A Closer Look At Inergy's 2011 Distributable Cash Flow

| About: Crestwood Midstream (CMLP)

In a January 29, 2012 article titled "What to expect following Inergy, L.P.'s (NRGY) announcement on January 27, 2012" I made a preliminary assessment that a 55% cut in distributions (to ~$1.27) accompanied by a further ~14% drop in unit price (to around $15 or lower) would be a good entry point for an investment in Inergy, L.P., but noted that a full analysis will have to wait until NRGY publishes quarterly results. NRGY has since submitted its Form 10-Q for the quarter ended 12/31/11 (the first fiscal quarter of 2012) and the unit price has dropped further (from $17.33 on 1/27/12 to $15.97 on 3/16/12). So this is an appropriate time for an update.

The definition of DCF used by NRGY is described in an article titled Distributable Cash Flow ("DCF") and compared to definitions used by other master limited partnerships. Using NRGY's definition, DCF for the 12 month period ending 12/31/11 was $226 million ($1.86 per unit), down from $239 million in 2010 ($2.98 per unit).

However, reported DCF numbers may differ considerably from what I consider to be sustainable. The generic reasons for this are reviewed in an article titled "Estimating Sustainable DCF-Why and How." Applying the method described there to NRGY results through December 31, 2011 generates the comparison outlined in the table below:

12 months ended: 12/31/11 9/30/11 12/31/10 9/30/10
Net cash provided by operating activities 117.0 114.4 145.1 173.6
Less: Maintenance capital expenditures (15.5) (14.0) (10.1) (9.9)
Add: cash expense on disposal of liability 57.7 39.4 - -
Sustainable DCF 159.2 139.8 135.0 163.7
Working capital used 41.8 97.1 76.8 50.4
Risk management activities (1.7) (1.2) (0.6) 1.0
Other 26.7 14.7 28.0 12.2
DCF as reported 226.0 250.4 239.2 227.3

Figures in $ Millions

Note that in deriving sustainable DCF I include $57.7 million and $39.4 million of cash expenses relating to a disposal of liabilities for the 12 months ended 12/31/11 and 9/30/11, respectively. These items represent cash consumed upon early extinguishment of debt, primarily related to the premium paid to bondholders as inducement to accept early payoff. It was deducted in deriving net cash from operations. I see it as a genuine one-time, non-operations related, item and therefore add it back in deriving sustainable DCF.

The principal differences of between sustainable and reported DCF numbers in 2011 and 2010 are attributable to working capital consumed and other items. As detailed in my prior articles, I generally do not include working capital generated in the definition of sustainable DCF but I do deduct working capital invested. Despite appearing to be inconsistent, this makes sense because in order to meet my definition of sustainability the master limited partnerships should, on the one hand, generate enough capital to cover normal working capital needs. On the other hand, cash generated from working capital is not a sustainable source and I therefore ignore it. Over reasonably lengthy measurement periods, working capital generated tends to be offset by needs to invest in working capital. I therefore do not add working capital consumed to net cash provided by operating activities in deriving sustainable DCF.

The "other" category includes a variety of items (in this case principally cash outflows from risk management activities that are not considered as outflows for reported DCF purposes) that I ignore in calculating sustainable DCF.

Coverage ratios cannot currently be calculated since because the distribution rate is unknown. In its January 27 2012 press release NRGY stated and that "… management and the board of directors of Inergy are evaluating a reset of the quarterly distribution to a level that is supportable by the cash flow expected to be generated from Inergy's businesses in the near term".

Based on the above table and assuming no further deterioration in the underlying business, it seems to me that sustainable DCF is $140 to $160 million per year, or around $1.22 per unit per annum (~$0.305 per quarter), compared to the unsustainable $2.82 ($0.705 per quarter) that was previously being distributed. Assuming a cut of this order of magnitude is implemented and that the new distribution level is indeed sustainable, the question then becomes what yield should NRGY trade at. Given NRGY's higher risk profile, low level of visibility with respect to its current operations and limited growth opportunities, 8.5% does not seem unreasonable and may well be on the low side. This implies a unit price of $15 or below.

Investors should, however, take into consideration the risk of further business deterioration. The winter quarters (ending Dec 31 and Mar 31) are critical for NRGY, and results in the quarter ended 12/31/11 were poor. Retail propane gallon sales were 89.3 million gallons compared to 107.1 million gallons sold in the same quarter of the prior year. Retail propane gross profit was $97.0 million compared to $132.3 million for the prior year period. Overall, gross profit was down $24 million (~12%). The March 2011 results were disappointing, but the current quarter's results may be even more so given the warm winter. This may put further pressure on the unit price.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.