A Closer Look At MLP Cash Flow Sustainability - Inergy, L.P.

| About: Crestwood Midstream (CMLP)
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With a distribution yield of 11.65%, a stock price down ~43% from its 52-week high, and recent purchases by insiders, an evaluation of the potential risks and rewards of buying Inergy L.P. (NRGY) should include a review of its cash flows and the sustainability of its distributions.

Readers of my prior articles on Buckeye Partners (NYSE:BPL), Plains All American Pipeline L. P. (NYSE:PAA), Enterprise Products Partners (NYSE:EPD), and Energy Transfer Partners (NYSE:ETP) may choose to skip the three following paragraphs since they contain general information relating to my approach with which they may already be familiar.

As an investor seeking the high yields being offered by MLPs, I look carefully at what portion of the distributions being received are really “earned” and generally seek to avoid or reduce positions in MLPs that fund distributions with debt or through issuance of equity (i.e., sale of additional partnership units). Since money is fungible and the MLP financial statements are voluminous and not always easy to read, ascertaining whether you are genuinely receiving a yield on your money (rather than of your money) can be a complicated endeavor.

In addition, it is important for a conservative investor to understand how safe is the current return before tackling the question of what are the MLP’s growth prospects. Sustainable distributions provide some protection in that under a downside scenario those MLPs that cannot maintain their distribution rates are likely to suffer significantly greater price deterioration.

In prior articles I noted that “sustainability” is not a clearly defined term and one has to settle on a subjective measure that one is comfortable with. My approach begins with the requirement that to be considered sustainable, an MLP’s net cash from operations should at least cover maintenance capital expenditures plus distributions over a 6-9 months measurement period.

NRGY has not raised distributions to its limited partners since 3Q FY2010 (quarter ended June 30, 2010) but offers one of the highest yields in the MLP universe. How do sustainable and reported distributable cash flows (DCF) generated by NRGY compare with its level of distributions? My analysis begins with the table below:

12 months ended:



Net cash provided by operating activities



Less: Maintenance capital expenditures



Less: Working capital (generated)



Add: cash expense on disposal of liability



Sustainable DCF



Working capital used



Risk management activities






DCF as reported



Figures in $ Millions; fiscal year ends Sep 30.

By my method, sustainable DCF for the 12 months ending 9/30/11 was $139.8 million. The principal differences vs. the $250.4 million reported DCF is attributable to $97.1 million of working capital consumed and $13.5 million of 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 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. Over reasonably lengthy measurement periods (9-12 months), 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 largest component of the $13.5 million of other items forming part of reported DCF is $9.5 million of transaction expenses. I do not include items such as this in my definition of sustainable DCF.

Note that I did include $39.4 million of cash expenses relating to a disposal of liabilities in deriving sustainable DCF for the 12 months ended 9/30/11. This represents cash consumed on 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 resultant coverage ratios are as follows:

12 months ended:



Distributions to unitholders ($ Millions)



Coverage ratio based on sustainable DCF



Coverage ratio based on reported DCF



Clearly there is an enormous gap between sustainable DCF and distributions.

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 Funds:

12 months ended:



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



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



Acquisitions (net of operating unit sale proceeds)



Debt incurred (repaid)



Other CF from financing activities, net





Debt incurred (repaid)



Partnership units issued





Net change in cash



Figures in $ Millions; fiscal year ends Sep 30.

We can see that for the past two years distributions have not been funded by DCF, let alone sustainable DCF. Maintaining, let alone growing, distributions will be a challenge for NRGY unless: (i) additional debt and/or partnership units are issued; and/or (ii) internally generated growth projects substantially increase cash from operations relative to their current levels.

The ability to issue debt or units to maintain distribution levels is largely a function of market conditions. If market conditions are not accommodating, distributions will have to be cut unless NRGY can significantly improve its results from operations. Investors looking to get a yield of 11.65% while waiting for such improvement to materialize should bear in mind how this yield is sourced and closely watch developments regarding major internal growth projects:

  1. The proposed MARC I pipeline (anticipated to be placed into service in mid-year 2012);
  2. The North/South II expansion project announced in September 2011 and expected to add significant incremental transportation capability and fee-based revenue to the natural gas transportation business;
  3. Expansion of the Seneca Lake facility by approximately 0.6 Bcf by December 2012, and conversion of existing cavern capacity on US Salt properties into approximately 10.0 Bcf of natural gas storage capacity by 2014;
  4. Development of a 2.1 million barrel propane and butane storage facility near Watkins Glen, New York expected to be placed into service by June 2012; and
  5. Tres Palacios, TX. Higher storage volumes at this facility are expected as greater volumes of NGLS are produced from the Eagle Ford shale and other plays in and around Texas.

Disclosure: I am long BPL, EPD, ETP, PAA.