Diversified utility company UGI recently embarked on a corporate strategic review, focusing on its non-regulated propane businesses (~40% of earnings) with hopes to reduce earnings volatility and fortify the company's balance sheet.
We addressed the review in an August 2023 note. Given the size of the business under review and its potential impact on UGI's payout ratio, we reached out to management several times with hopes of gaining more clarity on how the dividend was being viewed. Here's what we wrote in August:
It's too early to know if and how dividend investors would be kept whole if UGI decides to spin off or sell its propane businesses or how much higher of a payout ratio management would be comfortable with.
We've contacted UGI directly by phone and email for more guidance but have yet to get a response, likely because the firm's investor relations department is swamped with incoming calls about the review.
Unfortunately, we've been unable to get management on the phone before the company's earnings call on Friday, November 17. Lacking this clarity, we are downgrading UGI's Dividend Safety Score from Safe to Borderline Safe until we hear more about management's plans.
When the review was announced at the end of August, UGI's investor presentation listed the dividend as the firm's first capital priority and reiterated a target of 4% long-term dividend growth.
But the firm's press release contained a vague statement that could indicate less commitment (emphasis added):
Embedded within the review will also be actions to optimize the company's cost structure and re-align its capital allocation priorities.
We will hopefully know more a week from now. If UGI provides more transparency about its intentions to keep income investors whole, we will likely upgrade the company's Dividend Safety Score.
While we are not invested in UGI, we would likely maintain our position if we were shareholders. Most "strategic reviews" don't excite us, but UGI's stock looks undervalued, and its core utility operations seem likely to remain cash cows with moderate growth potential.
As a refresher on the the strategic review, UGI's propane operations have faced a series of challenges in recent years, including rising transportation costs due to truck driver shortages, decreased demand resulting from milder winter weather (propane is often used for heating), and competition from more economical natural gas alternatives in certain markets.
These factors have resulted in more volatile income from UGI's non-regulated business and caused the stock to trade at a significant discount compared to the broader utility sector, as we recently noted:
For instance, if we apply industry-average price-to-earnings multiples of 16x and 8x to UGI's regulated utility and midstream segments, respectively, we see a combined value of $4.6 billion for these two stable, growing businesses. This value is nearly on par with UGI's market capitalization of $4.8 billion, indicating that little value has been attributed to the propane segment, which could potentially be valued at around $1 billion if valued at just 5 times adjusted EBITDA.
With management now looking to address this valuation gap, likely through a sale or spin-off of the propane division, there's some uncertainty surrounding the dividend, which has been paid without interruption for almost 140 years.
Refocusing on the regulated utility business, which contributed to the firm's stellar dividend streak, should result in a more stable earnings stream and a predictable future.
Nevertheless, considering that nearly half of the company's profits are under review, there are implications for UGI's dividend profile.
While the company has reiterated its commitment to dividend payments and its long-term goal of 4% annual dividend growth, the forward-looking payout ratio, including propane earnings, is already at the upper end of UGI's target range, at 45%. We estimate that the divestiture of UGI's propane segment could elevate the payout ratio to around 70% or higher, which is reasonable for most regulated utility firms. Still, it represents a major shift that management has not yet expressed an opinion on.
Hopefully, we have more clarity soon. We'll pay close attention to next week's update from UGI and provide an update if more clarity is provided on the strategic review and the dividend's outlook.