A Closer Look At Plains All American Pipeline's Distributable Cash Flow As Of 3Q 2012

| About: Plains All (PAA)

On November 6, 2012, Plains All American Pipeline L.P. (NYSE:PAA) reported results of operations for 3Q 2012. Revenues, operating income, net income and earnings before interest, depreciation & amortization and income tax expenses (EBITDA) for 3Q 2012 and for the trailing 12 months ("TTM") are summarized in Table 1:

Period: 3Q12 3Q11 TTM 9/30/12 TTM 9/30/11
Revenues 9,354 8,837 37,242 32,621
Operating income 247 357 1,381 1,153
Net income 173 288 1,084 852
EBITDA 470 421 1,835 1,391
Adjusted EBITDA 502 414 1,967 1,450
Weighted average units outstanding (million) 331 300 1,281 1,166

Table 1: Figures in $ Millions

PAA provided updated financial and operating guidance for 2012, increasing adjusted EBITDA guidance by $137 million to slightly over $2 billion (~7% increase vs. the guidance provided on 8/6/12 and ~22% over the full year guidance provided at the beginning of the year). This implies a projection of $520 million of adjusted EBITDA for 4Q12. PAA also provided preliminary adjusted EBITDA guidance of $1,925 million (mid-point) for 2013 on the assumption that favorable market conditions will not continue beyond 1Q13. Hence it is lower than the TTM number.

Strong performance was exhibited by all segments, particularly Supply & Logistics, as seen in Table 2:

Period: 3Q12 3Q11 TTM 9/30/12 TTM 9/30/11
Transportation segment profit 184 152 654 539
Facilities segment profit 140 95 443 327
Supply & Logistics segment profit 142 179 727 551
Total segment profit 466 426 1,824 1,417
Depreciation and amortization (210) (65) (414) (255)
Interest expense (74) (62) (277) (254)
Other income/(expense), net 4 (5) 11 (25)
Income tax benefit/(expense) (13) (6) (60) (31)
Net income 173 288 1,084 852
Less: Net income attributable to noncontrolling interests (8) (7) (33) (22)
Net income attributable to PAA 165 281 1,051 830

Table 2: Figures in $ Millions

In 3Q12 PAA wrote down a substantial portion of its investment in the Pier 400 project. The write down, amounting to ~$125 million, is reflected in Table 2 as an increase to depreciation & amortization, hence the large increase in this line item in 3Q12 and TTM ending 9/30/12 vs. the prior year periods. The Pier 400 terminal project involved development of a deepwater petroleum import terminal at Pier 400 and Terminal Island in the Port of Los Angeles for the purpose of handling marine receipts of crude oil and refinery feedstock. During 3Q12 PAA decided not to proceed with this project, hence the write down of its investment in it.

In 2011 the Supply & Logistics segment generated extraordinary profits ($647 million vs. $240 million in 2010). In a prior article I noted the drivers behind this growth. Management cautioned that the margins delivered in 2011 may not be repeated. Results for 1Q 2012 indicated a 3.8% decline in that segment's contribution compared to the prior year period. However, in 2Q12 Supply & Logistics's profit contribution jumped 81% over the prior year period. In 3Q12 we see a 21% decline. Unlike the Facilities and Transportation segments which are predominantly fee based businesses, Supply & Logistics is margin based and hence its results are more volatile.

Given quarterly fluctuations in revenues, working capital needs and other items, it makes sense to review TTM numbers rather than quarterly numbers for the purpose of analyzing changes in reported and sustainable distributable cash flows.

In an article titled Distributable Cash Flow ("DCF") I present the definition of DCF used by Plains All American Pipeline L.P. and provide a comparison to definitions used by other master limited partnerships. Using PAA's definition, DCF for the TTM ending 9/30/12 was $1,434 million ($4.48 per unit), up from $1,039 million ($3.56 per unit) in the corresponding prior year period. As always, I first attempt to assess how these figures compare with what I call sustainable DCF for these periods and whether distributions were funded by additional debt or issuing additional units.

The generic reasons why DCF as reported by the MLP may differ from sustainable DCF are reviewed in an article titled Estimating Sustainable DCF-Why and How. Applying the method described there to PAA results through 9/30/12 generates the comparison outlined in Table 3 below:

12 months ending: 9/30/12 9/30/11
Net cash provided by operating activities 1,493 1,548
Less: Maintenance capital expenditures (165) (106)
Less: Working capital (generated) - (315)
Less: Net income attributable to non-controlling interests (33) (22)
Sustainable DCF 1,295 1,105
Add: Net income attributable to non-controlling interests 33 22
Working capital used 236 -
Risk management activities (45) (61)
Proceeds from sale of assets / disposal of liabilities 19 45
Other (104) (72)
DCF as reported 1,434 1,039

Table 3: Figures in $ Millions

The principal differences between reported DCF and sustainable DCF relate working capital, risk management activities and a variety of items grouped under "Other".

Under PAA's definition, reported DCF always excludes working capital changes, whether positive or negative. My definition of sustainable DCF only excludes working capital generated (I deduct working capital consumed). Despite appearing to be inconsistent, this makes sense because in order to meet my definition of sustainability the MLP should generate enough capital to cover normal working capital needs. On the other hand, cash generated by the MLP through the liquidation or reduction of working capital is not a sustainable source and I therefore ignore it. Over reasonably lengthy measurement periods, working capital generated tends to be offset by needs to invest in working capital. In the TTM ending 9/30/12 working capital consumed cash amounting to $236 million. Management adds back this amount in deriving reported DCF while I do not.

