A Closer Look At Enterprise Products Partners' Results For Q1 2016

| About: Enterprise Products (EPD)

Summary

Absolute levels of gross margins have held up remarkably well in the face lower energy prices, but have declined for 5 consecutive quarters on a per unit basis.

Mainly due to acquisitions, increases in distributions per unit have been accompanied by declines in DCF per unit; however the pace of decline slowed significantly in the last two quarters.

Coverage ratios, while having declined, are generally still robust. But in 1Q16, the ratio based on sustainable DCF is considerably thinner.

A key question is whether the gap between per unit DCF growth and the faster per unit distribution growth can be narrowed or reversed in the difficult environment facing EPD.

For reasons outlined in the article, a t the current price level continue to hold my position.

This article focuses on some of the key facts and trends revealed by 1Q16 results reported by Enterprise Products Partners L.P. (NYSE:EPD). A brief description of EPD and its business segments is provided in a prior article.

EPD uses gross operating margin, a non-GAAP financial measure, to evaluate performance of its business segments. This measure forms the basis of its internal financial reporting and is used by management in deciding how to allocate capital resources. The principal differences between gross operating margin and operating income are that the former excludes: a) depreciation, amortization and accretion expenses; b) impairment charges; c) gains and losses attributable to asset sales and insurance recoveries; and d) general and administrative costs. Another difference is that gross operating margin includes equity in income of unconsolidated affiliates. Gross operating margin is presented on a 100% basis before any allocation of earnings to non-controlling interests.

While absolute levels of gross margins have held up remarkably well in the face the sharp decline in energy prices, they have been declining when measured on a per unit basis:

Click to enlarge Table 1: Figures in $ Millions (except per unit amounts and % change). Source: company 10-Q, 10-K, 8-K filings and author estimates.

The contribution to gross operating margin by each of EPD's business segments is shown in Table 2. The adverse effects of the decline in energy prices on results (for example, through lower processing margins and lower volumes) is noticeable in 3 of EPD's segments:

Click to enlarge Table 2: Figures in $ Millions (except per unit amounts and % change). Source: company 10-Q, 10-K, 8-K filings and author estimates.

There are some notable differences in the asset base between 1Q16 and 1Q15. The offshore Gulf of Mexico business, which contributed $44 million in gross margin in 1Q15, was sold on July 24, 2015 and therefore made no contribution in 1Q16. On the other hand, the EFS Midstream assets, which were acquired effective July 1, 2015, contributed $53 million of gross operating margin in 1Q16, mitigating the decline in gross margin generated by the Crude Oil Pipeline segment.

The higher gross margin generated by the NGL Pipelines segment reflects higher equity production (i.e., NGL volumes that EPD earns and takes title to in connection with its processing activities), primarily due to higher ethane recoveries, a substantial increase in liquefied petroleum gas ("LPG") export volumes reflecting the new LPG assets placed in service in December 2015, and the ramp up of other new assets, including ATEX, Aegis, Front Range and Texas Express pipelines.

Declining volumes (down ~5%) hurt the Natural Gas segment's results. The Petrochemicals and Refined Products segment was hurt primarily by lower propylene sales margins.

Earnings before interest, depreciation & amortization and income tax expenses (EBITDA) decreased in the five recent quarters vs. the corresponding prior year periods when measured on a per unit basis. The declines in Adjusted EBITDA per unit followed 8 consecutive quarterly increases vs. the comparable prior year periods.

Click to enlarge Table 3: Figures in $ Millions (except per unit amounts and % change). Source: company 10-Q, 10-K, 8-K filings and author estimates.

Growth in reported distributable cash flow ("DCF") and a comparison to distributions for the periods under review are presented in Table 4 below. The data excludes $1.53 billion of proceeds from the sale of the offshore business in 3Q15. Table 4 indicates 5 consecutive quarters in which DCF per unit declined (albeit minimally in the last two) while distributions increased.

Click to enlarge

Table 4: Figures in $ Millions (except % change). Source: company 10-Q, 10-K, 8-K filings and author estimates.

The declines in DCF per unit are mainly due to large increases in units outstanding (~54.8 million units issued in October 2014 and ~36.8 million in February 2015) resulting from the Oiltanking acquisition. From a timing perspective, the number of outstanding units increases immediately upon consummation of an acquisition, while DCF contribution from the acquisition generally builds up more gradually.

DCF is one of the primary measures typically used by a midstream energy master limited partnership ("MLP") to evaluate its operating results. Because there is no standard definition of DCF, each MLP can derive this metric as it sees fit: and because the definitions used indeed vary considerably, it is exceedingly difficult to compare across entities using this metric. Additionally, because the DCF definitions are usually complex, and because some of the items they typically include are non-sustainable, it is important (albeit quite difficult) to qualitatively assess DCF numbers reported by MLPs.

Table 5 presents the manner in which DCF is derived:

Click to enlarge Table 5: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.

