This article supplements my preliminary review of 4Q13 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 or debt.
DCF and "Adjusted EBITDA" are the primary measures typically used in master limited partnerships ("MLPs") to evaluate their operating results. However, each MLP may define these terms differently, making comparisons difficult. In addition, DCF as reported may include non-sustainable items. Evaluating an MLP based on sustainable DCF is an exercise that must be undertaken (in conjunction with an evaluation of its 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.
KMP's reported DCF per unit for 2013 was $5.39 ($2,244 million in total), up from $5.07 ($1,778 million in total) for 2012. The method used by KMP to derive DCF is shown in Table 1 below:
Two items of particular note with respect to Table 1 are the adjustments labeled "Certain Items" and payments made to Kinder Morgan, Inc. (NYSE:KMI), KMP's general partner. The major reason for the increase in such payments is the higher incentive distribution rights ("IDRs") payment by KMP to KMI. The IDRs claim a significant portion of KMP's net income and cash flows. They totaled $1,632 million in 2013, an increase of approximately $310 million vs. 2012. KMI's IDRs entitle it to 48% of KMP's marginal DCF (i.e., to 48% of each incremental dollar of DCF generated by KMP). KMI also owns 11.6% of KMP's limited partner units as well as a 2% general partner's interest.
KMP's list of the "Certain Items" that are excluded in deriving DCF illustrate the ability of each MLP to adopt a unique approach to defining DCF. Table 2 shows the wide range of items that can be included in the list and provides a breakdown of each for the periods under review:
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 3. This table indicates that in 2013 management prudently did not increase distributions faster than the rate of increase in EBDA.
Table 3: Figures in $ Millions, except per unit amounts
In 4Q13 distribution growth exceeded growth in EBDA compared to 4Q12. Although this has occurred periodically in the past, it is nevertheless a development that bears watching because of its implications for sustainability of distributions.
In an article titled "Distributable Cash Flow" I present KMP's definition of DCF and definitions used by other MLPs. 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". A comparison between KMP's reported and sustainable DCF is presented in Table 4 below:
The principal differences between sustainable and reported DCF are attributable to working capital and to a host of items grouped under "Other".
Most of the MLPs I follow exclude working capital changes, whether positive or negative, when deriving their reported DCF numbers. 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. Table 4 indicates that liquidation of working capital generated a substantial portion ($320 million) of the DCF reported in 2013.
The "Other" item of difference between reported and sustainable DCF is detailed in Table 5:
The adjustments in Table 5 further 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 $224 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.
Another example is depreciation. In deriving sustainable DCF, I use the depreciation number appearing on the cash flow statement. KMP on the other hand reports a DCF number that is derived using a larger depreciation factor. KMP adds back its proportionate share of the joint ventures' depreciation, depletion and amortization expenses and subtracts its proportionate share of the joint ventures' sustaining capital expenditures.
Coverage ratios based on KMP's methodology are shown in Table 6 below:
KMP's method of determining DCF differs from most of the non-Kinder Morgan MLPs I follow and is another major source of difference between reported and sustainable DCF. As shown in Table 4, KMP deducts the general partner's portion of net income in deriving DCF. It thus adopts a narrow definition, one that includes only that portion of DCF that is attributable to limited partners. The more common and broader definition of coverage is one whose numerator is total DCF (available to both LPs and GP) and whose denominator is the total of all distributions made to all the stakeholders, including the general partner.
Given KMP's narrow definition, investors should bear in mind that but for the temporary IDR waivers granted by KMI, reported coverage would have been lower. In 2013 these waivers included $75 million related to common units issued to finance the May 2013 Copano acquisition and $4 million related to other acquisitions. In 2012 the waivers amounted to $26 million.
Also, the DCF coverage analysis is not complete without adjusting for the capital structure of the Kinder Morgan entities. Kinder Morgan Management, LLC (NYSE:KMR) owns approximately 28.3% of KMP in the form of i-units that receive distributions in kind, not in cash (i.e., i-unit holders receive additional KMP units in lieu of cash). In my opinion, in order to make KMP's coverage ratios comparable to other MLPs that do not have the equivalent of i-units, an adjustment is required so that i-units are deemed to have received the same distributions as common units.
