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Summary

  • Key business parameters, when measured on a per unit basis and compared to the prior-year period, have deteriorated for 8 consecutive quarters.
  • Increasing distributions in face of adverse business environment was enabled by issuance of equity and debt. But no significant need for additional equity projected in 2014-2015.
  • Cash flows in 2014 getting a boost from insurance recoveries.
  • Improvements in fee-based business and major capital projects soon to be placed in service drive sizable increases in per unit DCF forecasted for 2014-2016.

Williams Partners, L.P. (NYSE:WPZ) recently reported its results of operations for 1Q 2014. This article analyses some of the key facts and trends revealed by this and prior WPZ reports, evaluates the sustainability of WPZ's Distributable Cash Flow ("DCF") and assesses whether WPZ is financing its distributions via issuance of new units or debt.

WPZ's operations are managed through four geographically-based segments:

  1. Northeast G&P: this midstream gathering and processing segment is in the early stages of developing large-scale energy infrastructure solutions for the Marcellus and Utica shale regions. It also includes a 51% equity investment in Laurel Mountain Midstream, LLC ("Laurel Mountain") and a 58% equity investment in Caiman Energy II, LLC ("Caiman") that has a 50% interest in a partnership expanding its gathering and processing infrastructure to serve oil and gas producers in the Utica Shale.
  2. Atlantic-Gulf: this segment includes the Transcontinental Gas Pipe Line Company, LLC ("Transco"), WPZ's 10,200-mile pipeline system that transports natural gas to markets throughout the northeastern and southeastern United States. It also includes natural gas gathering and processing and crude production handling and transportation in the Gulf Coast region, a 50% equity investment in Gulfstream Natural Gas System L.L.C. ("Gulfstream"), a 60% equity investment in Discovery Producer Services LLC ("Discovery"), and a 51% consolidated interest in Constitution Pipeline Company, LLC ("Constitution").
  3. West: this segment includes gathering, processing and treating operations in southwestern Colorado & northeastern New Mexico ("Four Corners"), northwestern Colorado (Piceance Basin), and Wyoming and WPZ's interstate natural gas pipeline, Northwest Pipeline GP ("Northwest Pipeline").
  4. NGL & Petchem Services: this segment includes WPZ's NGL and natural gas marketing business, a natural gas liquids ("NGL") fractionator and storage facilities near Conway, Kansas, a 50% equity investment in Overland Pass Pipeline ("OPPL"), and an 83.3% interest in an olefins production facility in Geismar, Louisiana, along with a refinery grade propylene splitter and pipelines in the Gulf Coast region.

Williams Companies, Inc. (NYSE:WMB), WPZ's general partner, owns ~64% of the limited partner units, a 2% general partner interest and 100% of the incentive distribution rights ("IDRs").

Segment profit for recent quarters and the trailing twelve months ("TTM") ended 3/31/14 and 3/31/13 is presented in Table 1 below. Segment profit, a non-GAAP measure, is one of the key metrics used by management to evaluate performance of its businesses. It is defined as revenues from external and internal customers, less costs and expenses, equity earnings (losses), and income (loss) from investments. Intersegment revenues primarily represent the sale of NGLs from WPZ's natural gas processing plants to its marketing business and are generally accounted for at current market prices as if the sales were to unaffiliated third parties. General corporate expenses are comprised of selling, general, and administrative expenses ("SG&A") that are not allocated to one of the segments.

(click to enlarge)Table 1: Segment Profit; figures in $ Millions, except % changes and per unit amounts. Source: company 10-K, 10-Q, 8-K filings.

Tables 1 indicates that when total segment profit is measured on a per unit basis and each period is compared to the corresponding prior-year period, results have deteriorated for 7 consecutive quarters (8 quarters if we look back as far as 2Q12). This is primarily due to continued pressure on NGL processing margins, reduced ethane recoveries and decreases in average NGL per-unit sales prices, as well as lower olefin margins associated with lost production related to the Geismar incident described in an article dated August 4, 2013. These factors, coupled with a 25% increase in the number of limited partner units outstanding since 3Q12, adversely impacted operating income per unit.

