In an article titled Distributable Cash Flow ("DCF") I present the definition of DCF used by Kinder Morgan Energy Partners LP (NYSE:KMP) and provide a comparison to definitions used by other master limited partnerships ("MLPs"). KMP's definition and method of deriving of DCF (what KMP refers to as "DCF before certain items") is complex and differs considerably from other MLPs I have covered. Using KMP's definition, DCF per unit for the trailing 12 months ("TTM") ending 9/30/12 was $4.99, up from $4.57 for the TTM ending 9/30/11.
Segment earnings before depreciation and amortization are summarized in Table 1 below (click to enlarge images):
Table 1: Figures in $ Millions
The Products Pipeline segment currently is expected to end the year slightly below its annual budget of 6% growth. The Natural Gas Pipeline is expected to exceed the year's budgeted growth of 19% due to drop downs by Kinder Morgan, Inc. (NYSE:KMI) into KMP of 100% interest in Tennessee Gas Pipeline and the 50% interest in El Paso Natural Gas pipeline to KMP for $6.22 billion, including assumed debt. This more than makes up for the loss of income due to FTC-mandated asset sales (the Federal Trade Commission's approval of the KMI-El Paso transaction was conditioned on such dispositions). Absent the drop-downs, natural gas segment would be down for the year versus its budget due to lower dry gas volumes (primarily on KinderHawk), as well as a slower ramp-up in Eagle Ford volumes. The CO2 segment is expected to finish the year modestly below the 26% growth target indicated in its annual budget. The Terminals segment is currently meet the year's budgeted growth of 8%.
The drop down also affected KMP's capital structure. The difference between the KMI's book value of the assets dropped down and the price paid by KMP accounts for the bulk of the was recorded as a general partner's contribution and accounts for $2.6 billion of the ~$3.4 billion increase in KMP's capital from 6/30/12.
As always, I attempt to assess how the reported 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 TTM numbers rather than quarterly numbers for the purpose of analyzing changes in reported and sustainable distributable cash flows.
The generic reasons why DCF as reported by an MLP may differ from sustainable DCF are reviewed in an article titled Estimating Sustainable DCF-Why and How. Applying the method described there to KMP' results with respect to sustainable cash flowing to the LPs generates the comparison outlined in Table 2 below:
Table 2: Figures in $ Millions
The principal differences of between sustainable and reported DCF numbers in Table 1 are attributable to risk management activities, working capital and a host of other items grouped under "Other".
In deriving reported DCF for the 9 months ending 9/30/12 and 9/30/11, management added back to net cash from operations $108 million and $74 million, respectively, of working capital used. I generally do not add back working capital used, but do deduct working capital generated, from net cash from operations in deriving sustainable DCF. Despite appearing to be inconsistent, this makes sense because in order to meet my definition of sustainability the MLP should generate enough capital to cover normal working capital needs. On the other hand, cash generated by the MLP through the liquidation or reduction of 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 used to net cash provided by operating activities in deriving sustainable DCF.
Risk management activities present a complex issue. I do not generally consider cash generated by risk management activities to be sustainable, although I recognize that one could reasonable argue that bona fide hedging of commodity price risks should be included. In this case, the KMP risk management activities items reflect proceeds from termination of interest rate swap agreements rather than commodity hedging and I therefore exclude them.
Items in the "Other" category include numerous adjustments as detailed in Table 3 below:
Table 3: Figures in $ Millions
These adjustments further illustrate the complexity and subjectivity surrounding DCF calculations. For example, as indicated by Table 3, depreciation added back for purposes of deriving management's reported DCF exceeds the amount in the cash flow statement because it includes KMP's share of depreciation in various joint ventures. These adjustments highlight the difficulty of comparing MLPs based on their reported DCF numbers, which is another reason why I exclude them from my definition of sustainable DCF.
Distributions, reported DCF, sustainable DCF and the resultant coverage ratios are as follows:
In 1Q12 management wrote down by $322 million the value of assets to be disposed by KMP as a result of the FTC mandate in connection with the El Paso acquisition. Based on information gained in the sale process, this estimate was increased by over 100% (an additional $327 million) in 2Q12, and further increased it by $178 million in 3Q12. An agreement to divest the assets for $3.3 billion ($1.8 billion in cash plus debt assumption) was entered into on 8/20/12. Notwithstanding the write downs, management exceeded the $3 billion price estimated by some analysts in March 2012.
Table 5 below presents a simplified cash flow statement that nets certain items (e.g., acquisitions against dispositions, debt incurred vs. repaid) and separates cash generation from cash consumption in order to get a clear picture of how distributions have been funded:
Simplified Sources and Uses of Funds
Table 5: Figures in $ Millions
Net cash from operations, less maintenance capital expenditures, less cash related to net income attributable to non-partners exceeded distributions by $545 million in the TTM ended 9/30/12 and by $516 million in corresponding prior year period. In light of the low distribution coverage ratios noted in Table 4, how can this excess be explained? I believe the capital structure of the Kinder Morgan partnerships provides an answer. Kinder Morgan Management, LLC (NYSE:KMR) owns approximately 31% of KMP in the form of i-units that receive distributions in kind. I estimate that had these units received cash instead, the $545 million excess would have been reduced by ~$514 million ($4.85 times an average of ~106 million i-units outstanding) for the TTM ended 9/30/12.
KMP closed at $83.72 on 11/1/12 and, with a $5.04 per annum current rate of distributions per unit, the yield is 6.02%. Distributions for the first 9 months of 2012 total $3.69. KMP expects total distributions declared in 2012 to reach $4.98 per unit (i.e., $1.29 per unit in 4Q12) and to reach ~$6.04 by 2015 (growth of ~ 7% per annum from 2011). Therefore 2013-2015 growth is expected at 6.67%.
In summary, despite including earnings from dropped-down assets for periods prior to their acquisition, sustainable DCF for the trailing 12 months ended 9/30/12 did not improve much compared to the prior year period and, in fact, declined on a per unit basis. Coverage ratio based on sustainable DCF is just below 1 both for TTM 9/30/12 and substantially below 1 in 3Q12. Another factor to consider is the need to issue a significant number of additional units to fund the KMI dropdowns. Negative operational trends cited by management include weak refined products demand, weakening domestic coal shipments and steel throughput across our system (that adversely affect the Terminals business segment), as well as drilling declines in some of the dry gas plays. On the other hand, natural gas power demand was up 8% in 3Q12 (up 20% year-to-date) on the Tennessee Gas Pipeline system, up 26% for the quarter and 47% year-to-date on pipelines serving the southeastern U.S., and up 13% for the quarter and 44% year-to-date on the TransColorado Gas Transmission system. These reflect what appears to be an encouraging increase in the utilization of these pipelines to ship natural gas to be used for electric generation purposes. Other positive trends include growth in the market for CO2 used in tertiary recovery, particularly in the Permian Basin, strong exports of coal, and increased demand for KMP's infrastructure due to increased drilling, accompanied by increased production, in the wet gas shale plays. Overall, I remain on the sidelines with respect to KMP. KMI which yields 4.16% but is growing distributions much faster (12.5% vs. 7%) may be a better alternative.