The generic reasons why DCF as reported by an MLP may differ from what I call sustainable DCF are reviewed in an article titled " Estimating sustainable DCF-why and how". EPD's definition of DCF and a comparison to definitions used by other MLPs are described in an article titled " Distributable Cash Flow".

A comparison between reported an d sustainable DCF in 1Q16 vs. 1Q15 and the trailing 12 months ("TTM") ended 3/31/16 and 3/31/15 is presented in Table 6:

Click to enlarge Table 6: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.

Reported DCF includes proceeds from asset sales, in this case primarily the previously mentioned $1.53 billion from the sale of the offshore business in 3Q15. But as readers of my prior articles are aware, I do not include proceeds from asset sales in my calculation of sustainable DCF.

Excluding sale proceeds from DCF for the same quarterly and periods, coverage ratios, while having declined, are generally still robust. But in 1Q16, the ratio based on sustainable DCF is considerably thinner:

Click to enlarge Table 7: Figures in $ Millions, except ratios. Source: company 10-Q, 10-K, 8-K filings and author estimates.

Variances between reported and sustainable DCF are also caused by working capital fluctuations. DCF as reported ignores all changes in working capital, while I ignore cash generated by liquidating working capital (I consider it not sustainable) but deduct funds required for working capital (because they are not available for distributions).

Sustainable coverage of distributions dropped to 1.07x in 1Q16 from 1.28x in 1Q15. As shown in Table 6, this was mainly due to a reduction in cash generated by operating activities coupled with an increase in cash required for working capital in the most recent period. Still, on a TTM basis coverage, however measured, remains solid and is one of the highest among midstream energy MLPs.

Table 8 below presents a simplified cash flow statement that nets certain items (e.g., acquisitions against dispositions, debt incurred vs. repaid) and separates cash generation from cash consumption in order to get a clear picture of how distributions have been funded:

Click to enlarge Table 8: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.

EPD issued 42.7 million units in 1Q16, which generated $1.01 billion of net cash proceeds. In the first 8 days of April EPD issued units to the tune of ~$438 million. Table 8 indicates the ratio of equity to debt financing has increased in the more recent periods. But EPD is not using cash raised from issuance of equity, or for that matter from issuing of debt and from asset sales, to fund distributions. On the contrary, it generates excess cash that reduces reliance on the issuance of additional partnership units or debt to fund expansion projects. Indeed, Net cash from operations, less maintenance capital expenditures, exceeded distributions by $599 million in the TTM ended 3/31/16 and by $611 million in the prior year period.

Long-term debt over Adjusted EBITDA currently stands at 4.3x. Management expects it to drop to between 3.5x and 4x by 2017 as some large organic projects are placed into service and begin generating EBITDA. Large equity issuances help achieve the leverage targets but place further pressure on bridging the gap shown in Table 4 between the pace at which DCF per unit is growing and the faster pace of distribution growth. This gap will not prevent EPD from achieving its projected distribution growth of 5.2% in 2016, but unless the trend is reversed it may threaten distribution growth in later years.

Can the trend be reversed? This is not an easy question to answer. EPD, along with other midstream energy MLPs, is facing a difficult environment. Prices for virtually every commodity handled by EPD, whether natural gas, crude oil, NGL products and petrochemical products, continued to decline in 1Q16. Volumes are down in some major categories (notably NGL processing, crude oil marine terminals, and natural gas transportation). With few exceptions (notably storage), gross operating margins (key performance metric - see Tables 1 and 2) are down. EPD is facing increased competition and pressure when contracts come up for renewal.

Factors mitigating these developments to some extent include EPD's breadth of operations - an integrated network of natural gas, NGL, crude oil and refined products midstream infrastructure including pipelines, natural gas processing, liquid and gas storage, NGL fractionation, import and export terminals, and marine transportation assets. It provides a leg up in terms of offering customers services throughout the full value chain.

Another important factor is EPD's long-term relationships with many of its suppliers and customers, and that it jointly owns facilities with many of its customers who either provide raw materials to, or consume, the end products from these facilities. Joint venture partners include major oil, natural gas and petrochemical companies, including BP, Chevron (NYSE:CVX), ConocoPhillips (NYSE:COP), Dow Chemical (NYSE:DOW), Exxon Mobil (NYSE:XOM), Marathon (NYSE:MPC), Shell (NYSE:RDS.A) and Spectra Energy (NYSE:SE).

A third factor is the ~$6.5 billion of capital projects currently under construction (as of April 1, 2016) on top of $2.7 billion of organic growth projects that were completed and placed into service in 2015. Of the projects currently under construction, about $2.2 million will be placed in service during 2Q, 3Q and 4Q of 2016, and about $4.2 billion of projects will be placed in service in 2017 and 2018.

I began investing in EPD in 2004, added to my positions through 2012 and reduced it modestly in 2014. At the current price level, I intend to hold my position.

Disclosure: I am/we are long EPD.

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.