Coverage ratios based on reported DCF can differ significantly from those based on sustainable DCF, as shown in Table 7:
Table 8 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 $377 million in 2013, and by $466 million in 2012. However, Table 7 and the discussion preceding it explain how, despite these excesses, sustainable CDF coverage is below 1x. While in the periods reviewed KMP did not fund distributions by issuing units or debt, this would not have been achieved but for the impact of the i-units.
Table 9 below provides selected metrics comparing KMP to some of the other MLPs I follow based on the latest available trailing-twelve-months ("TTM") results.
As of 03/03/14:
EV / TTM EBITDA
Buckeye Partners (NYSE:BPL)
Boardwalk Pipeline Partners (NYSE:BWP)
El Paso Pipeline Partners (NYSE:EPB)
Enterprise Products Partners (NYSE:EPD)
Energy Transfer Partners (NYSE:ETP)
Kinder Morgan Energy
Magellan Midstream Partners (NYSE:MMP)
Targa Resources Partners (NYSE:NGLS)
Plains All American Pipeline (NYSE:PAA)
Regency Energy Partners (NYSE:RGP)
Suburban Propane Partners (NYSE:SPH)
Williams Partners (NYSE:WPZ)
Table 9: Enterprise Value ("EV") and TTM EBITDA figures in $ Millions. Source: Company 10-Q, 10-K, 8-K filings, author estimates
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.
A February 22 Barron's article repeated allegations made last September by Hedgeye analyst Kevin Kaiser that Kinder Morgan entities are skimping on maintenance in order to facilitate distributions. The subsequent drop in KMP and KMI unit prices seems to be related to this. In an article dated September 19, 2013, I concluded there is not sufficient evidence to either confirm or disprove this allegation.
As I see it, the two major issues around maintenance capital expenditures are: 1) whether enough is being spent on maintenance; and 2) whether amounts classified expansion capital should really have been classified as maintenance capital expenditure.
On point 1, more disclosure is needed because a portion of amounts spent on maintenance is expensed and buried within operating expenses. Only the portion that is capitalized is clearly disclosed. True, whether a maintenance expense is capitalized or expensed, it is deducted in deriving DCF. But unless we know the total amount spent on maintenance (expensed plus capitalized), we cannot even begin to assess whether the amount spent is adequate. MLPs including KMP do not provide this information (even if they did, the task would not be easy).
On point 2, correct classification can have a huge impact on DCF and on coverage ratios. The problem is that there does not appear to be a reliable, consistent and standard method of determining into which bucket (expansion vs. sustaining) a capital investment should be placed. I don't see a way of finding out if management inappropriately allocated more than it should have to the expansion bucket, and is thus overstating an MLP's DCF and its DCF coverage ratio.
KMP's Adjusted EBDA per unit grew 7% in 2013 and it is investing substantial amounts in capital expansion programs (the 2014 budget of ~$3.6 billion includes small acquisitions and investment contributions, but excludes asset acquisitions from KMI). KMP increased its quarterly distribution to $1.36 per unit (from $1.35 in 3Q13 and from $1.29 in 4Q12). Distributions for 2013 are up ~7% over 2012 and management guidance for 2014 is for distributions totaling $5.58 per unit, up 5% from $5.33 in 2013. Long-term debt to LTM EBITDA as of 12/31/13 was a manageable 3.7x.
But the pace of growth of Adjusted EBDA per unit has slowed considerably in the third and fourth quarters of 2013 (see my preliminary review of 4Q13 results). Also, KMP's reported distribution coverage is based on cash flows that include items I do not consider sustainable and exclude outflows that would have been required but for KMR holders receiving units in lieu of cash distributions. Finally, KMP will require assistance to meet its 2014 distribution objective in the form of $133 million IDR payments that KMI will waive. KMI will also waive $139 million of IDR payments in 2015 and $116 million in 2016, thereafter decreasing by $5 million per year (the bulk of these amounts are in support of the $5.2 billion Copano acquisition that closed on May 1, 2013).
Investors seeking more rapid distribution growth and/or concerned with KMP's distribution coverage for reasons detailed in this report should look at KMI which, at ~5.1%, yields less than KMP's 7.3% but has increased its 2013 projection of distribution growth to 14% over 2012 and provides a better alignment of interests with Kinder Morgan's management.