Management uses additional non-GAAP measures to evaluate results from ongoing operations. Adjusted Segment profit excludes items of income or loss that management characterizes as unrepresentative of WPZ's ongoing operations. Adjusted segment profit + DD&A is further adjusted to add back depreciation and amortization expense. These measures aggregated for all WPZ's segments are summarized in Table 2 below:

(click to enlarge)Table 2: Adjusted segment Profit; figures in $ Millions, except % changes and per unit amounts. Source: company 10-K, 10-Q, 8-K filings and author estimates.

Table 2 indicates that with management's adjustments, results on a per unit basis when each period is compared to the corresponding prior-year period, have deteriorated less severely and show an uptick in 1Q14. Management's adjustment 1Q14 included adding $54 million to offset the effect of the Geismar incident (it does not explain how this estimate was derived) and adding $6 million to offset the effect of a fire in one of WPZ's compressor stations.

Ethane exposure has contributed significantly to the decrease in product revenues. Sharp declines in NGL prices have pushed down processing margins (40% lower in 2013 vs. 2012, 26% lower in 1Q14 vs. 1Q13). Reduced processing margins led to ethane rejection and thus generated lower equity volumes under keep-whole agreements and percent-of-liquids arrangements. WPZ provides natural gas gathering and processing services under fee contracts (volumetric-based), keep-whole agreements and percent-of-liquids arrangements. A glossary of terms provides further explanations of these terms and of ethane rejection. Under keep-whole and percent-of-liquid processing contracts, WPZ retains the rights to all or a portion of the NGLs extracted from the producers' natural gas stream (these are the equity volumes referred to above). It recognizes revenues when the extracted NGLs are sold and delivered. Lower NGL prices coupled with lower volumes produce lower revenues, lower operating income and lower net income.

NGL & Petech results in 1Q14 were boosted by $119 million of insurance recoveries (net of $6 million of deductibles) related to the Geismar incident. This follows a $50 million insurance recovery in 3Q13. Management expects to receive additional insurance recoveries that will favorably impact operating results in 2014. WPZ could face fines and penalties from the various federal and state governmental agencies investigating the matter; these would not be covered by its insurance policy. Additionally, multiple lawsuits have been filed against various WPZ subsidiaries. Following the repair and plant expansion, the Geismar plant is expected to be in operation in June 2014 (the initial estimate was April).

The generally downward trend in revenues and earnings before interest, depreciation & amortization and income taxes (EBITDA) is shown in Table 3 below:

(click to enlarge)Table 3: Figures in $ Millions, except % changes and per unit amounts. Source: company 10-K, 10-Q, 8-K filings and author estimates.

The only encouraging trend visible in Table 3 is the growth in fee-based income, primarily due to higher fee revenues associated with the growth in businesses acquired in 2012, as well as contributions from processing and fractionation facilities placed in service in the latter half of 2012 and in 2013. It partially offsets continuing declines in NGL margins. Management projects that by 2015, fee revenues will increase approximately $900 million from the $2,900 million level reached in 2013.

WPZ's definition of DCF is presented in an article titled "Distributable Cash Flow". The article also provides definitions used by other master limited partnerships ("MLPs"). Based on this definition, DCF reported by WPZ for the TTM ended 3/31/14 was $1,856 million ($4.32 per unit), up from $1,511 million ($4.11 per unit) in the corresponding prior-year period, as shown in Table 4 below:

(click to enlarge)Table 4: Figures in $ Millions (except per unit amounts and % change). Source: company 10-K, 10-Q, 8-K filings and author estimates.

