A Closer Look At El Paso Pipeline Partners' 2011 Distributable Cash Flow

Mar. 5.12 | About: El Paso (EPB)

In an article titled Distributable Cash Flow ("DCF)" I present the definition of DCF used by El Paso Pipeline Partners, L.P. (NYSE:EPB) and provide a comparison to definitions used by other master limited partnerships (MLPS). Using EPB's definition, DCF per unit for 2011 was $2.91, down from $3.19 in 2010. How do these figures compare with what I call sustainable DCF for these periods?

The generic reasons why DCF as reported by the MLP may differs from call sustainable DCF are reviewed in an article titled "Estimating sustainable DCF-why and how." Applying the method described there to EPB results through December 31, 2011 generates the comparison outlined in the table below:

12 months ending: 12/31/11 12/31/10
Net cash provided by operating activities 748.0 671.7
Less: Maintenance capital expenditures (101.0) (94.0)
Less: Working capital (generated) (6.0) -
Less: Net income attributable to non-controlling interests (79.0) (226.6)
Sustainable DCF 562.0 351.1
Add: Net income attributable to non-controlling interests 79.0 226.6
Working capital used - 108.7
Other (67.0) (296.4)
DCF as reported 574.0 390.0
Click to enlarge

Figures in $ Millions

Results for 2011 present a very clean picture. There is no appreciable difference between reported DCF and what I term sustainable DCF. The 2011 vs. 2010 decrease in net income attributable to non-controlling interest is primarily due to the acquisition of additional interstate natural gas transportation and terminal facilities (the remaining 49% interest in each of Southern LNG Company (SLNG) and Elba Express in November 2010, the 28% interest in Colorado Interstate Gas Company (CIG) in June 2011 and the remaining 40% interest in Southern Natural Gas Company (SNG) in March and June 2011). Cash invested in working capital accounted for some of the difference between reported and sustainable DCF in 2010 (it was added back in deriving reported DCF), but changes in working capital did not cause a divergence between reported and sustainable DCF in 2011.

Coverage ratios, with and without this line item, are as indicated in the table below:

12 months ending: 12/31/11 12/31/10
Distributions to unitholders ($ Millions) 422.0 243.5
Coverage ratio based on reported DCF 1.36 1.60
Coverage ratio based on sustainable DCF 1.33 1.44
Click to enlarge

I find it helpful to look at a simplified cash flow statement by netting certain items (e.g., acquisitions against dispositions) and by separating cash generation from cash consumption.

Here is what I see for EPB:

Simplified Sources and Uses of Funds

12 months ending: 12/31/11 12/31/10
Capital expenditures ex maintenance, net of proceeds from sale of PP&E (162.0) (316.9)
Acquisitions, investments (net of sale proceeds) (1,412.0) (2,283.4)
Cash contributions/distributions related to affiliates & non-controlling interests (49.0) -
(1,623.0) (2,600.3)
Net cash from operations, less maintenance capex, less net income from non-controlling interests, less distributions 225.0 334.2
Cash contributions/distributions related to affiliates & non-controlling interests - 56.0
Debt incurred (repaid) 469.0 874.2
Partnership units issued 968.0 1,368.4
Other CF from investing activities, net (3.0) -
1,659.0 2,632.8
Net change in cash 36.0 32.5
Click to enlarge

Figures in $ Millions

Net cash from operations, less maintenance capital expenditures, less cash related to net income attributable to non-partners exceeded distributions by $225 million in 2011 and by $334 million in 2010. EPB is not using cash raised from issuance of debt and equity to fund distributions. The excess enables EPB to fund expansion projects without having to issue units or raise additional debt. EPB's current yield of ~5.5% 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.

In a January 10, 2012, article on EPB I noted the announcement by Kinder Morgan Inc. (NYSE:KMI) of its acquisition of El Paso Corp. (EP) resulted in a marked decline in EPB's unit price (price declined from $38 on October 14 to $32.17 on December 15, 2011 and was at $35.50 on January 10, 2012). 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 MLPs (KMP, KMR). I noted that while the market seemed to be marking down EPB's price to adjust for a slower pace of distribution expansion, 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 general partner. Subsequently, the share price increased back to $38, but dropped following publication of the 4Q11 results and closed at $36.26 on March 1, 2012.

Is this renewed drop justified? EPB's report on Form 10-K (filed February 27) suggests several reasons for investors to be concerned:

  1. Throughput volumes, measured in billion British thermal units per day (BBtu/d), have declined for 3 consecutive years (from 7,142 in 2009 to 7,014 in 2010, to 6,894 in 2011). Although, as management notes, "these decreases in throughput do not have a significant impact on EBIT as a material portion of our revenue is derived from firm reservation contracts", I remain concerned because of the downside given that 24% of contracted capacity expires in 2012-2013 and the fact that ~$17 million of 2011 revenues were generated by project cancellation payments indicates softening of demand on some pipelines (there were no such cancellations in 2010);
  2. Operating costs increased in 2011 (e.g., contractor and maintenance costs increased by $10 million, costs of assuring pipeline integrity increased by $5 million, payroll and benefit costs increased by $9 million); in 2011 overall, operating and maintenance costs grew at roughly the same ~4.8% pace as revenues (excluding), whilst in the two prior years revenue growth significantly exceeded growth in operating expenses;
  3. Management projects total cash capital expenditures in 2012 will fall below 2011 levels, both for maintenance and expansion ($91 million vs. $101 million for maintenance and $50 million vs. $163 million for expansion);
  4. In 2011 quarterly distributions, for the first time, exceeded the $0.43125 threshold beyond which the general partner's incentive distribution rights reach 50%; and
  5. In 2011 distribution coverage decreased each quarter (for a further drill-down that reviews the breakdown by quarter of the 2010-2011numbers in this report, click here). Note that coverage of sustainable distributions dropped below 1.0 in 4Q11.

My reasons for continuing to hold EPB units include:

  1. Distribution coverage of the 5.5% yield is still solid;
  2. There was no significant deterioration in per unit sustainable DCF ($2.85 in 2011 vs. $2.88 in 2010);
  3. Net income more than covers distributions. Such positive coverage is relatively rare in the MLP universe;
  4. There is no reason to assume EPB will be deprived of its "fair share" of dropdowns from the EP assets. KMI, EPB's soon-to-be general partner, has indicated it expects EPB will generate a very respectable 9% growth in distributions. Of course, funding these dropdowns will likely require issuing additional units;
  5. Post the EP acquisition, it will make sense for KMI to simplify its structure in order to avoid the complication, expense and potential conflict of interest inherent in being the general partner of three distinct MLPs. If such simplification occurs, EPB's limited partners may also share in some of its benefits. As an aside, in light of the scathing language used by Chancellor Leo E. Strine Jr. of the Delaware Court of Chancery in his decision not to halt the KMI's $21.1 billion acquisition of EP, I would expect KMI would exercise great effort to make sure any simplification proposal is really fair to all the limited partners, including EPB's.

Disclosure: I am long EPB.