Risk management activities aggregate numerous positive and negative adjustments. For example, the $121 million downward adjustment in inventory valuation in 2Q12 was offset by gains related to derivatives. I generally do not consider cash generated by risk management activities to be sustainable, although I recognize that one could reasonable argue that bona fide hedging of commodity price risks should be included. The PAA risk management activities seem to be directly related to such hedging, so I could be persuaded to also show what sustainable DCF would be if it included cash generated by risk management activities. But I do not do so since the amounts are relatively small in the periods being reviewed.

PAA also provided preliminary DCF guidance of $1,352 million (mid-point) for 2013 on the assumption that favorable market conditions will not continue beyond 1Q13. Hence it is lower than the TTM number.

Coverage ratios appear strong, as indicated in Table 4 below:

12 months ending: 9/30/12 9/30/11
Distributions to unitholders ($ Millions) $917 $759
Reported DCF per unit $4.48 $3.56
Sustainable DCF per unit $4.04 $3.79
Coverage ratio based on reported DCF 1.56 1.37
Coverage ratio based on sustainable DCF 1.41 1.46

Table 4

The high coverage ratios mean that PAA retains ~$400 to $500 million of excess cash flow as a source of capital and thereby reduces reliance on debt or issuance of additional units that dilute existing holders. The general partner gets 50% of any distributions in excess of $1.35 per unit per annum. Given the current distribution rate is $2.17 per unit per annum, this is a significant burden that pushes up PAA's cost of capital. The excess cash flow is therefore has a very low cost of capital compared to the cost of issuing additional units.

I find it helpful to look at a simplified cash flow statement by netting certain items (e.g., acquisitions against dispositions) and by separating cash generation from cash consumption. Here is what I see for PAA:

Simplified Sources and Uses of Funds

12 months ending: 9/30/12 9/30/11
Capital expenditures ex maintenance, net of proceeds from sale of PP&E (850) (469)
Acquisitions, investments (net of sale proceeds) (2,114) (598)
Cash contributions/distributions related to affiliates & noncontrolling interests (48) (33)
Debt incurred (repaid) - (370)
Other CF from investing activities, net (82) -
Other CF from financing activities, net (22) (13)
  (3,116) (1,483)
Net cash from operations, less maintenance capex, less net income from non-controlling interests, less distributions 410 683
Debt incurred (repaid) 1,525 -
Partnership units issued 1,198 799
Other CF from investing activities, net - 2
  3,133 1,484
Net change in cash 17 1

Table 5: Figures in $ Millions

Net cash from operations, less maintenance capital expenditures, less cash related to net income attributable to non-controlling partners exceeded distributions by $410 million in the TTM ending 9/30/12 and by $683 million in the TTM ending 9/30/11. Clearly PAA is not using cash raised from issuance of debt and equity to fund distributions. $2.7billion of the ~$3.1 billion spent (net of sale proceeds) on growth capital projects and acquisitions in the TTM ending 9/30/12 was funded by debt and the issuance of additional partnership units; the ~$400m balance was generated from internal cash flow.

PAA's per unit distributions have grown at a compounded rate of ~7.5% per annum since 2001. They grew 8.1% in the TTM ending 9/30/12 and are forecasted by management to grow 7-8% in 2013. In the TTM ending 6/30/12, distributions per unit increased by 7%.

PAA's balance sheet is strong. At September 30, 2012, long-term debt-to-capitalization ratio was 46%; total debt-to-capitalization ratio was 49%; and long-term debt-to-adjusted EBITDA ratio was 2.9x. Note that $834 million (~12.5%) of total debt is short-term debt that primarily supports hedged inventory. This debt is essentially self-liquidating from the cash proceeds when the inventory is sold.

PAA's current yield is at the low end of the MLP universe. A comparison to some of the MLPs I follow is provided in Table 6 below:

As of 11/15/12: Price Quarterly Distribution Yield
Magellan Midstream Partners (NYSE:MMP) $39.87 $0.47125 4.73%
Plains All American Pipeline $43.59 $0.54250 4.98%
Enterprise Products Partners L.P. (NYSE:EPD) $48.81 $0.65000 5.33%
Inergy (NRGY) $17.90 $0.29000 6.48%
Kinder Morgan Energy Partners (NYSE:KMP) $76.24 $1.26000 6.61%
El Paso Pipeline Partners (NYSE:EPB) $34.31 $0.58000 6.76%
Williams Partners (NYSE:WPZ) $46.38 $0.80750 6.96%
Targa Resources Partners (NYSE:NGLS) $36.00 $0.66250 7.36%
Regency Energy Partners (NYSE:RGP) $21.56 $0.46000 8.53%
Energy Transfer Partners (NYSE:ETP) $41.74 $0.89375 8.56%
Suburban Propane Partners (NYSE:SPH) $37.98 $0.85250 8.98%
Boardwalk Pipeline Partners (NYSE:BWP) $23.69 $0.53250 8.99%
Buckeye Partner (NYSE:BPL) $44.92 $1.03750 9.24%

Table 6

PAA, EPD and MMP are all outstanding MLPs. The relatively low yields notwithstanding, their operational results have been excellent and have driven up unit prices, thus generating significant capital gains for the partners. They are a solid choice for more conservative MLP investors. The only reason I would favor EPD and MMP over PAA is the capital structure - no general partner incentive distributions for EPD and MMP vs. 50% in the case of PAA. On the other hand, PAA seems to show greater unit price resiliency in the face of steep declines that have adversely affected MLPs since November 6. From 11/5/2012 to 11/15/2012 EPD fell 7.98% and MMP fell 7.19%, while PAA declined 4.07%.

Disclosure: I am long EPB, EPD, ETP, PAA, WPZ, SPH. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.