Reported DCF may differ from sustainable DCF for a variety of reasons. These are reviewed in an article titled "Estimating sustainable DCF-why and how". Applying the method described there to WPZ's results generates the following comparison between reported and sustainable DCF:

(click to enlarge)Table 5: Figures in $ Millions. Source: company 10-K, 10-Q, 8-K filings and author estimates.

Most of the gap between reported DCF and sustainable DCF shown under "other" for the TTM ending 3/31/14 reflects management's adjustment for the Geismar Incident (of which $54 million is in 1Q14) and pre-acquisition cash flows allocated to WMB. The absence of Geismar's contribution to the TTM ending 3/31/14 is a one-time event to be reversed in 2014 as insurance proceeds are received. By adding it back management is reducing the variability of DCF. But this does not convert the Geismar adjustments into distributable cash flow. I prefer the DCF to more closely track the sustainable cash generated even if it means having to deal with lumpy results.

WPZ increased 4Q13 distributions to $0.9045 (up 1.3% from 4Q13 and up 6.7% from 1Q13). I calculate coverage ratios in Table 5 below in two ways: first based on the actual distributions made (e.g., the distribution actually made in 1Q14 was announced in 4Q13); second, based on declared distributions (e. g., as if the distribution declared for 1Q14 had been made in 1Q14).

(click to enlarge)Table 6: $ millions, except coverage ratios. Source: company 10-K, 10-Q, 8-K filings and author estimates.

Coverage ratios based on sustainable DCF are below the 1x threshold. This reflects the difficulties faced by WPZ in terms of the previously mentioned factors: declines in NGL processing margins, reduced ethane recoveries, decreases in average NGL per-unit sales prices, lost production related to the Geismar incident and the rapid growth in the number of units outstanding as a result of issuing equity to partially finance large drop-down acquisitions. But management's inclination to increase distributions based on projections of future performance even if the distributions are not covered raises a red flag.

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-K, 10-Q, 8-K filings and author estimates.

Net cash from operations, less maintenance capital expenditures fell short of covering distributions by $153 million in the TTM ending 3/31/14 (vs. an excess of $61 million in the TTM ended 3/31/13). This was due to deterioration in key performance parameters being accompanied by growth in distributions. Table 6 shows distributions in the TTM ended 3/31/14 were funded through the issuance of additional equity and/or debt.

Management's decision to significantly dilute unitholders in executing two transformative transactions, in conjunction with an adverse NGL pricing environment, the Geismar incident, and its decisions, despite all that, to increase distributions has brought about significant shortfalls in DCF coverage. Given that poor operational performance has been coupled with significant equity issuances ($2.56 billion in 2012, $1.96 billion in 2013) and with some downward guidance adjustments, it is not surprising that there has been gradual loss of investor confidence and that the unit price has languished. WPZ's unit price is down 1.05% in the past 12 months, a far poorer performance than most MLPs.

On the other hand, WPZ is making huge growth capital investments, the bulk of which are devoted to the Northeast G&P and the Atlantic-Gulf segments. Approximately $1.9 billion of new projects are coming into service in the second half of 2014 and a further ~$1.2 billion will come into service in 2015, plus a round of fully contracted Transco projects. The flip side of 2012-2013 large equity issuances is that WPZ has very limited needs for equity capital in the foreseeable future (~$300 million in 2014, none for 2015).

A few metrics indicating the enormous growth anticipated in the next 2-3 years are shown in Table 8 below:

Table 8: Figures in $ millions except per unit amounts and coverage ratios. Source: company 10-K, 10-Q, 8-K filings.

Cash flows in 2014 will get a boost from insurance recovery payments related to Geismar. Management also anticipates further improvements in the fee-based business. Beyond that, if the ~21% projected increase in DCF per unit between 2014 and 2016 will materialize, patient investors may be rewarded with capital appreciation over and above distribution growth that is forecasted at 6% for 2014, 6% for 2015 and 4.5% for 2016.

Source: A Closer Look At Williams Partners' Distributable Cash Flow As Of Q1 2014