On EPS and MLPs

Third quarter earnings season is in full swing, which means there’s dozens of press releases and conference calls from energy companies to dig through. The information gleaned from these reports is absolutely crucial to understanding trends underway in the sector.

Typically, the financial media focuses solely on three things: revenue, earnings per share (EPS) and how a company performs relative to consensus estimates.

All of those factors are important, but it's hardly the whole story for any company-- investors need to understand the comments made by a firm's management team during the conference call and accompanying question and answer (Q&A) session. In many cases, this is by far the most important part of every earnings release.

In the case of master limited partnerships (MLPs), focusing on earnings per unit--the MLP equivalent of EPS--not only provides an incomplete picture of a company's health but it's also downright misleading. Unfortunately, most news services continue to report this meaningless figure in stories on MLPs.

Over the years I’ve read numerous articles from a wide range of pundits warning investors to steer clear of MLPs because their EPS doesn't cover their quarterly distribution payouts. These misinformed warnings likely have scared plenty of individual investors away from a sector that's provided consistent, high tax-advantaged yields for years.

This quarter I’ve already received several questions from subscribers to MLP Profits and The Energy Strategist asking how MLPs can continue to pay out more than their earnings in distributions quarter after quarter. We addressed this common query in the most recent issue of MLP Profits, but given the level of interest in this group, it's important to clear up this common fallacy to a broader audience in this forum.

Earnings per share are an accounting construct and are a useful figure for evaluating results for most corporations. But earnings by definition include a large number of non-cash charges--expenses that don’t actually involve a company paying out any money.

The most common and prevalent non-cash charge to earnings for MLPs is depreciation. Most names in the group operate asset intensive businesses with expensive physical assets such as pipelines, terminals and storage facilities. Under traditional accounting, these assets depreciate over time; MLPs face astronomical depreciation charges on their huge asset bases.

But depreciation and other accounting constructs don’t represent a real cash charge or expense, nor do they affect a MLPs ability to pay distributions to unitholders. Because distributions are the group’s primary attraction, investors should focus on actual cash generated by the business--this cash forms the basis for the distributions paid to investors.

Distributable cash flow (DCF) is the most common measure of an MLP’s actual distribution power. To calculate DCF, companies add non-cash charges back into earnings and then subtract what’s known as maintenance or sustaining capital expenditure. Maintenance capital spending is an estimate of the amount required to ensure that existing assets remain in working order--that is, the actual cash amount the MLP must spend to sustain its business.

A quick look at one of the oldest and most respected MLPs of all, Enterprise Products Partners (NYSE: EPD), demonstrates the extent to which depreciation charges can skew results. The company generated net income in the second quarter of $186.6 million, but that includes a $156.7 million non-cash charge for depreciation and amortization. To calculate DCF, Enterprise added that $156.7 million non-cash charge back into earnings. The company’s actual cash cost to maintain its huge asset base in the quarter: a $33.1 million sustaining CAPEX charge.

In fact, MLP investors should actually be happy to see high depreciation charges. Depreciation and other non-cash charges are passed through to untiholders at tax time, providing a shield against tax liability. Simply put, these non-cash charges are a major reason for the tax-advantaged treatment of MLP distributions.

Let’s take a look at Enterprise Products Partner’s results over the past several quarters.

Source: Bloomberg, Enterprise Products Partners, MLP Profits

This table shows the reported earnings per unit (EPU), distributable cash flow (DCF) per unit and distributions per unit for each of the past three quarters. Based on earnings per unit, Enterprise has not covered any of its past three distributions; in the second quarter for example, Enterprise reported EPU of $0.32 and a cash distribution of $0.545 per unit for a total shortfall of $0.225 per unit. And that doesn’t even factor in the incentive distribution fee--an additional 9 cents per unit--that Enterprise must to its general partner.

Enterprise has 459 million units outstanding, so the shortfall between the company’s total earnings and total distributions was a massive $103.3 million in the second quarter alone. Logically, it would be totally impossible for a company to sustain that shortfall for even a few quarters without being forced to cut its payout. But Enterprise has done just the opposite, announcing its 21st consecutive quarterly distribution increase just a few days ago.

Logically, this simple example shows the EPU figure bears no relation to an MLP’s actual earnings or distribution power. Nonetheless, you will still see the occasional article, even from reputable websites, erroneously comparing MLPs’ payouts with EPU figures.

The distributable cash flow offers a far better metric. In the October 10 issue of Personal Finance Weekly, Strong Parents Make Healthy MLPs, I explain how the general partner’s take of an MLP’s distribution is calculated. Even after adjusting for this fee, Enterprise has easily covered its distribution in all three of the quarters listed in the table above.

A focus on earnings per unit would indicate that distributions for MLPs are unsustainably high. But the reality is far different.

The fundamental that matters most for MLPs is the sustainability of and potential growth in distributions over time. As a whole, MLPs have survived the financial crisis in excellent shape; the best-positioned names have held or continued to boost their distributions over the past year.

