SGU

Business Context and Reporting Period

Company: Star Gas Partners, L.P. (SGU) and Star Gas Finance Company.
Reporting Period: Quarterly period ended March 31, 2010 (Fiscal Q2 2010).
Business Overview: A master limited partnership and retail distributor of home heating oil, propane, and other petroleum products, primarily serving residential and commercial customers in the Northeast and Mid-Atlantic regions. The company also provides installation, maintenance, and repair services for heating and air conditioning equipment.

Key Financial Metrics

Material Changes vs. Prior Comparable Period

• Revenue: Total sales increased 6.0% for the three months ended March 31, 2010, compared to the prior year, driven by a 19.1% increase in selling prices which offset a 10.8% decline in home heating oil volume. For the six-month period, sales decreased 2.5% due to an 11.7% volume decline partially offset by higher prices.
• Volume: Retail home heating oil volume decreased 19.1 million gallons (10.8%) for the quarter and 33.3 million gallons (11.7%) for the six months. Declines were attributed to warmer temperatures (8.4% warmer for the quarter) and net customer attrition.
• Profitability: Net income decreased significantly year-over-year ($40.5M vs. $108.7M for the quarter). This was primarily due to a $35.8 million decrease in operating income and a $26.5 million increase in deferred income tax expense resulting from the release of a valuation allowance in the prior fiscal year.
• Derivatives: The fair value of derivative instruments resulted in a $4.7 million credit for the quarter and an $8.1 million credit for the six months, compared to a $42.3 million credit and $5.4 million credit in the prior year periods, respectively.
• Debt: Total debt decreased from $133.1 million at September 30, 2009, to $101.9 million at March 31, 2010, following the redemption of $50 million in 10.25% Senior Notes in February 2010.

Guidance, Outlook, and Risks

• Outlook: Management notes that the business is highly seasonal, with approximately 45% of volume occurring in the second fiscal quarter. Future performance depends on weather conditions, wholesale energy prices, and customer retention.
• Customer Attrition: The company lost 5,800 net accounts (1.5% of the base) in the six months ended March 31, 2010, an improvement over the 17,900 net losses in the prior year period. However, management warns that adverse economic conditions and price volatility may continue to impact customer acquisition and retention.
• Protected Price Renewals: Approximately 68% of protected price customers face annual renewal. Renewal rates may be adversely impacted as wholesale costs for the next twelve months are approximately $0.80 per gallon higher than the previous year.
• Acquisition: On May 10, 2010, the company acquired Champion Energy Corporation for approximately $50.2 million plus working capital, adding over 45,000 customers.
• Tax Structure: The Partnership is evaluating an election to be taxed as a corporation (C-Corp) in calendar 2010 or thereafter to reduce administrative costs associated with K-1 filings, though this could have short-term tax implications for unitholders.
• Liquidity: The company maintains a $240 million revolving credit facility (expandable to $290 million during heating season). As of March 31, 2010, availability was $198.6 million, and the company was in compliance with all financial covenants.

Investor Verification Checklist

• Deferred Tax Expense: Verify the impact of the $35.8 million deferred tax expense on the six-month net income, which stems from the release of a valuation allowance in the prior fiscal year rather than current operational performance.
• Volume vs. Price Sensitivity: Assess the sustainability of margins given the 10.8% volume decline driven by warmer weather and customer attrition, despite higher per-gallon selling prices.
• Derivative Accounting: Review the volatility in earnings caused by the mark-to-market accounting of derivative instruments, which are not designated as hedges under GAAP.
• Debt Redemption Costs: Confirm the $1.1 million loss recorded on the redemption of $50 million in Senior Notes and its impact on cash flow.
• Customer Retention: Monitor the renewal rates of price-protected customers in the upcoming season, given the significant increase in wholesale heating oil costs.