A Closer Look At El Paso Pipeline Partners' Distributable Cash Flow As Of 1Q 2014

| About: El Paso (EPB)


No growth in revenues or Adjusted EBDA.

DCF per unit declining, but coverage of 7.8% yield is still positive, albeit tight.

Management conservatively aligned distribution to DCF, halt in distribution growth was warranted.

$1.3 billion capital expansion program targeted at taking advantage of surge in demand for natural gas.

Main concerns: zero growth in near term, KMI (general partner) conflict of interests.

El Paso Pipeline Partners, L.P. (NYSE:EPB) recently reported its results of operations for 1Q 2014. This article focuses on some of the key facts and trends revealed by this and prior EPB reports.

EPB's assets consist of Southern Natural Gas Company ("SNG"), an interstate natural gas company located in the southeastern United States; Colorado Interstate Gas Company ("CIG"), an interstate pipeline company which is located in the Rocky Mountains; Wyoming Interstate Company, L.L.C. ("WIC"), an interstate pipeline company primarily located in Wyoming and Colorado; Southern LNG Company, L.L.C. ("SLNG"), which owns a liquefied natural gas ("LNG") storage and regasification terminal near Savannah, Georgia; Elba Express Pipeline Company (Elba Express), an interstate pipeline company which is located in Georgia and South Carolina; and Cheyenne Plains Gas Pipeline Company ("CGP"), a pipeline extending from the Rocky Mountain region to Kansas. Combined, these businesses consist of more than 13,000 miles of pipeline and associated storage facilities with aggregate storage capacity of nearly 100 billion cubic feet.

As shown in Table 1 below, EPB has not generated quarter vs. prior-year quarter revenue growth for the past seven quarters.

Table 1: Figures in $ Millions (except % change); Source: company 10-Q, 10-K, 8-K filings

Revenues in the trailing twelve months ("TTM") ended 3/31/14 were slightly lower than in the prior year period despite the Elba Express pipeline expansion project coming online on April 1, 2013, and despite full period contributions by CIG and CGP. As a reminder, EPB acquired the remaining 14% interest in CIG and 100% of CPG on May 24, 2012; thus, results for the TTM ended 3/31/13 include ~10 months of incremental contributions from 14% of CIG and 100% of CPG compared to 12 months of contributions for the TTM ended 3/31/14.

Adjusted earnings before depreciation and amortization and "certain items" ("Adjusted EBDA") is one of the important yardsticks used by management to measure its success in maximizing returns to the partners, to evaluate performance and to allocate resources. Adjusted EBDA for recent quarters and the TTM ended 3/31/14 and 3/31/13 is presented in Table 2 below:

Table 2: Figures in $ Millions; Source: company 10-Q, 10-K, 8-K filings

Table 3 below shows that when Adjusted EBDA numbers are compared to the prior year period on a per unit basis, 1Q14 is flat vs. 1Q13 and we see declines for the 3 prior quarters, as well as for the TTM ended 3/31/14.

Table 3: Figures in $ Millions (except % change); Source: company 10-Q, 10-K, 8-K filings

Distributable cash flow ("DCF"), as reported by EPB, is shown in Table 4. Reported DCF per unit dropped in each of the last 4 calendar quarters, principally due declines in operating income and to larger incentive distribution rights ("IDR") payments made to Kinder Morgan Management Inc. (NYSE:KMI), EPB's general partner. For the TTM ended 3/31/14, DCF per unit was down ~10% compared to the corresponding prior year period.

Table 4: Figures in $ Millions (except % change); Source: company 10-Q, 10-K, 8-K filings and author estimates

EPB's method of determining DCF is detailed in an article titled Distributable Cash Flow (DCF) that also provides a comparison to definitions used by other MLPs. Based on this method, EPB derives DCF as shown in Table 5. The adjustments made by management to EBDA are referred to as "certain items."

Table 5: Figures in $ Millions; Source: company 10-Q, 10-K, 8-K filings and author estimates

EPB's reported DCF per unit for the TTM ended 3/31/14 was $2.59 ($563 million in total), down from $2.91 ($616 million in total) for the corresponding prior year period. The primary reason for the decline were the higher IDR payments made to KMI.

