This article analyses some of the key facts and trends revealed by 3Q16 results reported by Targa Resources Partners Corp. (NYSE:TRGP).
TRGP operates in two main segments:
Gathering and Processing: this segment is involved in "gathering of natural gas produced from oil and gas wells and processing this raw natural gas into merchantable natural gas by extracting NGLs and removing impurities" as well as crude oil gathering and terminal activities. Its assets are located "in the Permian Basin of West Texas and Southeast New Mexico; the Eagle Ford Shale in South Texas; the Barnett Shale in North Texas; the Anadarko, Ardmore, and Arkoma Basins in Oklahoma and South Central Kansas; the Williston Basin in North Dakota and in the onshore and near offshore regions of the Louisiana Gulf Coast and the Gulf of Mexico" (TRGP Form 10-K, 12/31/15).
Logistics and Marketing: this segment is involved in transporting, storing, and fractionating mixed natural gas liquids ("NGLs") and in terminal, storage and transport activities involving finished NGLs. These include services for exporting liquefied petroleum gas ("LPG"). It also provides storage and terminal services for refined petroleum products. Its assets are "generally connected to and supplied in part by the Gathering and Processing segment and are predominantly located in Mont Belvieu and Galena Park, Texas, in Lake Charles, Louisiana and in Tacoma, Washington" (TRGP Form 10-K, 12/31/15).
As a reminder, on 2/17/16, TRGP closed its acquisition of all of the outstanding common units of Targa Resources Partners LP ("NGLS") that it did not already own in a stock-for-unit transaction at a ratio of 0.62 common shares for each NGLS common unit. TRGP is now the general partner and sole limited partner of NGLS, whose common units no longer trade. However, TRGP did not acquire the 5 million 9% perpetual preferred units issued by NGLS in October 2015 at $25 per preferred unit. These remain outstanding and continue to receive dividends.
Concurrently, TRGP raised $994.1 by privately placing 965,100 shares of Series A Preferred Stock with detachable Series A Warrants exercisable into a maximum of 13.55 million shares of common stock at $18.88 per share, and Series B Warrants exercisable into a maximum of 6.53 million shares of common stock at $25.11 per share. The Series A Preferred pays a 9.5% fixed quarterly dividend in cash or, at the company's discretion, in kind. The warrants have a 7-year life.
In September 2016, Warrants exercisable into a maximum of 5.86 million shares were exercised and net settled for 3.19 million shares. In October 2016, Series A and B Warrants exercisable into a maximum of 13.3 million shares were exercised and settled for 7.63 shares.
This is TRGP's third quarterly report after the acquisition. So far, quarterly data reflecting the acquisition is available only with respect to the first three quarters of 2016 and 2015. Other quarterly data presented below (except for per share/unit amounts) reflects NGLS' results prior to the acquisition. The differences between those results and TRGP's consolidated results (which incorporated NGLS) should be sufficiently small to enable making reasonable comparisons across prior quarters.
Pro-forma per share metric comparisons for periods prior to the acquisition are more complicated to estimate. I derive my estimates of the number of TRGP shares that would have been outstanding each quarter had the acquisition been consummated in that quarter by adding 104.5 million shares (i.e., the number issued by TRGP in connection with the acquisition) to the number of TRGP shares that were outstanding in each quarter prior to the acquisition.
TRGP uses non-GAAP financial metrics such as Operating Margin, Adjusted EBITDA and DCF to evaluate the company's overall performance, evaluate performance of its business segments, evaluate business acquisitions, and set incentive compensation targets.
Table 1 shows results by segment for the past 9 quarters:
Table 1: Figures in $ Millions (except units outstanding, per share amounts and % change). Source: company 10-Q, 10-K, 8-K filings and author estimates.
Overall operating margin in 3Q16 is down 12% in absolute terms and 13% per share vs. 3Q15. The decline was principally driven by lower operating margin at the Logistics & Marketing segment (down 23.2% in 3Q16 vs. 2Q15), mostly due to lower LPG fees and volumes. These more than offset the 5.7% increase in the Gathering & Processing segment's operating margin, which was driven by higher NGL prices. But management expects a sharp recovery in LPG exports and fees in 4Q16.
Throughput comparison of 3Q16 to 3Q15 indicates the volume of natural gas processed (MMcf/d) was down 2%, gross NGL production was up 9%, the volume of natural gas sold (BBtu/d) excluding producer take-in-kind volumes) was up 3%, volume of crude oil gathered was down 5% and the volume of condensates sold was down 7%.
To reduce exposure to commodity price risk and reduce operating cash flow volatility due to fluctuations in commodity prices, management hedges the commodity prices associated with a portion of expected equity volumes of natural gas, NGL, and condensate generated by the Gathering & Processing segment. The hedged positions move favorably in periods of falling commodity prices and unfavorably in periods of rising commodity prices. Their impact on Operating Margin is included under "Other" in Table 1.
Total operating margin in the three most recent quarters is lower vs. the comparable prior year periods, both in absolute terms and on a per share basis. This is primarily due to lower commodity prices that drove down gross margins. In the trailing twelve months ("TTM") ending 9/30/16 operating margin is down only 2% in absolute terms vs. the corresponding prior year period, but down 25% on a per share basis.
TRGP defines operating margin as gross margin less operating expenses. Gross margin is generated by fee-based activities and the sale of commodities. The latter is greatly affected by fluctuations in energy prices and levels of uncertainty as to future price movements. Sale of commodities still generates a significant (and, in recent quarters, increasing) portion of total gross margin; this makes TRGP more susceptible to commodity price fluctuations.
