A Closer Look At Enterprise Products Partners' Results For Q2 2016

| About: Enterprise Products (EPD)

Summary

On a per unit basis, gross margins and EBITDA have been declining for 6 consecutive quarters; increases in units due to acquisitions are the major contributors to this trend.

DCF per unit in 2Q16 increased, albeit slightly, over the prior year quarter; the first such increase in 7 consecutive quarters.

For the last two years (since 2Q14), distribution growth has been outpacing DCF growth when both are measured on a per unit basis; correspondingly, excess coverage has declined.

Although trending lower, coverage ratios reported by EPD are generally still robust. But in 1Q16 and 2Q16, coverage ratios based on sustainable DCF are considerably thinner.

Despite some unfavorable trends, for reasons outlined in the article I continue to hold my position at the current price level.

This article focuses on some of the key facts and trends revealed by 2Q16 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.

Absolute levels of gross margins in 2Q16 are no worse than they were in 2Q14. They have held up remarkably well in the face the sharp decline in energy prices. However, when measured on a per unit basis, they have been declining for the last six consecutive quarters vs. the corresponding prior year periods. Increases in outstanding units due to acquisitions are major contributors to the trend seen in Table 1:

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 enlargeTable 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 2Q16 and 2Q15. The offshore Gulf of Mexico business, which contributed $44 million in gross margin in 2Q15, was sold on July 24, 2015 and therefore made no contribution in 2Q16. On the other hand, the EFS Midstream assets, which were acquired effective July 1, 2015, contributed $56 million of gross operating margin in 2Q16, mitigating the decline in gross margin generated by the Crude Oil Pipeline segment.

Higher pipeline transportation volumes (up ~12% vs. 2Q15) and marine terminal volumes (up ~53% vs. 2Q15 due to the ramp up of the Aegis Ethane Pipeline) drove up gross margin generated by the NGL Pipelines segment, which also benefited from higher equity production (i.e., NGL volumes that EPD earns and takes title to in connection with its processing activities). EPD's July 28 press release notes "equity NGL production increased 16% …primarily due to higher ethane recoveries by the partnership's processing plants in the Rockies and South Texas". This segment also benefited from a substantial increase in liquefied petroleum gas ("LPG") export volumes, although the press release noted EPD had "…three loadings of LPG exports cancelled for July 2016 and has received notices from customers cancelling five LPG loadings for August 2016…" Management expects the resulting decrease in total gross operating margin "…will be more than offset by the associated cancellation fees and the additional fees earned…" from exports of additional cargoes of polymer grade propylene ("PGP").

Lower pipeline transportation volumes (down ~8% vs. 2Q15) and marine terminal volumes (down ~13% vs. 2Q15) hurt the Crude Oil segment's results. The $58 million decline in this segment's gross operating margin vs. 2Q15 includes ~ $47 million of non-cash mark-to-market losses in 2Q16 on hedges related to blending activities. The decline would have been much greater but for the $56 million generated by the EFS Midstream system. Declining volumes (down ~3%) also hurt the Natural Gas segment's results, while the Petrochemicals and Refined Products segment was hurt primarily by lower sales margins attributable to higher global inventories of gasoline products.

Earnings before interest, depreciation & amortization and income tax expenses (EBITDA) have been declining for the last six consecutive quarters vs. the corresponding prior year periods when measured on a per unit basis. The declines in Adjusted EBITDA per unit followed eight consecutive quarterly increases vs. the comparable prior year periods. Increases in outstanding units due to acquisitions are major contributors to the trend seen in Table 1:

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

Distributable cash flow ("DCF") and a comparison of DCF to distributions for the periods under review are presented in Table 4. The data excludes $1.53 billion of proceeds from the sale of the offshore business in 3Q15. For the last two years (since 2Q14), distribution growth has been outpacing DCF growth when both are measured on a per unit basis.

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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:

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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 2Q16 vs. 2Q15 and the trailing 12 months ("TTM") ended 6/30/16 and 6/30/15 is presented in Table 6:

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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 reported by EPD are generally still robust. But they are trending lower. In 2Q16, coverage ratios based on sustainable DCF was considerably thinner (this was also the case in 1Q16):

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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 1.08x in 2Q16 from 1.21x in 2Q15. As shown in Tables 6 and 7, this was mainly due to distributions being increased while sustainable DCF was flat. Sustainable coverage of distributions dropped to 1.18x in the TTM ended 6/30/16 from 1.39x in the corresponding prior year period, mainly due to higher distributions coupled with a reduction in cash generated by operating activities and an increase in cash required for working capital. Still, coverage on a TTM basis, 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:

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

EPD issued 36.4 million units in 2Q16, generating $877 million of net cash proceeds. Table 8 indicates the ratio of equity to debt financing has increased in the more recent TTM period. 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 $506 million in the TTM ended 6/30/16 and by $1,026 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.

Can the unfavorable trends identified be reversed? This is not an easy question to answer. EPD, along with other midstream energy MLPs, is facing a difficult environment. Natural gas prices continued to decline in 2Q16 and although prices for crude oil and NGLs increased in 2Q16 vs. 1Q16, they are still at depressed levels. Volumes are down in some major categories (as noted in the discussion of Table 2) and 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, ConocoPhillips, Dow Chemical, ExxonMobil, Marathon, Shell and Spectra Energy.

A third factor is the ~$6.6 billion of capital projects currently under construction (as of July 1, 2016). Organic growth projects that were completed and placed into service totaled $2.7 billion in 2015, $300 million in 1Q16 and $600 million in 2Q16. In its second quarter report EPD notes it is "on schedule to place another $1.4 billion of projects into commercial service during the final six months of 2016" and, in addition, "approximately$5.2 billion of projects will be placed in service in 2017 and 2018. Once fully operational, every $1 billion placed into production can be expected to increase EBITDA by approximately $125 million per annum, about a 2.5% increase at the current run rate.

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.