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, Wise Analysis (348 clicks)
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As an investor seeking the high yields being offered by MLPs, I look carefully at what portion of the distributions being received are really “earned” and generally seek to avoid or reduce positions 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 return on your capital (rather than of your capital) 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 under a downside scenario those MLPs that cannot maintain their distribution rates are likely to suffer significantly greater price deterioration.

In a prior article regarding Buckeye Partners, L.P. (NYSE:BPL) I noted that "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. I noted that in periods where a large portion of net cash from operations is the result of changes in working capital rather than ongoing operations, I take a close look whether and what adjustments should be made. Plains All American Pipeline (NYSE:PAA) presents such a case, so in this article I will show how my sustainable DCF approach deals with working capital adjustments.

PAA derives DCF by making adjustments to net income to calculate EBITDA, then making further modifications to calculate Adjusted EBITDA, then applying additional adjustments to the Adjusted EBITDA number to finally calculate DCF. One can reach the same number by starting out from the cash flow statement (rather than from net income). For me, this latter approach provides better insights in the case of PAA:

9 months ending ($M)

9/30/11

9/30/10

Net cash provided by operating activities

1,752.0

463.0

Less: Maintenance capital expenditures

(77.0)

(62.0)

Working capital (generated) used

(785.0)

135.0

Risk management activities)

(79.0)

3.0

Proceeds from sale of assets

42.0

24.0

Other

(46.0)

(33.0)

DCF as reported

807.0

530.0

Distributions to unitholders

612.0

512.0

Coverage ratio

1.32

1.04

The period-to-period growth in net cash from operations is impressive and, as management noted, driven by all three operating segments but particularly by the supply and logistics segment. Compared to the prior year period, for the 9 months ending 9/30/11 profits from supply and logistics were up 205% compared to increases of 6% and 28% for the transportation and facilities segments, respectively; overall, PAA increased its reported distribution coverage from 104% to 132%.

From the perspective of cash flow sustainability, the year-over-year improvement is even better than that. Note that the 132% coverage ratio in the 9 months ending 9/30/11 is achieved after deducting $785 million of working capital generated in the period, primarily reflecting liquidation of crude oil inventories. On the other hand, the 104% coverage in the prior year period is achieved by adding back $135 million invested in working capital. This raises the question whether it is appropriate to include changes in working capital when calculating sustainable DCF. Generally I do not include working capital generated but I do deduct working capital invested. Despite appearing to be inconsistent, this makes sense because in order to meet my definition of sustainability the MLP should, on the one hand, generate enough capital to cover normal working capital needs. On the other hand, cash generated from working capital is not a sustainable source and I therefore ignore it.

Beyond working capital, additional adjustments are required in order to derive what I term “sustainable DCF.” Specifically, these include deducting maintenance capital expenditures, distributions and net income attributable to non-controlling shareholders. In addition, I disregard certain items that management includes in its reported DCF number (specifically, cash from risk management activities, proceeds from asset sales and other should not, in my view, be in the sustainable category). These adjustments are best viewed over a measurement period of at least 6-9 months. A reconciliation of sustainable DCF to reported DCF is provided in the table below:

9 months ending ($M)

9/30/11

9/30/10

Net cash provided by operating activities

1,752.0

463.0

Less: Maintenance capital expenditures

(77.0)

(62.0)

Less: Working capital (generated)

(785.0)

-

Less: Net income (loss) attributable to non-controlling interests

(18.0)

(5.0)

Sustainable DCF

872.0

396.0

Add: Net income (loss) attributable to non-controlling interests

18.0

5.0

Working capital used

-

135.0

Risk management activities

(79.0)

3.0

Proceeds from sale of assets

42.0

24.0

Other

(46.0)

(33.0)

DCF as reported

807.0

530.0

By my calculation, sustainable DCF for the 9 months ending 9/30/10 was $395 million. As indicated by the table above, the $530 million reported DCF was derived after adding back $135 million of working capital consumed by the business; this does not meet my sustainability criteria. Rather than improving from 104% to 132%, by my definition the coverage ratio for sustainable distributions improved from a worrying 77% to 142%. Hence my conclusion that the improvement is greater than it initially appears.

I also find it helpful to look at a simplified cash flow statement by netting certain items (e.g., acquisitions against dispositions) and by separating cash generation from cash consumption.

Here is what I see for PAA:

9 months ending ($M)

SIMPLIFIED SOURCES AND USES OF FUNDS

9/30/11

9/30/10

Net cash from operations, less maintenance capex, less distributions, less net income from non-controlling interests

-

(111.0)

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

(367.0)

(256.0)

Acquisitions (net of operating unit sale proceeds)

(738.0)

(197.0)

Debt incurred (repaid)

(838.00)

-

Other CF from investing activities, net

(3.0)

-

Other CF from financing activities, net

(12.0)

(2.0)

(1,958.0)

(566.0)

Net cash from operations, less maintenance capex, less distributions, less net income from non-controlling interests

1,063.0

-

Cash contributions/distributions related to affiliates & non-controlling interests

370.0

268.0

Debt incurred (repaid)

-

266.0

Partnership units issued

503.0

-

Other CF from investing activities, net

-

20.0

1,936.0

554.0

Net change in cash, as reported

(22.0)

(12.0)

Unlike what we saw in the BPL, the period-to-period analysis for PAA shows a marked improvement. For the 9 months ended 9/30/10 net cash from operations fell short of covering distributions, maintenance capital expenditures, and downward adjustments for net income belonging to non-controlling interests. The shortfall was $111 million. However, for the 9 months ended 9/30/11 there was a significant surplus of $1.063 billion which helped finance acquisitions and debt repayments. Unlike what we saw in the PL analysis, distributions for that period were not funded by issuance of additional partnership units or debt.

Source: Cash Flow Sustainability Of MLPs: Plains All American Pipeline