That performance has continued in the third quarter: 20 of the 48 MLPs that comprise the Alerian Index have announced their third quarter distributions. Of that total, 13 will pay more in the current quarter than one year ago and 10 have boosted their payouts sequentially, paying more in the current quarter than they did three months ago.

Only one of the 20 MLPs has announced an outright distribution cut and that MLP, Dorchester Minerals LP (NSDQ: DMLP) varies its payout every quarter based on shifting commodity prices. Dorchester's inconsistent payout and commodity leverage is the main reason we rate the stock a "Hold" in our "How They Rate" table, which includes advice on over 100 MLPs.

Comments

[Karl Glazier:]

By adding back depreciation, aren't you assuming the assets will never have to be replaced?
If the assets are depreciated over a shorter period than their expected life, an adjustment should be made accordingly.
But adding back all depreciation is not reflecting reality.
If I am counting only the maintenance expenses on my car, I am fooling myself.

Nov 01 02:07 PM

[Elliott Gue:]

Thanks for the comment. There are refineries in the US that have been in operation for a century, long beyond what would be considered the useful life of such an asset. However, over the years, every piece of this equipment has been replaced and upgraded, likely several times.

To use your example, the effect would be the same as you replacing every part of your car gradually over time including the body itself.

Maintenance expenses from an MLP are designed to reflect normal replacement and upgrading of equipment surrounding the asset over time. It's likely that these pipelines will not be replaced if, by replacement, you mean totally dismantled, scrapped and rebuilt.

Adding back depreciation and then factoring in a maintenance expense that reflects the need for ongoing replacement and upgrading is the most relevant measure of an MLP's earnings power in my view. Of course, as I noted in the article, one has to account for the reasonableness of the maintenance expenses the particular MLP uses to calculate DCF.


On Nov 01 02:07 PM Karl Glazier wrote:

> By adding back depreciation, aren't you assuming the assets will
> never have to be replaced?
> If the assets are depreciated over a shorter period than their expected
> life, an adjustment should be made accordingly.
> But adding back all depreciation is not reflecting reality.
> If I am counting only the maintenance expenses on my car, I am fooling
> myself.

Nov 01 02:52 PM

[mbkelly75:]

I like MLPs - thank you for the article and your work. I will refer others to this article when they ask me the same question. Well done and clearly written. Thank you once again.

Nov 01 09:58 PM

[elliot_mllr:]

Moreover, depreciation is a P & L charge, as are depletion allowances, but when a new capital asset is needed (pipeline, refinery, etc.) that is a balance sheet item and does not impact the P & L or DCF. That capital asset is paid for by debt, new equity or a combination of those.


On Nov 01 02:52 PM Elliott Gue wrote:

> Thanks for the comment. There are refineries in the US that have
> been in operation for a century, long beyond what would be considered
> the useful life of such an asset. However, over the years, every
> piece of this equipment has been replaced and upgraded, likely several
> times.
>
> To use your example, the effect would be the same as you replacing
> every part of your car gradually over time including the body itself.
>
>
> Maintenance expenses from an MLP are designed to reflect normal replacement
> and upgrading of equipment surrounding the asset over time. It's
> likely that these pipelines will not be replaced if, by replacement,
> you mean totally dismantled, scrapped and rebuilt.
>
> Adding back depreciation and then factoring in a maintenance expense
> that reflects the need for ongoing replacement and upgrading is the
> most relevant measure of an MLP's earnings power in my view. Of course,
> as I noted in the article, one has to account for the reasonableness
> of the maintenance expenses the particular MLP uses to calculate
> DCF.

Nov 02 10:49 AM

[elliot_mllr:]

See my comment to Mr. Gue's reply to you.


On Nov 01 02:07 PM Karl Glazier wrote:

> By adding back depreciation, aren't you assuming the assets will
> never have to be replaced?
> If the assets are depreciated over a shorter period than their expected
> life, an adjustment should be made accordingly.
> But adding back all depreciation is not reflecting reality.
> If I am counting only the maintenance expenses on my car, I am fooling
> myself.

Nov 02 10:50 AM

[TJ Schoenlein:]

Now this is the type of informative posting I really enjoy seeing here. It's clear, understandable and simply put.
Yes, I'm a big fan of MLP's, They have been my bread & butter during the financial abyss.

Nov 10 12:53 AM

[metal27:]

Pipeline operators exist in a nether world where assets have useful lives much longer than the lives assigned to them by the accountants. In addition, there is little in the way of technological obsolescence. Still, investors should keep a wary eye on the level of "maintenance cap-ex" to make sure it is adequate. That said, the article reflects my experience as an owner of several MLPs for many years--DCF is a better gauge than EPS.

What a relief to find a writer on SA who actually knows what they are talking about!

Nov 18 01:01 AM