fairly expensive acquisition – one that would be diluted over the near term because of integration expense that they are going to incur over the next 12 to 18 months and the fact that there’s skepticism over how much cost savings they can squeeze out of blending operations of Heritage into AmeriGas. They basically said that they are going to blend about 200 of the 440 locations that Heritage operates. We calculate savings of anywhere from $100,000 to maybe $125,000 per location, which gives you $25 million in savings. If they decide to relocate Heritage’s administrative office in Helena, Mont., to the AmeriGas facility in Pennsylvania, we think that could possibly provide another $5 million in cost savings, if that happens. So that’s $30 million. The company talked about a cost savings of about $50 million, so there would be another $20 million that they would have to garner in some way or another, either through what they call productivity and density improvements or logistics and supply improvements. I’m unsure whether the market really thinks they’ll be able to do that, at least over the next couple of years. So I believe that’s something that’s kind of weighing on the units/stock.

In addition, Energy Transfer Partners is going to own about 34% of the common units outstanding – or 29.1 million units. That’s a lot of units. ETP has agreed to hold those units through 2013. So, after 2013 you might see some of those units come to the market. That’s going to be somewhat of an overhang and probably a bigger question mark as we move forward through 2012 and into 2013. I think those are things that have kept the stock from doing better than one might have expected.

And also, I think the deal was done at a fairly high multiple. If you look at the company’s advertised multiple, they said it was about 10.5 times EBITDA. We try to be a little more conservative on our EBITDA estimate and felt it was transacted closer to 10.9 times EBITDA. But even then in the company’s press conference they said they thought they could get to an effective EBITDA multiple of 8.5 times over time (with cost savings). Well, that’s still a pretty expensive acquisition relative to the 5- to 7-times EBITDA multiples that are typically seen in smaller acquisitions. Now, you probably will pay up for a large acquisition like this, but it’s still a pretty hefty multiple.

So for the $2.9 billion price that was paid, was it a good price for Heritage’s 560 million gallons?

LONDE: I think it’s an expensive price. I think you have to really look at the amount of cash flow that is thrown off by those gallons. On that basis, you’d have to say it was a very full multiple.

Do their 6 million annual wholesale gallons play much of a factor?

LONDE: No. Wholesale gallon margins in an average year are usually about 2 cents a gallon. They’re not significant. Where you really make your money is on residential margins. Of late, because of the economy, I think margins on the commercial side of the business have been probably more difficult to garner. They have somewhat of a unique situation in that the ACE cylinder business is a good business. The way they account for it makes it very hard to tell what the margins are in the ACE business. I would expect they are better than the commercial margins, but probably not quite as good as residential margins. But ACE does keep their people busy during the summer, offsetting some of the seasonality of the business.

Gene Bissell at AmeriGas has talked about the performance of that segment alone giving them some pretty steady growth and stability during otherwise rocky times.

LONDE: I think that’s probably true. And it added to the performance. Now here again you are moving into the law of large numbers where it becomes more and more difficult to grow the business because it is bigger and so you have less new outlets to capture. Plus there are competitors now in the market – obviously Ferrellgas’ Blue Rhino is a competitor – but there are a few mom-and-pops out there that are doing the same thing on a regional basis.

AmeriGas is in all 50 states and Heritage 41. Does AmeriGas gain any geography that they were particularly weak in?

LONDE: I don’t think so. It’s possible in the Rocky Mountain areas and the West Coast that they gain a little market share. But AmeriGas and Heritage both avoided the Midwest because of the lower margins and the competition with co-ops. When you look at a map of the combined operation you can see a big strip down the middle of the country that both Amerigas and Heritage have avoided.

Are they looking to do a lot through cost cutting, or is it growth opportunities from a stronger market share, or where are they looking at effectively paying for that transaction?

LONDE: I think the cost cutting is important. However, in the interim, they estimated incurring about $70 million in integration expense over the next 12 to 18 months. So, the question boils down to, what is the actual timing and magnitude of those integration costs and can AmeriGas improve upon or reach the $50 million cost savings they have talked about?

I think one of the big uncertainties surrounds loss of customers because of the merger/combination. There is a risk that some of the furloughed Heritage managers may start up their own propane operation and try to take customers from AmeriGas. Whether they can integrate non-compete agreements with these managers is another unknown aspect surrounding the long-term success of the deal.

Another question mark relates to Heritage’s Helena administrative office. Will they retain Helena and successfully integrate that operation into the administrative functions at AmeriGas or just service all customers from Radner, Pa., and eliminate the Helena, Mont., operation? Those are factors that make estimating the amount of cost savings difficult for an outsider.

Is everything going to go under the AmeriGas brand?

LONDE: I think they said that initially the Heritage independent branding would be retained but in location blends it would be decided on a case-by-case basis.

How much staff/operational cutting do you foresee? Is there a normal range of what gets cut? Heritage has 4,500 employees; AmeriGas has 6,000 employees.

LONDE: That’s hard to say. If they blend 200 Heritage locations, with let’s say three people per location, that’s 600 people. Plus, I believe Helena has about 100 staffers. But that’s just a “guesstimate.”

Gene Bissell is quoted as saying the deal provides AmeriGas a broader platform to enhance productivity, develop new growth opportunities and deploy new technologies.

LONDE: Yes, size matters, but I don’t know of any new technologies that are out there, unless it relates to routing.

Is this transaction a reflection of the current value of propane companies in general?

LONDE: No, I think it’s just a big burly deal. It was a once-in-20-years kind of opportunity that came along and you have to put up or shut up. And so they put up almost $3 billion dollars at a 10.5 multiple, which is a very rich multiple.

They have “advertised” that going forward their goal is to continue to raise the distribution 5% a year and they’re going to do a special 3% increase probably in May as a sweetener for Energy Transfer Partners – that’s the way we look at it – and to placate their unit holders. I think 5% distribution/dividend growth is a pretty tall order for a large propane company given the mature nature of the industry, what we believe will be continued high propane prices that will keep conservation in the minds of the customer, and a slow-growth economic environment. They’ve got a tough road to hoe. Not impossible – they are good managers or they wouldn’t be here today. But it’s going to be a two- or three-year workout.

Any reason to think industry consolidation won’t continue given the decline in sales over the last decade? Should we look for other majors/Top 5 to consolidate?

LONDE: I think it’s possible that you could see some consolidation among the top 5 – possibly Suburban or Ferrellgas, just because of the nature of the management there. But the timing, magnitude and price is anybody’s guess.

But you obviously still see overall industry shrinkage in terms of growth through acquisitions?

LONDE: Yes, I think there will be more acquisitions. There aren’t that many large mom-and-pops that can really move the needle for the propane MLPs. It’s just tough to move the needle even if you can find a distributor that sells 50 million gallons a year. For some of the MLPs, that’s only a 2 or 3 percent volume benefit. I think acquisitions will get done, but it’s just hard to see any mom-and-pops that are going to be meaningful for the big guys. AmeriGas indicated that they’re not going to be looking for propane acquisitions until they digest Heritage. This may allow other MLPs to be more aggressive in making acquisitions by putting together smaller acquisitions.