UGI Mulls Separating Propane Business to Unlock Value, Potentially Causing Jump in Payout Ratio

UGI has announced it will undergo a corporate strategic review focused on the firm's non-regulated propane businesses (~40% of earnings), intending to reduce earnings volatility and strengthen its balance sheet.

UGI's propane operations have faced challenges from higher transportation costs due to truck driver shortages, lower demand caused by warmer-than-usual winter weather (propane can be used to heat homes), and competition from cheaper natural gas alternatives in some markets.

These factors have demonstrated the volatility of UGI's non-regulated income and caused the stock to trade at a substantial discount to the utility sector and, arguably, the collective value of its individual business segments.

To use a simple example, applying industry-average price-to-earnings multiples of 16x and 8x to UGI's utility and midstream segments, respectively, suggests a combined value of $4.6 billion for these two regulated, growing businesses.

That was almost equal to UGI's market cap of $4.8 billion yesterday, suggesting very little value has been given to the company's propane businesses, which could be worth around $1 billion to UGI if they were valued at just 5 times adjusted EBITDA.

With management now looking to address this valuation disconnect, likely by selling or spinning off the firm's propane businesses, UGI shares jumped by 10% on the news.

Refocusing the firm on its stable regulated Pennsylvania and West Virginia utility business, which dates back to 1882 and has allowed UGI to pay dividends without interruption for almost 140 years, should result in a steadier earnings stream and a more predictable outlook.

Even so, with segments representing nearly half of the company's profits under review, there are surely implications for UGI's dividend profile.

In a presentation that accompanied the strategic review announcement, UGI reaffirmed its commitment to "maintaining our strong track record of paying dividends," and its long-term goal of 4% annual dividend growth.

However, the firm's forward-looking payout ratio of 45%, including LPG earnings, is already at the top of UGI's target range of 35% to 45%. And the potential divestiture of the company's propane businesses could stretch that ratio to around 70% or higher.

While a payout ratio of around 70% is reasonable for most regulated utility firms, it marks a notable rise that management might feel uneasy about.

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.

Until we learn more, hopefully by November's earnings call, we are downgrading UGI's Dividend Safety Score from Very Safe to Safe given the size of the business under review and its potential impact on UGI's payout ratio. 

Should UGI more clearly communicate plans to keep income investors whole, which seems well within the realm of possibilities, we would consider upgrading the company's rating. This downgrade shouldn't be viewed as a reason to sell the stock.

We plan to provide another update on UGI when more details are shared from the review, and it's possible to develop a more concrete outlook on the firm's dividend plans.

If we owned shares of UGI, we would probably maintain our position and see how the strategic review unfolds from here. Regardless of the outcome, UGI should remain a cash cow with solid dividend coverage.

As noted, we'll watch for news on the review and provide updates as needed.