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This article analyzes recent quarterly and annual results of Targa Resources Partners LP (NYSE:NGLS), looks "under the hood" to properly ascertain sustainability of Distributable Cash Flow ("DCF") and assesses whether NGLS is financing its distributions via issuance of new units or debt.

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. But it is an exercise that must be undertaken, in conjunction with evaluating an MLP's growth prospects, because sustainable distributions coverage provides some protection in a downside scenario. When faced with such a scenario, MLPs that cannot maintain their distributions, or are totally reliant on debt and equity to finance growth capital, are likely to suffer significantly greater price deterioration.

NGLS operates in two primary divisions. The first, Natural Gas Gathering and Processing, gathers and processes raw natural gas (produced from oil and gas wells) into merchantable natural gas by extracting natural gas liquids ("NGLs") and removing impurities. It consists of segments 1 and 2 outlined below. The second primary division, NGL Logistics and Marketing (the Downstream Business), consists of segments 3 and 4 outlined below:

  1. Field Gathering and Processing: This segment's assets are located in North Texas, the Permian Basin of West Texas and New Mexico, and North Dakota. Crude oil and natural gas gathering, terminals and processing assets in North Dakota were added following the 12/31/12 Badlands acquisition.
  2. Coastal Gathering and Processing: This segment's assets are located in the onshore and near offshore regions of the Louisiana Gulf Coast and the Gulf of Mexico.
  3. Logistics Assets: This segment transports, stores and fractionates mixed NGLs into finished NGL products (ethane, propane, normal butane, isobutane and natural gasoline). It also provides logistics services for exporting Liquefied Petroleum Gas ("LPG") and storing refined petroleum products and crude oil. This segment's assets are predominantly located in Mont Belvieu, Texas and Southwestern Louisiana.
  4. Marketing and Distribution: This segment markets and distributes raw and finished NGLs produced by Gathering and Processing. Its activities encompass marketing and purchasing NGLs; marketing and supplying NGLs for refinery customers; transporting, storing and selling propane and providing related propane logistics services to multi-state retailers, independent retailers and other end-users.

NGLS derives its revenues principally from percent-of-proceeds ("POP") contracts, under which it receives a portion of the natural gas and/or natural gas liquids as payment for its gathering and processing services. POP contracts share price risk between the producer and processor. Operating income generally increases as natural gas prices and natural gas liquid prices increase, and decreases as they decrease.

Revenues grew significantly in the second half of 2013, as shown in Table 1 below. Growth was driven by commodity sales, principally NGLs and natural gas, as shown in Table 1 below:

(click to enlarge) Table 1: Revenues; figures in $ Millions; Source: Company 10-Q, 10-K, 8-k filings

The fee portion of the revenue stream is important, because it serves to mitigate the impact of fluctuations in commodity prices on NGLS' results and to enhance both gross and operating margin percentages. Also, a large portion of the fee income revenues flows through directly to the operating margin line.

Operating margin, the key metric used by management to evaluate performance of its business segments, also showed substantial growth in the second half of 2013. Contribution to operating margin by each segment is shown in Table 2. Note that "Other" reflects results of commodity hedging activities included in operating margin.

(click to enlarge) Table 2: Figures in $ Millions; Source: Company 10-Q, 10-K, 8-k filings

Favorable comparisons in the second half of 2013 vs. prior-year periods were driven by higher fractionation fees and increased liquefied petroleum gas ("LPG") exports from Logistics Assets' growth projects that came online in the third and fourth quarters. They were also driven by the increased volumes in the Field Gathering and Processing segment, including from Targa Badlands (which began contributing to operating margins in 2013). This segment also benefited from higher natural gas prices and NGL prices.

As a reminder, the $976 million Saddle Butte Pipeline acquisition (renamed Targa Badlands) closed on December 31, 2012. It positions NGLS to participate in the Bakken Shale infrastructure build-out and to generate fee-based revenue by gathering, processing and transporting natural gas and crude oil from wellheads in North Dakota to various takeaway options (including LPG exports).

