A Closer Look At Plains All American Pipeline's Distributable Cash Flow As Of Q3 2013

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 |  About: Plains All American Pipeline, L.P. (PAA), Includes: EPD, MMP
by: Ron Hiram

This article analyzes the most recent quarterly and the trailing twelve 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.

PAA transports, stores and markets crude oil and refined products; it also transports, processes, stores and markets natural gas liquids ("NGL"). Through its 2% general partner interest and 61% limited partner interest in PAA Natural Gas Storage, L.P., (NYSE:PNG), it also owns and operates natural gas storage facilities. PAA's operations are managed through three operating segments: Transportation, Facilities (which includes PNG), and Supply & Logistics.

Revenues, operating income, net income and earnings before interest, depreciation and amortization and income tax expenses [EBITDA], and DCF 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:

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Table 1: Figures in $ Millions

On 8/5/13, PAA increased its 2013 Adjusted EBITDA guidance by $30 million (to $2,190 million at mid-point). On 11/5/13, this was further revised up by ~$50 million to $2,240 million. Management also provided a preliminary 2014 Adjusted EBITDA guidance of $2,175 million at mid-point. To understand why Adjusted EBITDA guidance in 2014 is below that of 2013 requires a closer look at PAA's operating segments.

The principal activities conducted by PAA's operating segments are:

  1. Transportation: fee-based activities associated with transporting crude oil and NGL on pipelines, gathering systems, trucks and barges;
  2. Facilities: fee-based activities associated with providing storage, terminal and throughput services for crude oil, refined products, natural gas and NGL, NGL fractionation and isomerization services and natural gas and condensate processing services; and
  3. Supply & Logistics: margin based activities associated with sale of gathered and bulk-purchased crude oil, as well as sales of NGL volumes purchased from suppliers (including the sale of additional barrels exchanged through buy/sell arrangements entered into to supplement the margins of the gathered and bulk-purchased volumes).

Segment performance is shown in Table 2 below:

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Table 2: Figures in $ Millions

Unlike the Facilities and Transportation segments that are predominantly fee-based businesses, a substantial portion of Supply & Logistics is margin-based, and hence results are more volatile. Management looked at 2012 as a year in which market conditions were extremely favorable for the Supply and Logistics segment. In a prior article, I noted the drivers behind the extraordinary performance generated by this segment. Management rightly predicted there would be a "return to baseline" in 2013. This occurred in 2Q13 and 3Q13 as infrastructure additions began to relieve certain of the transportation constraints that had previously created opportunities for favorable crude oil margins benefiting Supply & Logistics. The "return to baseline" also explains why Adjusted EBITDA guidance in 2014 is below that of 2013. Although Supply & Logistics' performance still shows improvement on a TTM basis vs. the prior year period, this is mainly due to outstanding results in 1Q13.

A ~$125 million, one-time, asset impairment charge resulting from PAA abandoning a project called Pier 400 (involving development of a deep-water petroleum import terminal in the Port of Los Angeles) was reflected as an increase to depreciation & amortization in 3Q12; hence the large decrease in this line item in 3Q13 and TTM ending 9/30/13 vs. the prior year periods.

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 9/30/13 was $1,688 million ($4.95 per unit), up from $1,434 million ($4.48 per unit) in the prior year period.

Table 3 below shows sustainable DCF increased by ~$316 million (24%) on a TTM basis. Over the same period, reported DCF by $254 million (18%). The table provides a comparison between the components of reported and sustainable DCF:

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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. 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.

The $107 million adjustment for risk management activities in the TTM ending 9/30/13 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 $62 million adjustment for "Other" items in the TTM ending 9/30/13 consists of non-cash compensation and distributions in excess of earnings from unconsolidated investments (consisting of (NYSE:A) an approximate 37% interest in PNG and (NYSE:B) a 25% interest in SLC Pipeline LLC). The prior year period includes a particularly large ($121 million) inventory valuation adjustment made in 2Q12. Again, management adds back these items in calculating reported DCF. I do not do so when calculating sustainable DCF.

