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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 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 the current return is before tackling the question of 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 prior articles 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 month period.

How do reported distributable cash flow (DCF) and sustainable DCF compare with distributions being made by NGLS? My analysis is provided in the table below:

9 months ended 9/30/11

9 months ended 9/30/10

Net cash provided by operating activities

191.3

238.9

Less: Maintenance capital expenditures

(57.2)

(29.7)

Less: Net income (loss) attributable to noncontrolling interests

(29.6)

(18.2)

Sustainable DCF

104.5

191.0

Working capital used

93.8

12.2

Risk management activities

21.1

2.5

Loss (gain) on sale of assets

0.4

-

Other

9.7

(4.9)

DCF as reported

229.5

200.8

Figures in $ millions; fiscal year ends Sept. 30.

By my method, sustainable DCF for the 12 months ending 9/30/11 was $104.5 million. The principal differences vs. the $229.5 million reported DCF is attributable to $93.8 million of working capital consumed.

As detailed in my prior articles, I generally do not include working capital generated in the definition of sustainable DCF, 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. Over reasonably lengthy measurement periods (9-12 months), working capital generated tends to be offset by needs to invest in working capital (unless growth is very rapid). I therefore do not add working capital consumed to net cash provided by operating activities in deriving sustainable DCF.

Risk management activities present a more complex issue. In my recent article covering ETP, I explained that generally I do not generally consider cash generated by risk management activities to be sustainable, although I recognize that one could reasonable argue that bona fide hedging of commodity price risks should be included. The NGLS risk management activities seem to be directly related to such hedging, so I could go both ways on this.

The resultant coverage ratios are as follows:

9 months ending 9/30/11

9 months ending 9/30/10

Distributions to unitholders ($ Millions)

$165.9

$117.8

Coverage ratio based on sustainable DCF

62.8%

162.1%

Coverage ratio based on sustainable DCF (including cash from risk management)

75.7%

164.3%

Coverage ratio based on reported DCF

138.3%

170.5%

The figures are calculated based on distributions actually made during the relevant period. If, as was the case with NGLS, a distribution increase is announced, the coverage ratios do not incorporate it, so they may be somewhat overstated.

The simplified cash flow statement in the table below gives a clear picture of how distributions have been funded in the last two years. The table nets certain items (e.g., debt incurred vs. repaid) and separates cash generation from cash consumption

Simplified Sources and Uses of Funds:

9 months ending 9/30/11

9 months ending 9/30/10

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

(31.8)

-

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

(154.2)

(52.8)

Acquisitions (net of operating unit sale proceeds)

(176.1)

-

Cash contributions/distributions related to affiliates & noncontrolling interests

(10.7)

(159.7)

Debt incurred (repaid)

-

(216.1)

Other CF from financing activities, net

(6.2)

(20.2)

(379.0)

(448.8)

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

-

91.4

Debt incurred (repaid)

67.0

-

Partnership units issued

304.3

317.8

Other CF from investing activities, net

0.3

3.2

371.6

412.4

Net change in cash

(7.4)

(36.4)

Net cash from operations, less maintenance capital expenditures, less cash related to net income attributable to non-partners exceeded distributions by $91.4 million for the 9 months ended 9/30/10. But in the 9 months ending 9/30/11 it but fell short of covering distributions. While distributions have increased sharply (as a result of growth both in per unit amounts and number of units outstanding), net cash from operations and sustainable DCF have decreased. Reported DCF did increase, but only because working capital consumed is not incorporated into that measure.

However, applying the same analysis to the 6 months ending 6/30/11 would have shown that working capital actually generated $37.9 million of cash. Given the rapid growth in revenues and the large fluctuations between 2nd and 3rd quarter working capital needs, I would wait for the next quarter’s results and redo the analysis based on 12 month numbers.

Source: Examining Targa Resources' Cash Flow Sustainability