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This article analyzes the most recent quarterly and the trailing 12 months ("TTM") results of Plains All American Pipeline L.P. (NYSE:PAA) and looks under the hood to properly ascertain sustainability of Distributable Cash Flow ("DCF"). The task is not easy because the definitions of DCF and adjusted EBITDA, the primary measures typically used by master limited partnerships ("MLPs") to evaluate their operating results, are complex. In addition, each MLP may define these terms differently, making comparison across MLPs very difficult. Nevertheless, this is an exercise that must be undertaken to ascertain what portions of the distributions being received are really sustainable. For example, MLPs distributions that are funded by issuing debt or through issuance of additional partnership units cannot be considered sustainable. In a downside scenario, MLPs that finance distributions from unsustainable sources or are totally reliant on debt and equity to finance growth capital will suffer significantly greater price deterioration.

Revenues, operating income, net income and earnings before interest, depreciation and amortization and income tax expenses (EBITDA) for the periods under review are presented in Table 1 below. Given quarterly fluctuations in revenues, working capital needs and other items, a review of TTM numbers tends to be more meaningful than quarterly numbers for the purpose of analyzing changes in reported and sustainable distributable cash flows. However, I present both:

Click to enlarge images.

Table 1: Figures in $ Millions

On Nov. 5, 2012, the midpoint of the preliminary adjusted EBITDA guidance for 2013 was $1,925 million. On Feb. 6, 2013, PAA increased its 2013 guidance to $2,025 million, but still a lower number than the $2,107 million achieved in 2012. This was because management looked at 2012 as a year in which market conditions were extremely favorable for the Supply and Logistics segment, and assumed there would be a return to baseline. On May 7, 2013, PAA again increased its 2013 guidance to $2,160 million (midpoint) because rather than returning to baseline, Supply and Logistics segment performance improved dramatically in Q1 2013, as shown in Table 2 below:

Table 2: Figures in $ Millions

Unlike the Facilities and Transportation segments, which are predominantly fee based businesses, Supply and Logistics is margin based and hence its results are more volatile. This segment has benefited from higher volumes and higher margins. Increased drilling activities and increased production of oil and natural gas liquids ("NGL") in the areas it services (Bakken, Eagle Ford, West Texas, Western Oklahoma, and Texas Panhandle) drove higher volumes. Margins were driven higher because production volumes exceed existing pipeline takeaway capacity in these regions, so customers will pay more to whoever can get their products to markets. Supply/demand imbalances also increased the volatility of historical differentials for various grades of crude oil and also impacted the historical pricing relationship between NGL and crude oil. Market conditions in 2011, 2012, and Q1 2013 were thus highly favorable to the Supply and Logistics segment. Management is cautioning that these conditions may not be repeated going forward and that a normalization of margins will occur as the logistics challenges are addressed.

The generic reasons why DCF as reported by an MLP may differ from what I call sustainable DCF are reviewed in an article titled "Estimating sustainable DCF - Why And How." PAA's definition of DCF and a comparison to definitions used by other MLPs are described in an article titled "Distributable Cash Flow." Using PAA's definition, DCF for the TTM ended March 31, 2013, was $1,766 million ($4.85 per unit), up from $1,253 million ($4.09 per unit) in the prior-year period.

Table 3 below shows sustainable DCF increased substantially on a TTM basis. It also provides a comparison between reported and sustainable DCF:

Table 3: Figures in $ Millions

The principal differences between reported DCF and sustainable DCF relate to 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.

A good example of this is provided by the working capital lines for the TTM ending March 31, 2012, and 2011 in Table 3. In the TTM ending March 31, 2012, working capital consumed $175 million of cash, principally due to an increase in crude oil inventories, while in the TTM ended March 31, 2011, crude oil inventories were liquidated and thus generated a very significant amount of cash ($638 million). Management adds back working capital consumed in deriving reported DCF, while I do not.

