This article supplements my preliminary review of 2Q13 results and trailing twelve months ("TTM") results recently reported by Kinder Morgan Energy Partners LP (NYSE:KMP). I now evaluate the sustainability of KMP's Distributable Cash Flow ("DCF"), and assess whether KMP is financing its distributions via issuance of new units. 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.
KMP's term for earnings before depreciation and amortization ("EBDA") is "Segment earnings before DD&A and certain items." EBDA and DCF reported by KMP for the periods under review are summarized in Table 1 below:
Using KMP's definition, DCF per unit for the TTM ending 6/30/13 was $6.06, up from $5.06 for the TTM ending 6/30/12. In 2Q13 DCF per unit increased to $1.22 from $1.07 in 1Q12.
As always, I attempt to assess how the reported DCF figures compare with what I call sustainable DCF for these periods and whether distributions were funded by additional debt or issuing additional units. Given quarterly fluctuations in revenues, working capital needs and other items, it makes sense to review TTM numbers rather than just the quarterly numbers for the purpose of analyzing changes in reported and sustainable distributable cash flows.
The generic reasons why DCF as reported by an MLP may differ from sustainable DCF are reviewed in an article titled Estimating Sustainable DCF-Why and How. Applying the method described there to KMP's results with respect to sustainable cash flowing to the limited partners generates the comparison outlined in Table 2 below:
Table 2: Figures in $ Millions
The principal differences between sustainable and reported DCF numbers in Table 2 are attributable to working capital and to a host of items grouped under "Other".
Under KMP's definition, reported DCF always excludes working capital changes, whether positive or negative. In contrast, as detailed in my prior articles, I generally do not include working capital generated in the definition of sustainable DCF, but I do deduct working capital invested. Despite appearing to be inconsistent, this makes sense because, on the one hand, in order to meet my definition of sustainability, the master limited partnerships should generate enough capital to cover normal working capital needs. On the other hand, cash generated from 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. I therefore do not add working capital consumed to net cash provided by operating activities in deriving sustainable DCF. Cash consumed by working capital accounts for $215 million of the variance between reported and sustainable DCF in the TTM ended 6/30/13. As shown in Table 2, management does not deduct this cash outflow in its reported DCF number.
The "Other" items of difference between reported and sustainable DCF are detailed in Table 3 below:
In an article titled Distributable Cash Flow (DCF) I present the definition of DCF used by KMP and provide a comparison to definitions used by other MLPs. KMP's definition and method of deriving of DCF (what KMP refers to as "DCF before certain items") is complex and differs considerably from other MLPs I have covered.
The adjustments in Table 3 illustrate the complexity and subjectivity surrounding DCF calculations and highlight the difficulty of comparing MLPs based on their reported DCF numbers. An example is a $225 million gain on sale incorporated into the reported DCF number. This pre-tax gain stems from the March 14, 2013 sale by KMP of its one-third equity ownership interest in the Express pipeline system. I exclude this from my definition of sustainable DCF.
The exclusion of net income attributable to Kinder Morgan Inc. (NYSE:KMI), the general partner of KMP, from reported DCF is another example. As can be seen in Table 2, the principal component of DCF is net cash from operations. Net income plus depreciation is, of course, a major contributor to net cash from operations. But Table 2 also shows that KMP deducts the general partner's portion of net income. By doing so, KMP chooses to report a DCF number that covers only that portion attributable to limited partners. I prefer to look at total coverage ratio, one that includes all sustainable cash generated by the partnership vs. the distributions made to all the partners (general and limited). The impact of doing so is shown in Table 4 below:
But this does not conclude the coverage ratio analysis. To understand why, we must look at the capital structure of the Kinder Morgan entities. Kinder Morgan Management, LLC (NYSE:KMR) owns approximately 27.7% of KMP in the form of i-units that receive distributions in kind. Had these units received cash instead, KMP would have had to fund additional distributions totaling ~$541 million ($5.17 per share distribution times ~105 million i-units outstanding, on average) in the TTM ended 6/30/13. If we add the $541 million to the $2,802 million in distributions made in this period, the coverage ratio drops to 1.07x based on DCF as reported, and to 0.91x based on sustainable DCF.
Table 5 below presents a simplified cash flow statement that nets certain items (e.g., acquisitions against dispositions, debt incurred vs. repaid) and separates cash generation from cash consumption in order to get a clear picture of how distributions have been funded:
Simplified Sources and Uses of Funds
Net cash from operations, less maintenance capital expenditures, less cash related to net income attributable to non-partners exceeded distributions by $364 million in the TTM ended 6/30/13 and by $504 million in corresponding prior-year period. The discussion following Table 4 provides an explanation for these excesses (i.e., KMR holders receive KMP shares instead of cash).
Table 6 below compares KMP's current yield to some of the other MLPs I follow:
As of 08/03/13:
Magellan Midstream Partners (NYSE:MMP)
Enterprise Products Partners (NYSE:EPD)
Plains All American Pipeline (NYSE:PAA)
Targa Resources Partners (NYSE:NGLS)
Buckeye Partners (NYSE:BPL)
El Paso Pipeline Partners (NYSE:EPB)
Kinder Morgan Energy Partners
Regency Energy Partners (NYSE:RGP)
Boardwalk Pipeline Partners (NYSE:BWP)
Williams Partners (NYSE:WPZ)
Energy Transfer Partners (NYSE:ETP)
Suburban Propane Partners (NYSE:SPH)
In summary, I believe KMP's distribution coverage is overstated because of differences between reported and sustainable DCF and because the amounts being distributed are in effect understated given that KMR holders receive units in lieu of cash. A reader recently referred me to an interesting article titled "The Intriguing Case of KMP and KMR". The surprising result of a study reported by this article is the presence of a significant and continuing price differential between the two securities, but an absence of distinctions between them that can explain the price differential's level or its variation over time. My simplistic explanation (not backed by academic research) is that KMP productively invests a portion of the cash that would otherwise be distributed to KMR unit holders - i.e., capital expenditures, acquisitions, etc. But a portion is used to make distributions to KMP unit holders, and that portion is of value only to the recipients. As a prospective KMR unit holder, I would therefore demand a discount.
KMI which yields ~4.25% but is expected to grow distributions at ~14% per annum in 2013 vs. 2012 seems to be a better alternative.