This article analyses some of the key facts and trends revealed by 2Q14 results reported by Williams Partners, L.P. (NYSE:WPZ). It 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:
- 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.
- 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").
- 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").
- 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 the Overland Pass Pipeline ("OPPL"), Canadian assets (an oil sands off-gas processing plant, ~260 miles of NGL and olefins pipelines, an NGL/olefins fractionation facility and butylene/butane splitter facility), 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 6/30/14 and 6/30/13 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.
Table 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 (9 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 6/13/13 Geismar incident (explosion and fire) described in an article dated August 4, 2013. These factors, coupled with a 15% increase in the number of limited partner units outstanding since 4Q12, 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:
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, show consecutive quarterly upticks in 1Q14 and 2Q14. Management's adjustment for 2Q14 included adding $96 million to offset the effect of the Geismar incident (it does not explain how this estimate was derived), adding $17 million for "certain equipment held for sale," and adding $6 million to offset the effect of shutting down the Opal, WY, gas processing facility after the April 2014 explosion and fire.
Ethane exposure has contributed significantly to the decrease in product revenues. Sharp declines in NGL prices have pushed down processing margins. 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 2Q14 were boosted by $42 million of insurance recoveries (net of $8 million of deductibles) related to the Geismar incident ($119 million net of $6 million of deductibles in 1Q13). Insurance recoveries received to date total $225 million and management expects to collect an additional $275 million. The actual loss will exceed the $500 million policy limit. WPZ could also face fines and penalties from the various federal and state governmental agencies investigating the matter. 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 4Q14 (the initial estimate was April, the second estimate was June).
The generally downward trend in revenues and earnings before interest, depreciation & amortization and income taxes (EBITDA) is shown in Table 3 below:
An 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 fee-based revenues will generate 77% of gross margins by 2016.
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 6/30/14 was $1,973 million ($4.52 per unit), up from $1,605 million ($4.15 per unit) in the corresponding prior year period, as shown in Table 4 below:
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:
The Geismar plant has been off-line since 2Q13. In its place, assumed business interruption insurance proceeds for 2Q14 totaling $138 million are included in DCF as reported by management. Additionally, DCF in 2Q14 was favorably affected by the Canadian asset drop-down to the tune of $23 million.
The gap between reported DCF and sustainable DCF illustrates the high degree of latitude exercised by management in defining DCF. The largest component of the $433 million shown under "other" for the TTM ending 6/30/14 is management's adjustment for the Geismar Incident (mostly consisting of ~$223 million of "assumed business interruption insurance proceeds"). Other components include adjustments for other incidents and impairments, and pre-acquisition cash flows allocated to WMB. The absence of Geismar's contribution to the TTM ending 6/30/14 is a one-time event to be reversed as insurance proceeds are actually received. By adding back insurance proceeds management assumes it will receive, WPZ's reported DCF is smoothed and its variability is reduced. 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 2Q14 distributions to $0.9165 (up 1.3% from 1Q14 and up 6.3% from 2Q13). I calculate coverage ratios in Table 5 below in two ways: first based on the actual distributions made in the period; second, based on distributions declared in the period (and paid the following quarter).
Table 6: $ millions, except coverage ratios
Coverage ratios based on sustainable DCF are well 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
Net cash from operations, less maintenance capital expenditures, fell short of covering distributions by $516 million in the TTM ending 6/30/14 (vs. an excess of $103 million in the TTM ended 6/30/13). This was due to deterioration in key performance parameters being accompanied by growth in distributions. Table 6 shows distributions in the TTM ended 6/30/14 were funded through the issuance of additional equity and/or debt.
Management's decision to significantly dilute unit holders 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 2.5% since the beginning of the year vs. a 7.5% increase for the Alerian MLP Index.
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
Due to delays in the Geismar startup, management reduced 2014 guidance for DCF, DCF per unit, coverage and Adjusted Segment Profit from the prior levels of $2,350 million, 3.59, 0.97 and $2,345 million, respectively. In any event, these projections may be rendered obsolete by the 6/15/14 WMB announcement that it has agreed to acquire the 50% general partner interest and 55.1 million limited partner units in Oklahoma City-based Access Midstream Partners L.P. (NYSE:ACMP) held by Global Infrastructure Partners II ("GIP") for ~$6 billion in cash.
WMB will propose a subsequent merger of WPZ and ACMP. WPZ shareholders are expected to receive 0.85 ACMP units for each unit of WPZ held, in addition to a one-time payment of $0.81/unit (cash or equivalent ACMP units) to compensate for lower distribution payout in 2015 (from the then combined entity). Assuming the merger is consummated in 2014, the merged MLP is expected to have a 2015 distribution increase of at least $3.4875 per unit.
If the 61% projected increase in WPZ's standalone DCF per between 2014 and 2016 and the benefits of the proposed merger (more substantial growth and a more stable, fee-based, business) will materialize, patient investors may be rewarded with capital appreciation over and above distribution growth. However, while WMB investors have already benefitted from a ~19% unit price appreciation since June 15, WPZ holders have suffered a decline of ~11%.
I continue to prefer WMB to WPZ. As owner of 100% of the general partner, it stands to benefit more than WPZ from ACMP's growth.
Disclosure: The author is long WMB. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.