Management expects positive coverage ratios in the 4th and 1st quarters of each calendar year and negative ratios in the 2nd and 3rd quarters. TTM coverage ratios are therefore more meaningful than quarterly ratios. Table 4 indicates a very tight coverage ratio in the latest TTM period and highlights the large portion of net income and cash flow claimed by KMI. EPB's ability to generate distribution growth is constrained by its obligation to distribute ~48% of every additional DCF dollar to KMI. As of 3/31/14 KMI owned 40.4% of EPB's limited partner units in addition to its 2% general partner's interest.

EPB's method of determining DCF differs from most of the non-Kinder Morgan MLPs I follow. As shown in Table 4, EPB deducts the general partner's IDRs 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. DCF coverage as computed by EBP is not consistently lesser or greater than it would have been had the broader definition been used. It is just different. Making an apples-to-apples comparison to other MLPs therefore requires adjusting for this factor.

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 6 below:

Table 6: Figures in $ Millions; Source: company 10-Q, 10-K, 8-K filings and author estimates

Table 6 shows no material difference between reported DCF (using the broad definition) and sustainable DCF in the quarter and TTM ended 3/31/14.

Coverage ratios of sustainable DCF are shown in Table 7 below:

Table 7: Figures in $ Millions, except coverage ratios; Source: company 10-Q, 10-K, 8-K filings and author estimates

A comparison of Tables 5 and 7 shows that sustainable DCF coverage exceeded reported coverage for the TTM ended 3/31/14.

Table 8 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

Table 8: Figures in $ Millions; Source: company 10-Q, 10-K, 8-K filings and author estimates

Net cash from operations less maintenance capital expenditures exceeded distributions by $34 million in the TTM ending 3/31/14 and by $103 million in the TTM ending 3/31/13. In both periods EPB did not use cash raised from issuance of debt and equity to fund distributions. But, as previously seen, coverage ratios are lower.

The much-anticipated drop-down from KMI of a 50% interest in Ruby Pipeline, a 50% interest, and a 47.5% interest in Young Gas Storage was announced on April 28, 2014. EPB will pay $1,984 million (of which $1,012 million through the assumption of debt). The assets are being acquired at a reasonable multiple of 9x 2013 EBITDA and the transaction should be accretive to unit holders.

I expressed concerns about EPB and advised to reduce positions in an article dated November 16, 2013). But my concerns centered on structural issues and on cash distributions growing faster than cash generation. I did not anticipate the December 3, 2013, announcement that even with the expected drop-down EPB would not generate additional cash sufficient to warrant an increase in the current distribution rate of $0.65 per quarter. Management halted distribution increases because it built into its 2014 projections several factors that will largely offset the positive impact from the drop-down. These factors include the unfavorable impact of settlements with the Federal Energy Regulatory Commission ("FERC"), pursuant to which EPB reduced tariff rates on some of its pipelines, non-renewal of some pipeline contracts, as well as lower rates expected upon renewal of other pipeline contracts. Management incorporated these developments in its 2014 forecasts. Guidance for 2014 EBITDA is approximately $1.2 billion, an increase of only $90 million compared to 2013. I prefer management teams that align distribution to DCF in contrast to those that continue to grow distributions in the face of insufficient coverage.

Following the 12/3/13 announcement, the unit price declined ~20% from ~$41.58 to $33.35 and declined a further ~10% following the 80% cut in distributions announced by Boardwalk Pipeline Partners (NYSE:BWP) on February 10. In an article dated February 28 I expressed my view that further reductions in position at a price around $30 were not warranted. The unit price has since recovered to the $33 range and the units currently yield ~7.8%, but this could still present a buying opportunity, especially if 3rd party forecasts cited by management and predicting U.S. natural gas demand will increase over 30% materialize.

Notwithstanding that, I'm reluctant to add to my position. My greatest concern is the conflict issue that arises when several MLPs share the same general partner. It is exceedingly difficult for management to fulfill its duty to act in the best interest of both EPB and KMP, as well as its own (i.e., KMI's) shareholders, in a situation where both MLPs vie for the same assets and KMI also wants to retain them for its purposes. In addition, the pricing of such related-party transactions is always an issue because a higher price is advantageous for KMI but disadvantageous for its MLPs. The difficulties faced will be even greater if/when a consolidation transaction involving various Kinder Morgan entities is proposed.

Disclosure: I am long EPB. 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.