Higher operating margin drove improvements in operating income (operating margin differs from operating income in that it excludes expense depreciation and amortization, general and administrative, and certain other expenses), as well as in earnings before interest, depreciation & amortization and income tax expenses (EBITDA).

Management makes certain adjustments to EBITDA to better measure the partnership's ability to generate sufficient cash to support distributions. Adjusted EBITDA excludes items such as: gains or losses on asset disposals and debt repurchases/redemptions; non-cash risk management activities related to derivative instruments; changes in the fair value contingent consideration; and the non-controlling interest portion of depreciation and amortization expenses. The improvements in Adjusted EBITDA in the second half of 2013 can be seen in Table 3 below:

(click to enlarge) Table 3: Figures in $ Millions (except per unit amounts and % change); Source: Company 10-Q, 10-K, 8-k filings

NGLS slightly exceeded its 2013 Adjusted EBITDA guidance ($629 million vs. $625 million, the mid-point of management's range).

Distributable cash flow ("DCF") reported by NGLS and distributions for the periods under review are presented in Table 4 below:

(click to enlarge)Table 4: Figures in $ Millions (except per unit amounts and % change); Source: Company 10-Q, 10-K, 8-k filings

In 2013, DCF as reported by NGLS grew at a slower rate than distributions per unit. To me, this serves as a note of caution.

In an article titled "Distributable Cash Flow", I present NGLS' definition of DCF and also provide definitions used by other MLPs. Based on this definition, NGLS' DCF per unit for 2013 was $440 million ($4.17 per unit), up from $354 million ($3.92 per unit) in the prior-year period.

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". Applying the method described there to NGLS' results generates the comparison between reported and sustainable DCF presented in Table 5 below:

(click to enlarge) Table 5: Figures in $ Millions; Source: Company 10-Q, 10-K, 8-k filings, author estimates & calculations

The principal differences between reported and sustainable DCF for the periods reviewed are attributable to working capital consumed and various items grouped under "Other".

Under NGLS' 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 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 the $160 million of working capital consumed to net cash provided by operating activities in deriving sustainable DCF for 2013 (likewise with respect to the $58 million in 4Q13).

Under "Other", I group items such as non-cash compensation and accretion of retirement obligations that management adds back to derive reported DCF but I do not included in my definition of sustainable DCF.

Distributions, reported DCF, sustainable DCF and the resultant coverage ratios are as follows:

(click to enlarge) Table 6: Figures in $ Millions, except per unit amounts and coverage ratios; Source: Company 10-Q, 10-K, 8-k filings, author estimates & calculations

In a prior article, I noted that NGLS was acquiring Targa Badlands at an expensive EBITDA multiple and that the effect would be dilutive. Management expected distribution coverage to be 1.0x in 2013 due to the dilutive effect of Badlands. If you exclude the $160 million used to fund working capital needs, the 1.1x distribution coverage in 2013 was better than expected.

Table 7 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) Table 7: Figures in $ Millions; Source: Company 10-Q, 10-K, 8-k filings, author estimates & calculations

Net cash from operations, less maintenance capital expenditures, less cash related to net income attributable to non-partners fell $66 million short of covering distributions in 2013; this compares to a $112 million excess that was generated in the prior-year period. NGLS is therefore funding its working capital needs and distributions in part, albeit a small part, using cash raised from issuing debt and equity and from other financing activities. In 2013, the partnership did not generate excess cash that would enable it to reduce reliance on the issuance of additional partnership units that dilute existing holders, or issuance of debt to fund expansion projects.

