El Paso Pipeline Partners (NYSE:EPB) reported quarterly results after the bell on Wednesday, and in keeping with the recent trend, the numbers failed to impress. Thus far this year, EPB units are trading down 1%, and over the past twelve months, units are down a far more dramatic 19.6%. By comparison, the MLP index (AMZ) is up 12% over this time frame. El Paso has struggled ever since rates at its Wyoming pipeline network were cut, and it will likely be at least 18 months before the company should be able to sustainably increase its distribution. With limited distribution upside and weak operating results, investors should avoid EPB in favor of companies with distribution growth like Enterprise Products (NYSE:EPD).
In the second quarter, El Paso earned $0.32 on $353 million in revenue compared to expectations of $0.38 and sales of $377 million (financial and operating data available here). Both figures were also lower on a year over year basis. EPS was 20% lower while revenue fell by 1.7% because its pipelines are not positioned in booming geographies like the Permian Basin. Distributable cash flow, which is a non-GAAP measure MLPs use to determine how much they can pay to investors, came in at $141 million compared to $129 million a year ago.
This sizable increase was driven by a dramatic increase in depreciation, which is added back to net income when calculating DCF. Even though net income fell by $10 million, depreciation jumped 72% to $81 million as the company invests in expansion projects in pipelines and storage. Even though depreciation increased dramatically, sustaining cap-ex, which is subtracted from DCF, stayed constant year over year at $10 million. Some analysts like Hedgeye's Kevin Kaiser have suggested sustaining cap-ex is understated, which makes DCF appear higher than it really is. This is a concern investors should consider as over the long run expansion activities should increase sustaining cap-ex, but EPB's sustaining cap-ex is not outside the norm of other MLPs. There is no reason to believe there is any accounting wrongdoing.
On a per unit basis, DCF came in at $0.62 compared to $0.60 a year ago. EPB maintained its $0.65 quarterly distribution, though the second quarter is often seasonally weaker. As a consequence, its coverage ratio should improve in the fourth quarter and make up for this quarterly shortfall. Nonetheless, a quarterly shortfall is never a good thing. Because of EPB's aggressive distribution policy, it has to issue debt and equity to fund its growth projects. After all, it is distributing out all of the cash it generates.
Over the past year, its unit count increased by 10 million to 227 million. If EPB's expansion projects cannot restart growth, this issuance could dilute existing holders and will retard distribution growth. Thus far this year, El Paso has also had to issue debt to fund acquisitions with long term debt increasing by $570 million since the beginning of the year to $4.74 billion. Debt growth has been faster than EBITDA growth because of problems at the Wyoming pipeline system and its exposure to the Gulf region. Debt to EBITDA now stands at 4.2x vs. 3.8x a year ago. Higher leverage could be a red flag to investors, though leverage would likely have to reach 5x before its credit rating would be downgraded. Still if EPB has to roll over debt in a higher rate environment, its distribution would be under even further pressure.
In this quarter, El Paso generated less revenue, had a coverage ratio of less than 100%, saw leverage rise, and continued to increase its unit count. All in all, this is not a good picture for investors. With increasing growth cap-ex and an unimpressive geographic profile bogged down by its poorly performing Wyoming unit, the distribution is likely to remain stuck at $0.65 for the foreseeable future. Even with its problems, El Paso had to pay more to its general partner, Kinder Morgan (NYSE:KMI), with incentive fees totaling $55 million compared to $47 million a year ago. Rising payments to its general partner will only exacerbate EPB's problems. While it current 7% yield is enticing, EPB is a classic value trap. There are no immediate growth prospects, but the company faces rising GP payments, interest expense, and higher sustaining cap-ex requirements. With these structural problems, EPB is an MLP that should not be in your portfolio.
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