A Closer Look At Energy Transfer Partners' Distributable Cash Flow As Of 1Q 2012

| About: Energy Transfer (ETP)

In an article titled "Distributable Cash Flow ("DCF") I present the definition of DCF used by Energy Transfer Partners, L.P. (NYSE:ETP) and provide a comparison to definitions used by other MLPs. Using ETP's definition, DCF for the trailing 12 months ("TTM") period ending 3/31/12 was $5.17 per unit ($1,120 million), down 6% from $5.50 per unit ($982 million) for the TTM ending 3/31/11. In this article I compare reported DCF to what I call sustainable DCF, review distribution coverage ratios based on reported and sustainable DCF, look at how distributions were funded, and discuss issues relating to ETP's performance in 1Q 2012 and recent developments.

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 ETP results through December 31, 2011 generates the comparison outlined in the table below:

12 months ending: 3/31/12 3/31/11
Net cash provided by operating activities 1,309 992
Less: Maintenance capital expenditures (138) (99)
Less: Working capital (generated) (203) -
Less: Net income attributable to non-controlling interests (40) -
Sustainable DCF 928 893
Add: Net income attributable to non-controlling interests 40 -
Working capital used - 102
Risk management activities 155 (21)
Other (2) 8
DCF as reported 1,120 982

Table 1: Figures in $ Millions

The principal difference between reported DCF and sustainable DCF in Table 1 relates to working capital and to ETP's risk management activities. As explained in prior articles, in calculating sustainable cash flow I generally do not include working capital generated (see TTM ended 3/31/12) but I do deduct working capital invested (see TTM ended 3/31/11). Despite appearing to be inconsistent, this makes sense because in order to meet my definition of sustainability the MLP 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.

In deriving its reported DCF, ETP adds back losses from risk management activities. This item totals $155 million in the TTM ended 3/31/12, the bulk of which is comprised of unrealized losses on interest rate swaps and commodity derivatives, as well as fair value adjustments on inventory. I do not add back these losses when calculating sustainable DCF. I also deducted $40 million to reflect Regency Energy LP's (NYSE:RGP) interest in Lone Star.

Coverage ratios are as indicated in the table below:

12 months ending: 3/31/12 3/31/11
Total distributions $1,204 $1,072
Coverage ratio based on reported DCF 0.93 0.92
Coverage ratio based on sustainable DCF 0.77 0.83

Table 2

Incentive distributions to Energy Transfer Equity, L.P. (NYSE:ETE), ETP's general partner are included and accounted for 34.7% of total distributions for the TTM ended 3/31/12 and 35.8% for the comparable prior year period. The low coverage ratio of sustainable DCF is a warning signal.

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 ETP:

Simplified Sources and Uses of Funds

12 months ending: 3/31/12 3/31/11
Net cash from operations, less maintenance capex, less net income from non-controlling interests, less distributions (33) (179)
Capital expenditures ex maintenance, net of proceeds from sale of PP&E (1,586) (1,343)
Acquisitions, investments (net of sale proceeds) (2,467) (4)
Cash contributions/distributions related to affiliates & noncontrolling interests - (18)
Other CF from financing activities, net (38) (23)
(4,124) (1,567)
Cash contributions/distributions related to affiliates & noncontrolling interests 475 -
Debt incurred (repaid) 2,220 515
Partnership units issued 1,497 705
Other CF from investing activities, net 28 14
Other CF from financing activities, net - 8
4,221 1,243
Net change in cash 96 (324)

Table 3: Figures in $ Millions

Net cash from operations, less maintenance capital expenditures, less net income from non-controlling interests fell short of covering distributions in both periods. The $33 million shortfall in the TTM ending 3/31/12 would have been higher absent $203 million of cash generated by reducing working capital. Indeed, coverage ratio based on sustainable DCF is below 1 and is declining, as shown in Table 2.