As indicated by Table 3, 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:

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Table 4: $ millions, except coverage ratios

The extraordinarily high coverage ratios are expected to drop as the effect of the above-normal results produced by the Supply & Logistics segment in 2012 and 1Q13 dissipates. Management rightfully did not sharply increase distributions in light of the evaluation that the profit generated by this segment is "too good to continue." While coverage in 3Q13 is below 1.00, for the TTM ending 9/30/13, distributions increased in line with the increase in DCF. In that period, per unit DCF increased 10.5%, while distributions declared increased 10.4% over the prior year period. The 3Q13 distribution of $0.60 represents a 10.6% increase over the 3Q12 amount and a 2.1% increase over the 2Q13 amount.

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

(click to enlarge)Click to enlargeTable 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 $667 million in the TTM ending 9/30/13 and by $410 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. Absent significant acquisition activity, management does not expect to execute an equity offering during the remainder of 2013 or 2014 (although funds will be raised via the continuous equity offering program).

On 10/22/13 PAA signed an agreement to acquire ~33 million of the publicly held shares of PNG. PAA owns the rest of the 61.2 million PNG common units, as well as the general partner of PNG and all the subordinated units of PNG. PAA will issue 0.445 units for each of these ~33 million PNG units, or a total of 14.7 million PAA units. At PAA's current unit price ($50.70 as of 11/8/13) the value amounts to ~$745 million.

My back-of-the-envelope analysis indicates PAA has built in some margin of safety on this deal. After it is consummated, PAA will again own 100% of PNG's equity, but that equity should be worth ~$600 million more than it was in May 2010, the time of PNG's initial public offering ("IPO") due to the Southern Pines acquisition of February 2011. In addition, PAA received ~$270 million in proceeds from PNG's IPO. The rough total of value received and to be received, without taking into consideration distributions, incentive distribution rights ("IDRs"), various fees paid by PNG to PAA and any changes in the value of PNG's assets, is therefore $870 million. The $745 million purchase price therefore seems to me to incorporate some margin of safety for PAA in the event the natural gas storage market is slow to recover, in which case "the next several years will be challenging for PNG…".

I view the IPO of Plains GP Holdings LP (NYSE:PAGP) as a negative development for PAA unitholders. The reasons are set forth in a prior article dated August 19, 2013 and are briefly recapped below.

  1. It reduces the likelihood that PAA's significant cost of capital disadvantage when compares to peers like Enterprise Products Partners (NYSE:EPD) and Magellan Midstream Partners (NYSE:MMP) will be addressed.
  2. PAA's general partner has, in the past, approved IDR reductions totaling ~$106 million in the aggregate in connection with the closing of four prior PAA acquisitions. Such approvals may be harder to obtain from a GP that is a publicly traded corporation.
  3. Public ownership of the general partner may also lead to acquisitions of general partner interests in other (i.e., non-PAA) MLPs. This could lead to reductions in the time and attention devoted to running PAA.

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 11/08/13:

Price

Quarterly Distribution

Yield

Magellan Midstream Partners (MMP)

$60.73

$0.55750

3.67%

Enterprise Products Partners (EPD)

$61.81

$0.69000

4.47%

Plains All American Pipeline

$50.70

$0.60000

4.73%

Targa Resources Partners (NYSE:NGLS)

$49.85

$0.73250

5.88%

El Paso Pipeline Partners (NYSE:EPB)

$40.99

$0.65000

6.34%

Buckeye Partners (NYSE:BPL)

$67.38

$1.07500

6.38%

Kinder Morgan Energy Partners (NYSE:KMP)

$80.56

$1.35000

6.70%

Energy Transfer Partners (NYSE:ETP)

$52.68

$0.90500

6.87%

Williams Partners (NYSE:WPZ)

$49.95

$0.87750

7.03%

Regency Energy Partners (NYSE:RGP)

$25.14

$0.47000

7.48%

Boardwalk Pipeline Partners (NYSE:BWP)

$28.02

$0.53250

7.60%

Suburban Propane Partners (NYSE:SPH)

$45.75

$0.87500

7.65%

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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. My concerns with PAA revolve around capital structure. 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 relatively low ratio of required investment to the expected cash flow it will generate), it is a major factor in the case of large acquisitions that, under current market conditions, command high multiples and require lengthy time periods to generate the projected synergies. On the other hand, on a year-to-date basis, PAA's unit price is up only ~12% vs. much steeper appreciation for the other two (~23% for EPD and ~41% for MMP).

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