A Closer Look At Inergy's Distributable Cash Flow As Of 2Q FY2012

| About: Crestwood Midstream (CMLP)

In an article dated December 29, 2011 on the cash flow sustainability of Inergy, L.P. (NRGY) I noted that "… for the past two years distributions have not been funded by distributable cash flow (DCF), let alone sustainable DCF. Maintaining, let alone growing, distributions will be a challenge for NRGY. On 1/27/12 MRGY announced 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." Following this announcement, the unit price dropped 23.6% (from $22.68 to $17.33).

On 1/29/12, I published an article titled "What to expect following Inergy, L.P.'s announcement on January 27, 2012" in which 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. Then, in a subsequent article published on 3/19/12, I noted that for distributions to be sustainable, they would have to be cut from the then current level of $2.82 per annum ($0.705 per quarter) to around $1.22 per unit per annum (~$0.305 per quarter) and that a unit price of ~$15 may not be unreasonable once this adjustment occurs given NRGY's higher risk profile, low level of visibility with respect to its current operations and limited growth opportunities. On 3/20/12 the closing unit price stood at $15.88.

The price per unit stayed roughly at that level until 4/26/12 when NRGY announced: a) a cut in distributions to $1.50 per annum ($0.375 per quarter); and b) an agreement to contribute its retail propane operations to Suburban Propane Partners, L.P. (NYSE:SPH) in exchange for approximately $1.8 billion, comprised of $600 million in SPH common units, $200 million in cash and $1 billion in the form of an exchange of NRGY's outstanding senior notes for new SPH senior notes. In addition, NRGY will receive, and will distribute to its unit holders, ~13.7 million of the SPH common units following the registration of the units. NRGY expects the transaction to close by 9/30/12. The price per unit responded with an impressive 22.8% gain to ~$19.50 and has since trended lower, closing at $17.63 on 5/25/12.

Before looking into the implications of the sale of the propane business to SPH and the 5/4/12 announcement of the drop-down of U.S. Salt LLC to Inergy Midstream L.P. (NRGM), it is appropriate to review NRGY's results of operations as of its second fiscal quarter ended 3/31/12 (2Q FY2012).

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 3/31/12 was $183 million ($1.51 per unit), down from $243 million for the 12 month period ending 3/31/11 ($3.12 per unit). As always, I first attempt to assess how these DCF figures compare with what I call sustainable DCF for these periods and whether distributions were funded by additional debt or issuing additional units. Given quarterly fluctuations in revenues, working capital needs and other items, it makes sense to review trailing 12 months ("TTM") numbers rather than quarterly numbers for the purpose of analyzing changes in reported and sustainable distributable cash flows.

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 3/31/12 generates the comparison outlined in the table below:

12 months ended:

3/31/12

3/31/11

Net cash provided by operating activities

187

155

Less: Maintenance capital expenditures

(15)

(12)

Less: Working capital (generated)

(11)

-

Less: net income attributable to GP

-

-

Proceeds from sale of assets / disposal of liabilities

20

38

Sustainable DCF

181

182

Working capital used

-

54

Risk management activities

(1)

0

Other

4

6

DCF as reported

183

243

Click to enlarge

Table 1: Figures in $ Millions

The principal difference between sustainable and reported DCF numbers for the two periods presented in Table 1 is attributable to working capital consumed. 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 item "Proceeds from asset sales or disposal of liabilities" that I typically exclude is, in this particular instance, added back to net cash from operations in deriving sustainable DCF. The reason is that in this case the item consists principally of cash expenses resulting from 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 can accept this as genuine one-time, non-operations related, items and therefore am comfortable adding it back in deriving sustainable DCF.

Coverage ratios, calculated pro-forma for the reduced level of distributions, are indicated in the table below:

12 months ending:

03/31/12

03/31/11

Pro forma distributions to unitholders (per unit)

$1.50

$1.50

Weighted average units outstanding (millions)

121

78

Pro forma distributions to unitholders ($ Millions)

$182

$117

reported DCF per unit

$1.51

$3.12

Sustainable DCF per unit

$1.50

$2.33

Coverage ratio based on reported DCF

1.00

2.08

Coverage ratio based on sustainable DCF

1.00

1.56

Click to enlarge

Table 2

As can be seen in Table 2, coverage ratios remain thin even after implementing the 47% cut in distributions per unit.