Table 2: Figures in $ Millions (except percent). Source: company 10-Q, 10-K, 8-K filings and author estimates.
Table 2 indicates fee-based gross margin as a percent of total gross margin has been declining was 59% in 3Q16. In the conference call covering that quarter's results, management states: " our fee-based operating margin for the third quarter 2016 was approximately 79%". I cannot reconcile to that number.
Another important non-GAAP financial metric used by management is earnings before interest, taxes, depreciation & amortization (EBITDA). Management makes certain adjustments to EBITDA aimed at better measuring the partnership's ability to generate sufficient cash to support distributions. Adjusted EBITDA therefore excludes items such as: a) gains and losses on debt repurchases and asset dispositions; b) risk management activities related to derivative instruments used to hedge risk resulting from fluctuations in commodity prices and interest rates, c) unit-based compensation expenses; d) transaction costs related to business acquisitions; e) earnings/losses from unconsolidated affiliates net of distributions; and f) the non-controlling interest portion of depreciation and amortization expenses.
EBITDA and Adjusted EBITDA over the past 9 quarters are shown in Table 3. The three most recent quarters show decreases vs. the comparable prior year periods measured on a per share basis:
Table 3: Figures in $ Millions, except per unit amounts and % change. Source: company 10-Q, 10-K, 8-K filings and author estimates.
For the TTM ended 9/30/16, EBITDA per unit and Adjusted EBITDA per unit are down 24% and 27%, respectively, vs. the corresponding prior year period. In the conference call covering 3Q16 results, management noted it expects "Adjusted EBITDA to be higher than the first, second, or third quarters".
Asset impairments in Table 3 reflect goodwill reductions in the Field & Gathering segment.
TRGP derives DCF by deducting from Adjusted EBITDA the cash portion of its interest expense, maintenance capital expenditures, net income attributable to the 9% perpetual preferred units issued by NGLS, and adjusts for other items (e.g., by adding back a portion of maintenance capital expenditures attributable to non-controlling interests):
Table 4: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.
Coverage ratios shown below are calculated based on the dividends/distributions declared to common shares/units after publication of each quarter's results. For the three most recent quarters, the calculation also incorporates dividends declared to the Series A Preferred. Accrued dividends on restricted stock and restricted stock units that are payable upon vesting are also included (the amounts are very small). To avoid double counting in the quarters preceding the acquisition, I exclude distributions from NGLS to TRGP because those funds were, by and large, paid out as dividends to TRGP shareholders.
Coverage ratio in 3Q16 is substantially below 3Q15:
Table 5: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.
Reported DCF may differ substantially from what I consider sustainable DCF for a variety of reasons. Table 6 highlights the differences between the two DCF metrics:
Table 6: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.
The variance between reported and sustainable DCF results, in part, from differing treatments of working capital cash flows. Over reasonably lengthy measurement periods, working capital is not typically a huge consumer of funds for MLPs. But management's reported DCF numbers for 3Q16 and 3Q15 are derived by adding back funds invested in working capital. My sustainable DCF calculation deducts cash used for working capital because cash consumed is not available to be distributed. However, I ignore cash generated by liquidating working capital because I do not consider it a sustainable source. I acknowledge the apparent inconsistency in the methodology, but believe it results in a better approximation of sustainable DCF.
Coverage ratios based on both reported and sustainable DCF are shown in Table 7. It generally makes sense to focus more on TTM c overage ratios because seasonal fluctuations are neutralized (some of TRGP's businesses, notably wholesale propane marketing, are seasonal):
Table 7: Figures in $ Millions, except per unit amounts and coverage ratios. Source: company 10-Q, 10-K, 8-K filings and author estimates.
The quarterly and TTM periods ending 9/30/16 include one and two quarters, respectively, of preferred dividends vs. none that were paid in the prior year periods.
Comparing 3Q16 to 3Q15 we see that although total dividends/distributions declared decreased, coverage dropped substantially, measured both on a sustainable or as reported basis. Coverage on a TTM basis does not differ materially for reported and sustainable DCF and is above 1x under both measures. Management expects 1.2x dividend coverage in 4Q16 and at least 1x for 2016, in line with the level achieved in the latest TTM period.
The simplified cash flow statement in Table 8 indicates net cash from operations less maintenance capital expenditures exceeded distributions and that TRGP did not fund its distributions using cash raised from issuing debt and equity and from other financing activities:
Table 8: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.
TRGP's debt-to-TTM EBITDA ratio stood at 4.2x as of 9/30/16, an improvement over 4.7 as of 9/30/15. But it is still significantly higher than 3.2 where it stood as of 9/30/14 or the 3.5x debt-to-EBITDA ratio currently targeted by management. In the conference call discussing 3Q16 results, management noted that more than 50% of future growth capital expenditures would be funded with equity (vs. the 50/50 debt/equity ratio previously used) to help achieve the leverage target. At the same time, spending on growth capital expenditures has been curtailed. It is likely to be ~$525 million in 2016, down 23% from 2015, and is unlikely to be materially higher in 2017.
Dividend increases are unlikely before the leverage target is reached, but that could take several years given the modest amount excess cash (net cash from operations, less maintenance capital expenditures, less distributions) currently being generated, as can be inferred from Table 8. Investors should also bear in mind that in about 5 years DCF may be reduced by virtue of TRGP becoming a cash taxpayer.
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.