On January 12, 2012, ETP contributed its propane operations, excluding the cylinder exchange business, to AmeriGas Partners, L.P. (NYSE:APU). ETP received ~$1.46 billion in cash and ~29.6 million APU units (which ETP is obligated to hold until January 2013). APU assumed ~$71 million of debt related to the propane operations. ETP recognized a gain on deconsolidation of $1.06 billion. Investors should note that the propane business is not considered a discontinued operation. Rather, subsequent to the APU transaction propane results are reflected via ETP's investment in APU and accounted for under the equity method. For the three months ended March 31, 2012, ETP recorded $39.4 million of equity in earnings related to APU. Propane segment results for 1Q 2012 are harder to understand because they are comprised of 11 days of consolidated propane business activity and ~80 days of propane activity measured using the equity method. If we ignore propane, all segments appear to have improved in 1Q 2012 vs. the prior year period in terms of adjusted EBITDA, as shown by the table below:

3 months ending: 3/31/12 3/31/11
Intrastate transportation and storage 192,269 172,815
Interstate transportation 112,980 80,110
Midstream 100,288 75,376
NGL transportation and services (Lone Star) 35,217 -
Retail propane and other retail propane related 88,795 142,355
All other 6,513 643
Total Segment Adjusted EBITDA 536,062 471,299

Table 4: Figures in $ Millions

However, one needs to look beyond adjusted EBITDA numbers to evaluate DCF performance. In 1Q 2012 the Intrastate Transportation and Storage Segment experienced a decrease in transported volumes due to an unfavorable natural gas price environment, a decrease in gross margin due to unfavorable mark-to-market adjustments and losses on commodity risk management activities which caused unrealized losses to increase sharply in the three months ended March 31, 2012, primarily due to the impacts of holding a larger volume of natural gas in the Bammal storage facility due to the warmer weather. From a DCF perspective, these and other factors translate into a marked deterioration in ETP's 1Q 2012 results:

3 months ending: 3/31/12 3/31/11
Net income 1,126 247
Depreciation and amortization 102 96
(Gains) losses on disposals of assets (1,055) 2
Loss on extinguishment of debt 115 -
Unrealized (gains) losses on non-hedged interest rate derivatives (27) (1)
Unrealized (gains) losses on commodity risk management activities 86 (7)
Maintenance capital expenditures (24) (20)
Other (3) 20
Distributable Cash Flow, as reported 320 337

Table 5: Figures in $ Millions

Reported DCF in 1 Q 2012 was $320 million, $12 million less than in 1Q 2011. But absent adding back the loss on extinguishment of debt and unrealized losses related to risk management (net of unrealized gains on floating-to-fixed rate swaps), DCF in 1Q 2012 would have been ~$146 million. If we ignore the loss on extinguishment of debt recognized in connection with ETP using some of the cash received from APU to repurchase ~$750 million face value of senior notes at a cost of $886 million, DCF in 1Q 2012 would have been $261 million vs. $331 million in 1Q 2011. This 21% decline is actually understated when you take into consideration that the number of units outstanding increased by 16.9% from the prior year period.

Following the $5.3 billion acquisition of Sunoco, Inc. (NYSE:SUN), ETP will further reduce its dependence on natural gas and become a transporter of heavier hydrocarbons like crude oil, NGLs, and refined products. However, in an article dated May 3, 2012, I noted that I cannot understand how the SUN acquisition could be immediately accretive to ETP. This is still the case. In addition, I am concerned about other aspects of the acquisition. For example, ETP will own a retail gasoline business which is non-strategic and does not fit well structure-wise because it is a corporation and, unlike a partnership such as ETP, it is subject to corporate taxes. Also, ETP is acquiring SUN's aging and money-losing Pennsylvania refineries. Although SUN plans to exit this business and is in negotiations with Carlyle Group (NASDAQ:CG) to form a joint venture to which SUN would transfer its refineries, ETP"s acquisition of SUN will proceed even if no agreement is reached with CG.

I am long both ETP and ETE, but in light of the low coverage ratio, the 1Q 2012 results and my sense of discomfort with the SUN acquisition, I am considering reducing my position.

Disclosure: I am long ETP, ETE.