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As an investor seeking the high yields 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 to 9 month period.

The announcement of Kinder Morgan's (NYSE:KMI) acquisition of El Paso Corporation (EP) resulted in a marked decline in El Paso Pipelines Partners' (NYSE:EPB) unit price. This reflected investor concerns that drop-downs from EP (EPB's general partner) would no longer exclusively reach EPB but, instead, would be split between EPB and the other Kinder Morgan partnerships (NYSE:KMP), (NYSE:KMR). The market seemed to be marking down EPB’s price to adjust for a slower pace of distribution expansion. But a closer look at EPB’s cash flows seems to indicate significant room for increased distributions just from the existing asset base.

Applying the method I described in prior articles covering other MLPs, I compare EPB’s distributable cash flow as reported to its sustainable DCF, as I define it:

EPB

9 months ended 9/30/11

9 months ended 9/30/10

Net cash provided by operating activities

593

501

Less: Maintenance capital expenditures

(68)

(48)

Less: Working capital (generated)

(34)

-

Less: Net income attributable to noncontrolling interests

(73)

(172)

Sustainable DCF

418

281

Add: Net income attributable to noncontrolling interests

73

172

Working capital used

-

96

Other

(56)

(277)

DCF as reported

435

272

Figures in $ millions.

As you can see, the results for the 9 months ending 9/30/11 present a very clean picture. There is no appreciable difference between was reported DCF and sustainable DCF. To me, this is a very positive indication. For the 9 months ended 9/30/10 the reported DCF number includes $96 million of working capital consumed. On the other hand, distributions to EP exceeded net income attributable to EP by about $100 million reflecting distributions made by subsidiary pipelines prior to them being dropped down into EPB. This difference was deducted in deriving reported DCF.

An explanation of why I believe sustainable DCF should not include working capital generated but should reflect a deduction for working capital invested appears in my prior articles.

The resultant coverage ratios are as follows:

9 months ending 9/30/11

9 months ending 9/30/10

Distributions to unitholders ($ Millions)

$302

$171

Coverage ratio based on sustainable DCF

138%

164%

Coverage ratio based on reported DCF

144%

159%

The figures are calculated based on distributions actually made during the relevant period. EPB has been increasing its distribution per unit, so these coverage ratios may be somewhat overstated, but I do not expect the effect would be significant (especially since cash from operations is probably also on the rise).

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

EPB

9 months ending 9/30/11

9 months ending 9/30/10

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

(134)

(206)

Acquisitions, investments (net of sale proceeds)

(1,412)

(1,151)

Cash distributions related to affiliates & noncontrolling interests

(47)

(2)

(1,593)

(1,359)

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

223

282

Debt incurred (repaid)

471

541

Partnership units issued

968

976

Other CF from investing activities, net

-

4

1,662

1,803

Net change in cash

69

444

Figures in $ millions.

Net cash from operations, less maintenance capital expenditures, less cash related to net income attributable to non-partners exceeded distributions by $223 million for the 9 months ended 9/30/11 and by $282 million for the 9 months ending 9/30/10. The analysis indicates EPB is not using cash raised from issuance of debt and equity to fund distributions. Rather, the funds are being used for acquisitions, investments and capital expenditures.

EPB’s current yield of ~5.6% may not be at the high end of the MLP universe, but it is very sustainable and net cash from operations easily covers maintenance capital expenditures and distributions. These are solid numbers. The outlook seems positive because there is room for distribution expansion from existing assets and no reason to assume EPB will be deprived of its “fair share” of dropdowns from its new GP.

Disclosure: I am long EPB, EPD, ETP, BPL, PAA.

Source: A Close Look At El Paso Pipelines Partners' Cash Flows