The simplified cash flow statement in the table below gives a clear picture of how distributions have been funded in the last two years. The table nets certain items (e.g., debt incurred vs. repaid) and separates cash generation from cash consumption.

Simplified Sources and Uses of Funds

12 months ending:

03/31/12

03/31/11

Net cash from operations, less maintenance capex, less net income from non-controlling interests, less distributions

(163)

(212)

Capital expenditures ex maintenance, net of proceeds from sale of PP&E

(199)

-

Acquisitions, investments (net of sale proceeds)

(90)

(1,010)

Debt incurred (repaid)

(158)

-

Other CF from investing activities, net

-

(4)

(610)

(1,226)

Cash contributions /distributions related to affiliates & non-controlling interests (issuance of NRGM units)

293

-

Net of proceeds from sale of PP&E

199

Debt incurred (repaid)

-

581

Partnership units issued

309

414

Other CF from financing activities, net

5

32

606

1,226

Net change in cash

(4)

(1)

Click to enlarge

Table 3: Figures in $ Millions

Table 3 corroborates findings from my prior articles on NRGY. For the past two years distributions have been funded through issuance of partnership units, issuance of NRGM units and by debt. I concluded this is not sustainable and indeed that proved to be the case.

The risk of further deterioration in the propane business was noted in my 3/19/12 article. The winter quarters (ending Dec 31 and Mar 31) are critical for the propane business and while results for the quarter ended 3/31/11 were disappointing, results for the recent quarter ending 3/31/12 were much worse. Propane gross margin declined 56% to $121.3 million in the recent quarter compared to the comparable prior year period. Although gross margin on NRGY's other businesses increased 13.6% to $78.5 million, the overall gross margin level is insufficient. This is clearly demonstrated by the fact that NRGY's long term debt as of 3/31/12 stood at $1.68 billion and presented a very high multiple (5.9x) of EBITDA for the TTM ending 3/31/12.

The question whether to buy NRGY at its current unit price level of $17.63 and 8.50% yield should be considered in light of the fact the partnership has taken significant steps towards exiting the propane business and deleveraging.

Long term debt will be reduced by ~$1 billion by 9/30/12 following an exchange of NRGY's outstanding senior notes for new SPH senior notes. Long term debt could be further reduced assuming NRGY decides to use for that purpose: a) the $200 million cash it will receive from SPH; b) the $192.5 million proceeds from the drop-down to NRGM of U.S. Salt LLC; and c) the ~ $100 million it will receive should it issue a further 5 million NRGM units as contemplated by the amendment its credit agreement announced 4/19/12. Under this scenario, NRGY would be left with long term debt totaling only ~$200 million.

On the asset side, under this scenario, NRGY is left with: a) ~69% interest in NRGM worth ~$1.07 billion; b) the incentive distribution rights ("IDRs") in the general partner of NRGM which entitle NRGY to 50% of NRGM distributions beyond $0.37 per unit per quarter; c) the Tres Palacios natural gas storage facility in Texas and the West Coast NGL business (estimated by research analysts to be worth ~$300 million and $200 million, respectively); and d) ~ 13.7 million SPH units worth ~$645 million (these will be distributed to NRGY unit holders). So excluding the IDRs, the total value net of debt is ~$2 billion vs. the ~$2.32 billion obtained by multiplying the current unit price of $17.63 (as of 5/25/12) by ~ 131.5 million units currently outstanding. NRGM pays $0.37 per unit per quarter, so NRGY, via its IDRs, will get 50% of any increases beyond the $27.5 million per quarter ($110 million annualized) currently being distributed by NRGM. in distributions. I don't think the IDRs are worth $300 million (my back-of-the-envelope calculation indicates they are not), but in any event, I don't see NRGY providing much of an upside vs. some of the other MLPs I have covered, including for example: El Paso Pipeline Partners (NYSE:EPB), Enterprise Products Partners (NYSE:EPD), Magellan Midstream Partners (NYSE:MMP), Targa Resources Partners (NYSE:NGLS), Plains All American Pipeline (NYSE:PAA), and Williams Partners (NYSE:WMB).

Disclosure: I am long EPB, EPD, PAA, WPZ.