Master limited partnerships, also called MLPs, are a very popular choice among income-focused investors. On the surface, this makes a lot of sense. These companies generally sport very respectable distribution yields and, particularly in the case of midstream operators such as oil and gas pipeline operators, these distributions are widely perceived to be quite safe. However, as I discussed in a recent article about an MLP-like company, Seadrill Partners (NYSE:SDLP), there is one significant problem with the way most of these companies determine their distribution payouts. This is their focus on a metric known as distributable cash flow as opposed to free cash flow. In times of stress, such as now, this can greatly hinder growth prospects and may ultimately jeopardize the distribution.
First, let us take a moment to discuss the difference between distributable cash flow, which is used almost exclusively by master limited partners, and free cash flow, which is used by most other dividend-paying companies. Distributable cash flow can be defined as the cash flow that a business generates after expending the capital necessary to maintain its current assets. Here is the complete formula:
Free cash flow is similar, but has one notable difference. Investopedia defines free cash flow as,
"A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow ((NYSE:FCF)) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, its tough to develop new products, make acquisitions, pay dividends, and reduce debt. FCF is calculated as: EBIT (1-Tax Rate) + Depreciation & Amortization - Change in Net Working Capital - Capital Expenditures. It can also be calculated by taking Operating Cash Flow and subtracting Capital Expenditures."
As this definition states, free cash flow includes all capital expenditures, both those needed to maintain the company's existing asset base as well as those needed to expand it. This contrasts with distributable cash flow, which only considers the costs of maintain its existing asset base and not the costs of growth. Therefore, a company that pays out a high percentage of its distributable cash flow to unit holders, as many do, may be left with insufficient cash flow to finance distribution growth. In that case, the company is forced to finance this externally through the issuance of either new equity or debt. As many firms are loathe to significantly dilute equity investors, debt has largely been the preferred method of financing these necessary expenditures for growth. This has left many MLPs highly levered, which also results in another problem - if a company pays out a significant portion of its distributable cash flow to unitholders then it may be left with insufficient cash to pay off its debt as it matures. In times of industry stress, these firms may be unable to roll over their debt as it matures, which is a situation that many industry analysts believe may begin to occur. It is worth noting, however, that a firm that has high leverage and pays out a significant portion of its free cash flow to shareholders would also have this same problem.
Naturally, every firm in the industry has a different degree of exposure to this problem. In this series of articles, I will examine the degree of exposure that an individual company has to encountering problems with its debt and attempt to determine the potential of a distribution cut. For the first article in this series, I will discuss what I consider to be one of the best-managed firms in the space, Pembina Pipeline Corporation (NYSE:PBA).
Strictly speaking, Pembina Pipeline is not a master limited partnership but is instead structured as a corporation. However, prior to October 2010, the company was structured as a Canadian income trust, which was roughly the Canadian equivalent of a master limited partnership (yes, there are some difference but for most income investors, these differences are academic). The primary reason for the conversion into a corporation was a 2006 proposal to change the tax rules for non-real estate focused income trusts, dubbed the "Halloween Massacre," that would bring the taxation rates of these companies relatively into line with those of corporations. As a result of this, most Canadian income trusts found it advantageous to convert themselves into corporations. However, many of these trusts continued to pay appealing dividend yields even after converting to corporations. In addition, many investors consider Pembina Pipeline and many of the other former Canadian income trusts as part of the MLP space, despite the fact that they are not master limited partnerships. As a result, I believe I am justified in including the company in this category.
Pembina Pipeline is no exception to this policy of maintaining appealing dividend yields after its conversion. At the time of writing, Pembina Pipeline boasts an impressive distribution yield of 8.85%. Many readers may note that this figure is lower than that of many other midstream operators. This is largely due to the market perceiving that Pembina Pipeline is a less risky investment than many of its peers.
As I mentioned earlier in this article, many midstream MLP-type companies are very highly levered. However, Pembina Pipeline is an exception to this. As of the close of the third quarter 2015, Pembina Pipeline had total short- and long-term debt, including convertible debt, of $3.647 billion. This compares to total shareholders' equity of $6.766 billion. This gives the company a total debt-to-equity ratio of 0.54. Here is how that compares to other midstream pipeline operators:
Source: Company Filings, Yahoo! Finance
As this chart shows, Pembina Pipeline currently boasts one of the lowest debt-to-equity ratios of any of the major pipeline operators. There are a number of advantages to this position, including lower interest costs and increased accessibility to capital. As many analysts and investment professionals have noted over the past twelve to eighteen months, many debt covenants contain limits on the amount of leverage a borrowing company is permitted to have. A company that exceeds these limitations is said to be in violation of its debt covenants and may suffer financial penalties, which may include the requirement that it accelerate its debt payments, pay a higher interest rate, be unable to borrow any more money, or reduce its dividends. By maintaining a low leverage ratio, Pembina Pipeline reduces the risk that it will breach its loan covenants.
Another metric that can be used to measure the relative leverage of a company is the net debt-to-EBITDA ratio. Investopedia defines this ratio as,
"A measurement of leverage, calculated as a company's interest-bearing liabilities minus cash or cash equivalents, divided by its EBITDA. The net debt to EBITDA ratio is a debt ratio that shows how many years it would take for a company to pay back its debt if net debt and EBITDA are held constant. If a company has more cash than debt, the ratio can be negative."
The net debt-to-EBITDA ratio is quite popular with analysts because unlike the debt-to-equity ratio, the net debt-to-EBITDA ratio actually shows a company's ability to carry its debt. This is why many banks include in a company's loan covenants that it maintain a certain net debt-to-EBITDA ratio or below - this reduces the risk that the borrower will be unable to make the required payments on the loan. Here, too, Pembina Pipeline compares quite well to its peers, as shown in the following chart:
As this chart shows, Pembina Pipeline has a lower net debt-to-EBITDA ratio than many of its peers. This provides us with reason to believe that the company's lenders will continue to provide it with financing and provides added confidence that Pembina Pipeline has less need to reduce its dividend in order to focus on debt reduction, as several peer companies have either already done or are expected to do.
Ultimately however, a company's ability to pay out money to its investors is dependent upon its free cash flow as discussed earlier in this article. Unfortunately, here things do not look as good. During the three-month period ended September 30, 2015, Pembina Pipeline produced total operating cash flows of $187 million. During that same time period, the company spent a total of $478 million on capital expenditures. That gives the company a negative free cash flow of $291 million. This quarter was not unique either, as shown here:
As this chart shows, Pembina Pipeline is consistently failing to generate sufficient money internally to maintain and expand its asset base (primarily its pipeline network but the company also has gas extraction plants) despite continuing to pay a dividend to its shareholders. This means that the company is reliant on external financing in order to grow. With that said though, the dividend is significantly less than its operating cash flow, so there is some margin of safety there. However, should the financing market become less friendly towards the company then it may also have to take steps to preserve its business as other MLP and MLP-like companies have done. With that said, its lower leverage does make it more likely that the markets will remain friendly in the short- and possibly medium-term.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.