The $81 million adjustment for risk management activities in the TTM ending March 31, 2013, consists primarily of adjustments from derivative activities relating to interest rate swaps, foreign currency exchange rate changes and commodity price fluctuations. Management adds back these losses in calculating reported DCF. I do not do so when calculating sustainable DCF. The $223 million adjustment for "Other" items in the TTM ending March 31, 2013, consists of non-cash compensation, losses on inventory valuation adjustments, and distributions in excess of earnings from unconsolidated investments. It includes a particularly large ($121 million) inventory valuation adjustment in Q2 2012. Again, management adds back these items in calculating reported DCF. I do not do so when calculating sustainable DCF.

On May 7, 2013, PAA increased DCF guidance for 2013 to a midpoint of $1,557 million (up from $1,437 million guidance provided last February), but still essentially unchanged from the $1,550 million achieved in 2012 for the same reasons outlined in the discussion of Tables 1 and 2. Table 3 above shows the differences between reported and sustainable DCF can be pronounced. This, of course, impacts coverage ratios, as indicated in Table 4 below. TTM numbers tends to be more meaningful than quarterly numbers for the purpose of coverage ratios. However, I present both:

Table 4: $ Millions, Except Coverage Ratios

These coverage ratios are extraordinarily high. Perhaps management is being overly cautious in not sharply increasing distributions. But I see the logic of treating the results generated by the Supply and Logistics segment as "too good to continue" and am pleased with management's conservative bias (to say nothing of the outstanding performance over the past two years).

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

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 $705 million in the TTM ending March 31, 2013, and by $1,101 million in the prior year period. Clearly PAA is not using cash raised from issuance of debt and equity to fund distributions. On the contrary, the excess cash generated constitutes a significant source of capital for PAA and enables it to reduce reliance on the issuance of additional partnership units that dilute existing holders, or issuance of debt to fund expansion projects.

This is of particular importance to PAA limited partners because issuing new units is very expensive due to the general partner's incentive distribution rights ("IDR"). The IDRs entitle the general partner to 48% of amounts distributed in excess of $0.3375 per unit. Therefore, at the current distribution rate of $0.575 per quarter, each additional unit issued consumes ~$0.90 of DCF per quarter. This is a heavy burden that pushes up PAA's cost of capital. The excess cash flow has a very low cost of capital compared to the cost of issuing additional units.

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 May 10, 2013:

Price

Quarterly Distribution

Yield

Magellan Midstream Partners (NYSE:MMP)

$52.88

$0.50750

3.84%

Plains All American Pipeline

$59.34

$0.57500

3.88%

Enterprise Products Partners (NYSE:EPD)

$61.65

$0.67000

4.35%

Inergy (NRGY)

$23.89

$0.29000

4.86%

El Paso Pipeline Partners (NYSE:EPB)

$43.77

$0.62000

5.67%

Targa Resources Partners (NYSE:NGLS)

$48.27

$0.69750

5.78%

Kinder Morgan Energy Partners (NYSE:KMP)

$88.10

$1.30000

5.90%

Buckeye Partners (NYSE:BPL)

$67.11

$1.05000

6.26%

Williams Partners (NYSE:WPZ)

$52.51

$0.84750

6.46%

Regency Energy Partners (NYSE:RGP)

$26.63

$0.46000

6.91%

Boardwalk Pipeline Partners (NYSE:BWP)

$30.36

$0.53250

7.02%

Suburban Propane Partners (NYSE:SPH)

$49.52

$0.87500

7.07%

Energy Transfer Partners (NYSE:ETP)

$49.80

$0.89375

7.18%

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. My concerns with PAA revolve around capital structure and the sharper run-up in its unit price. From a capital structure standpoint, EPD and MMP are not burdened by IDRs, while PAA pays 48% at the margin.

While the IDR burden is less of an issue with respect to organic growth (because of the low ratio of required investment to the expected cash flow it will generate), it is a major factor in large acquisitions -- which, under current market conditions, command high multiples and require lengthy time periods to generate the projected synergies. From a price per unit standpoint, year to date PAA's unit price is up ~31% vs. ~23% for EPD and ~22% for MMP. For additional metrics comparing the MLPs in Table 6 see "Performance Comparison Of Selected MLPs."

Source: A Closer Look At Plains All American Pipeline's Distributable Cash Flow As Of Q1 2013