Table 8 below provides selected metrics comparing NGLS to some of the other MLPs I follow based on the latest available trailing twelve months' ("TTM") results:

As of 02/14/14:

Price

Current Yield

TTM

EBITDA

EV / TTM EBITDA

2014 EBITDA

Guidance

Buckeye Partners (NYSE:BPL)

$73.69

5.90%

627

17.7

Boardwalk Pipeline Partners (NYSE:BWP)

$13.38

2.99%

689

9.5

650

El Paso Pipeline Partners (NYSE:EPB)

$30.99

8.39%

1,113

9.7

1,200

Enterprise Products Partners (NYSE:EPD)

$66.84

4.19%

4,685

17.0

Energy Transfer Partners (NYSE:ETP)

$53.94

6.82%

3,587

10.0

Kinder Morgan Energy Partners (NYSE:KMP)

$79.77

6.82%

5,165

10.5

5,900

Magellan Midstream Partners (NYSE:MMP)

$68.75

3.40%

845

21.5

936

Targa Resources Partners

$55.32

5.40%

661

13.5

750

Plains All American Pipeline (NYSE:PAA)

$53.97

4.56%

2,168

11.9

2,150

Regency Energy Partners (NYSE:RGP)

$26.53

7.16%

444

19.2

Suburban Propane Partners (NYSE:SPH)

$44.56

7.85%

307

12.6

Williams Partners (NYSE:WPZ)

$50.16

7.12%

2,290

12.9

Table 8: Enterprise Value ("EV") and TTM EBITDA figures in $ Millions; Source: Company 10-Q, 10-K, 8-k filings, author estimates & calculations

EBITDA data in Table 8 is as of December 2013, except for ETP, RGP and WPZ that are as of September 2013.

It would be more meaningful to use 2014 EBITDA estimates rather than TTM numbers, but not all MLPs provide guidance for this year. Of those I follow, the ones that I have seen do so are included in the table.

NGLS generated $215 million in 4Q13, an impressive performance that set a new quarterly record. I was concerned that the 3Q13 elimination of a contingent liability relating to the Badlands acquisition could be an indication that Badlands is not yet achieving the high-end of management's original expectations. But even if that is the case, Badland's performance appears to be strong.

Management provided midpoint Adjusted EBITDA guidance of $750 million for 2014 based on commodity price assumptions for the year of $3.75 per million British thermal units ("MMBtu") for natural gas, $95 per barrel for crude oil and, on average, $0.90 per gallon for NGLs. Under these assumptions, a $0.05 per gallon change in the price of NGLs would correspondingly change 2014 Adjusted EBITDA by approximately 2%. NGLS expects distribution coverage to be approximately 1.0x in 2014. This coverage incorporates targeted increases in distributions of 7%-9% in 2014 compared to 2013.

Growth capital expenditures totaled $954 million in 2013 and are projected at $650 million in 2014. ~$1 billion in growth capital investments will be placed into service in 2014, the bulk of which will provide primarily fee-based margin. These projects will contribute towards the $750 million Adjusted EBITDA target for 2014 ($121 million above the $629 million actually achieved in 2013).

NGLS is burdened by the high cost of the Incentive Distribution Rights ("IDRs") payable to Targa Resources Corp. (NYSE:TRGP), the general partner. NGLS pays 48% of each marginal dollar of DCF it generates to TRGP. For example, in order to achieve a 7% increase in distributions to limited partners (to use round numbers, say from $3.00 to $3.20 per annum), NGLS needs to generate a $0.385 (~13%) increase in DCF per limited partner unit.

Other factors to consider include NGLS' still significant exposure to commodity prices, its fairly low DCF coverage ratio, and that it appears to be growing its DCF as a slower rate than it is growing its distributions. I also believe developing the infrastructure for the Bakken shale is more risky than the Texas shale plays and the Marcellus shale. However, management's projection that 2Q13 would be an inflection point for NGLS turned out to be on the money, and the current unit price is only moderately higher (~$55 per unit) today than it was 3 months ago (~$52 per unit). For investors wishing to increase their exposure to MLPs, this may be an opportune time to add to or initiate positions in NGLS or, alternatively, in TRGP, whose dividends are projected to increase by at least 25% in 2014.

Source: A Closer Look At Targa Resources Partners' Distributable Cash Flow As Of Q4 2013