Lessons Learned
In my opinion, there are four main takeaways from Ferrellgas Partners LP (NYSE:FGP)’s implosion last week:
1. Financial leverage is dangerous
Different types of businesses can handle varying amounts of leverage, but a stretched balance sheet can be disastrous. All it takes is a bout of unexpected weakness in cash flow (e.g. warm weather reducing propane demand plus the slump in oil hitting midstream results) and/or restricted access to capital markets for a highly leveraged firm to run into serious trouble.
The company’s equity value (i.e. stock price) will get hit the hardest, even if the dividend makes it through to the other side.
2. Major capital allocation decisions are game-changers
Ferrellgas’s management team saw opportunity to diversify the company’s revenue stream with its midstream deals in 2014 and 2015. While the intention was good, the outcome has proved to be a nightmare.
Unless the management team has an outstanding capital allocation track record, large deals should really be scrutinized – especially if they fall outside of a company’s wheelhouse (e.g. distributing propane versus crude oil transportation logistics).
3. Small cap companies are especially volatile
Small cap companies are usually defined as businesses with a market cap no greater than $2 billion. Since they are smaller, many times their revenue is concentrated in a very small handful of activities.
In other words, unexpected developments can really make or break some of these businesses. Small caps can also have a harder time gaining access to capital markets, depending on the circumstances.
For these reasons, small caps are usually much more volatile than their large cap brothers and should be approached with extra caution.
4. Commodities are unpredictable
Ferrellgas wagered on a set of assets that proved to be more sensitive to energy prices than management might have anticipated. Commodity markets are cruel and unforgiving. No one can accurately make forecasts, and there are many interconnected variables that are constantly at work.
Be aware of any commodities that materially impact companies you hold. While times could be good now, always expect the unexpected. Make sure your businesses have the balance sheet strength and cash flow generating capabilities to survive the next storm. It could very well be closer than anyone thinks.
These lessons overlap some of the habits of highly effective dividend investors I wrote about here. I know interest rates are extremely low and yield is hard to come by, but it’s more important than ever to scrutinize firms with high dividends and even higher financial leverage.
Additional Links
(1) http://www.ferrellgas.com/our-company/investor-information/press-releases/
(2) http://www.bizjournals.com/kansascity/news/2015/06/03/ferrellgas-ceo-bridger-not-a-deal-to-pass-up.html
(3) http://www.reuters.com/article/usa-oil-ferrellgas-part-idUSL1N1BA13Z
