We are maintaining our $14.50 per unit fair value estimate for Suburban Propane Partners after the partnership reported that its propane, refined fuels, and energy marketing businesses generated $172 million in adjusted EBITDA for the 2021 fiscal second quarter, up sharply from $130.6 million in the same the year-ago period. Net income was $127.2 million compared with $77.4 million in the 2020 second quarter. We increased our full-year expectations, which did not have a material impact on our fair value estimate. Our long-term outlook remains unchanged. We are reaffirming our no-moat and negative moat trend ratings.

Suburban's quarter was boosted by cold weather across its service territories, resulting in a 16.5% increase in propane volumes. Average temperatures were 9% lower than the prior-year quarter and comparable to the 10-year average. In February, temperatures were 16% lower than the same year-ago quarter. Also boosting demand was the relaxation in COVID-19 business restrictions that aided commercial and industrial volumes.

Management wisely used excess cash flow to reduce debt by $70 million in the quarter, bringing the trailing consolidated leverage ratio down to 3.95 times, significantly improving from last quarter's 4.86 times. Management's target leverage is mid-3 times, a metric we think is achievable by 2023, assuming normal weather. The company's distribution for the quarter was $0.30 per unit, flat from the prior quarter. We continue to incorporate minimal distribution increases through our forecast period.

Suburban Propane's lack of an economic moat is the product of industry dynamics, low natural gas prices, and the company's need to acquire businesses to offset weak organic growth. We forecast low natural gas prices in our long-term outlook, which we believe will continue to pressure the company's core business.

Propane prices relative to cheaper alternatives, such as electricity and natural gas, could speed propane usage declines as gas infrastructure spreads. Suburban's leverage over customers should support per-unit margins that help to offset usage declines. The propane industry remains fragmented--the major players control roughly a quarter of the market, leaving room for growth by acquisition. We continue to expect management to seek add-on acquisitions.

Leverage continues to be an industrywide concern. Management is slowly approaching its mid-3 times debt/EBITDA leverage target, recently boosted by strong quarterly results due to cold weather. We expect Suburban can hit its target leverage metrics in 2023 assuming normal weather and no distribution increases.

Management's evaluation of various demand scenarios led to a 50% distribution cut in 2020. With the company's headwinds, both short and long term, and leveraged balance sheet, we viewed a distribution cut as likely. We don't forecast any additional distribution cuts, assuming normal weather, with the company's distribution payout ratio now above 2.0 times.

We expect core usage to decline 1.5% annually, with recovery in volumes in 2021 after a decline in volumes in 2020 due mostly to pandemic headwinds. Longer term, headwinds from conservation will remain strong, owing to volatile propane prices and encroachment by electricity and natural gas.

We don’t assign Suburban Propane a moat. Suburban is an unregulated supplier of propane to mostly rural customers and businesses with limited access to natural gas. Propane customers are not protected from volatile propane prices, with customers paying the current market rate upon propane delivery. Suburban benefits from switching costs to an alternative propane supplier. Propane distributors own large storage tanks on customers' properties, and the hassle and fee involved with the process discourages customers from switching.

However, it does not prevent a natural gas distribution utility from encroaching on Suburban’s core business. In the environment of cheap natural gas, natural gas utilities have been able to undertake significant capital programs with minimal consumer bill impact. Part of these programs have been to expand natural gas infrastructure into areas historically served by propane. Volatile propane prices are making the economic benefit of this switch more attractive for both consumers and regulators.

We forecast continued declines in organic propane volumes. While Suburban Propane will need little invested capital to maintain its current asset base, thus boosting returns on invested capital, we don’t believe this is a sustainable strategy. To offset declining volumes, Suburban will need to continue to acquire smaller firms and drive efficiencies across the combined operations. Management risks overpaying for acquisitions, and the pipeline of attractive acquisition candidates continues to dwindle.

Weather volatility and declining business fundamentals have led to volatility in Suburban’s adjusted returns on invested capital, which have recently been below our weighted-average cost of capital. Management is limited in the amount of efficiencies it can drive out of the business during periods of unfavorable weather.

We are maintaining our $14.50 per unit fair value estimate after incorpating year-to-date results and operating updates that are in line with our forecast. We increased our full-year expectations, which did not have a material effect on our fair value estimate. Our long-term outlook remains unchanged.

Our forecasts incorporate weather-normalized propane demand in Suburban's key regions. Long term, we assume a 1.5% annual organic volume decline on a weather-normalized basis beginning in 2022. We project per-gallon gross profit for propane to improve, growing 2% annually, helping offset volume declines and in line with recent increases. There is a substantial risk, however, that Suburban will not be able to sustain profit levels despite management's proven abilities and the shift away from less profitable accounts.

We use an 11% cost of equity in our discounted cash flow valuation. This is higher than the average rate of return we think investors should demand of a diversified equity portfolio, reflecting Suburban's higher degree of operating leverage and high exposure to weather-driven product usage. Our cost of capital assumption is 8.2%.

We assign Suburban a high uncertainty rating. High commodity prices and warm weather can crimp sales volumes. Although the firm has generally been able to pass higher propane costs through to consumers, there's no guarantee that this will continue, given continued expansion of gas infrastructure in Suburban's operating regions. Margin compression from competition is a risk in the fuel oil and gas and electric marketing segments as well. Moreover, as Suburban cuts costs, service quality may suffer, and customers may defect, especially given the firm's aggressive pricing.

Historically, the firm has had leverage over customers and pricing, but we are wary of a shift in consumer attitude if propane prices rise and distributor margins expand.

Financial leverage is a significant risk, as it is for many propane distributors. Leverage targets are becoming harder to attain, and we forecast management will achieve its leverage targets in the back half of our forecast.

Finally, Suburban might fail to adequately integrate future acquisitions to a level that generates economic value.

We assign Suburban a Standard capital allocation rating. The rating reflects our assessment of Ameren's balance sheet strength, management's investment decisions, and plans to return capital to shareholders.

Suburban cut its distribution 50% to a more sustainable level, amid the company's sensitivity to changes in weather that create volatility in its cash flows. We expect the balance sheet to remain relatively weak, with the company having some revenue cyclicality and operating leverage. However, we think management's recent move to focus on debt reduction is a good capital allocation strategy. We expect the company's investment strategy to focus on growing through small bolt-on acquisitions, which we think is a reasonable approach given management's ability to drive synergies benefiting shareholders. We don't expect significant investments in the company's current assets.

Weather volatility and declining business fundamentals have led to volatility in Suburban’s adjusted returns on invested capital, which have recently been below our our weighted-average cost of capital. Management must now focus on deleveraging its balance sheet and managing operating margins against weather that is becoming more volatile and uncertain. We think management navigated through the difficult 2020 economic headwinds caused by the pandemic well.