A Closer Look At Cash Flow Sustainability Of MLPs: Buckeye Partners

Dec.19.11 | About: Buckeye Partners (BPL)

As an investor seeking the high yields being offered by MLPs, my first question is what portion, if any, of the distributions I am receiving are really “earned.” I am leery of investing in MLPs that fund distributions with debt or through issuance of equity (i.e., sale of additional partnership units). Since money is fungible and the MLP financial statements are voluminous and not always easy to read, ascertaining whether you are genuinely receiving a yield on your money (rather than of your money) can be a complicated endeavor. In addition, it is important for a conservative investor to understand how safe is the current return before tackling the question of what are the MLP’s growth prospects. Sustainable distributions provide some protection in that in a downside scenario those MLPs that cannot maintain their distribution rates are likely to suffer significantly greater price deterioration.

Most MLPs provide detailed information about how they derive “Adjusted EBITDA,” a term they coin to denote the primary measure used to evaluate operating results, and DCF (distributable cash flow). Many investors and analysts focus primarily on Adjusted EBITDA and DCF. But to properly ascertain sustainability additional analysis is required, including looking “under the hood” to understand how the MLP defines Adjusted EBITDA and DCF.

Let’s focus first on DCF.

Typically the starting point for deriving DCF can be either EBITDA or net cash provided by operating activities. Both are GAAP terms and are part of the MLP’s quarterly and annual financial statements. From these starting points, various non-GAAP adjustments are made. MLPs have significant degrees of freedom as to what adjustments to make and consequently the adjustments are not always consistent across MLPs.

Using net cash provided by operating activities as a starting point, let’s look at the DCF of Buckeye Partners, L.P. (NYSE: BPL):

9 months ending ($M)

9/30/11

9/30/10

Net cash provided by operating activities

182.1

296.1

Less: Maintenance capital expenditures

(36.6)

(18.5)

Working capital (generated) used

(52.9)

(86.5)

Risk management activities (Net changes in fair value of derivatives )

150.4

16.2

Other

3.5

(7.8)

DCF as reported

246.5

199.4

-

-

Distributions to unitholders

254.4

182

Coverage ratio

97%

110%

Click to enlarge

Since BPL reconciles DCF to Net Income (rather than net cash from operations), the above reconciliation does not appear directly in the financial statements but can be manually computed. Note the $150.4m that is added in deriving DCF. This amount equals the decrease in value of futures contracts executed to hedge physical inventory. The addition reflects “an offsetting adjustment made to the value of inventory by adjusting inventory to current market prices”. We have here a strong indication that risk management results account for a very substantial portion of DCF and has become far more important than it previously was to sustaining BPL’s financial results.

Additional observations regarding DCF can be made based by focusing on Adjusted EBITDA as a starting point:

9 months ending ($M)

9/30/11

9/30/10

EBITDA

226.1

143.6

Adjustments:

-

-

Net income attributable to noncontrolling interests affected by Merger (for periods prior to Merger)

-

130.2

Amortization of unfavorable storage contracts

(4.8)

-

Non-cash deferred lease expense

3.1

3.2

Non-cash unit-based compensation expense

6.5

5.6

Gain on sale of equity investment

(34.1)

-

Goodwill impairment expense

169.6

-

Adjusted EBITDA

366.4

282.6

-

-

Less:

-

-

Interest expense, net (cash)

(90.3)

(65.1)

Deferred Income tax expense

0.2

0.4

Maintenance capital expenditures

(36.6)

(18.5)

Other

6.8

3.4

Distributable Cash Flow as reported

246.5

202.9

Click to enlarge

It is disturbing to see $169.5m of goodwill impairment in the Natural Gas Storage business unit (acquired in 2008 for ~$440m) in light of “the continued downward performance in operating income and Adjusted EBITDA in the Natural Gas Storage segment due to decreases in contracted storage prices relating to low volatility in natural gas prices and compressed seasonal spreads.” Although it is a non-cash item, writing off 100% of the goodwill booked on a fairly recent acquisition seems to require a closer look at sustainability of distributions.

”Sustainability” is not a clearly defined term and one has to settle on a subjective measure that one is comfortable with. My approach begins with the requirement that to be considered sustainable, an MLP’s net cash from operations should at least cover maintenance capital expenditures plus distributions over a 6-9 months measurement period. In periods where a large portion of net cash from operations is the result of working capital being generated rather than ongoing operations, I would take a close look at whether a downward adjustment should be made. I also find it helpful to net certain items (e.g., acquisitions against dispositions) and to separate cash generation from cash consumption.

Here is what I see for BPL:

9 months ending

SIMPLIFIED SOURCES AND USES OF FUNDS ($M)

9/30/2011

9/30/2010

Net cash from operations, less maintenance capex, less distributions

(108.9)

Click to enlarge

-

Capital expenditures ex maintenance, net of PP&E sale proceeds

(69.8)

(30.8)

Acquisitions (net of operating unit sale proceeds)

(1,084.6)

7.7

Cash contributions/distributions related to affiliates & noncontrolling interests

-

-

Debt incurred (repaid)

-

90.6)

Other CF from investing activities, net

(0.5)

-

Other CF from financing activities, net

(10.9)

(7.8)

(1,274.7)

121.5)

Net cash from operations, less maintenance capex, less distributions

-

95.6

Debt incurred (repaid)

538.0

-

Partnership units issued

739.2

4.3

1,277.2

99.8

Net change in cash

2.6

(21.7)

Click to enlarge

Note that a goodwill impairment expense of $169.6m (which was deducted from net income in deriving net cash from operations) is added back in deriving Adjusted EBITDA. The two items somewhat offset each other – one being a non-cash charge and the other an adjustment to inventory and therefore also to DCF. I find it disturbing to have two such large adjustments within a short period (both occurred in 3Q11) even if they are offsetting.

What disturbs me most is that by my definition, sustainable cash flow decreased from a positive $95.6m in the 9 months ended 9/30/10 to a negative $108.9m in the 9 months ended 9/30/11. BPL has been increasing distributions at a CAGR of 5.7% since 2006. What I see for the 9 months ending 9/30/11 causes me concern regarding BPL’s ability to make distributions that are financed by operations, not by borrowings or sale of additional partnership units.

How do other MLPs fare based on this methodology? In subsequent articles I will examine several of them.

Disclosure: I am long BPL.