A Closer Look At Energy Transfer Partners' Q2 2016 Results

| About: Energy Transfer (ETP)
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Measured on a per unit basis, Adjusted EBITDA and DCF have been declining for the last 5-6 consecutive quarters vs. the corresponding prior year periods.

DCF does not cover distributions and coverage would have been even lower but for the IDR reduction agreed to by ETE.

Sustainable DCF coverage is substantially lower than the reported coverage.

ETP has been funding distributions by issuing debt and limited partnership units, by generating cash proceeds from asset sales, and by reducing cash reserves.

Maintenance capital expenditures are down 11% on a TTM basis, while investment in property plant and equipment is up significantly.

This article analyses some of the key facts and trends revealed by 2Q16 results reported by Energy Transfer Partners, L.P. (NYSE:ETP).

ETP operates and reports in seven business segments. These are described in a prior article. ETP's management uses Adjusted EBITDA, a non-GAAP financial metric, to evaluate segment performance, measure a segment's of core profitability, allocate capital resources among segments, evaluate business acquisitions, and set incentive compensation targets. Management defines it as earnings before interest, taxes, depreciation & amortization (EBITDA) less various non-cash items (e.g., non-cash compensation expense, gains and losses on disposals of assets, allowance for equity funds used during construction, unrealized gains and losses on commodity risk management activities, non-cash impairment charges, loss on extinguishment of debt, and gain on deconsolidation). Adjusted EBITDA includes amounts for less than 100% owned consolidated subsidiaries based on 100% of the subsidiaries' results of operations; for unconsolidated subsidiaries it includes ETP's proportionate ownership of the subsidiaries' results of operations.

Adjusted EBITDA by segment is presented in Table 1. When measured on a per unit basis, this metric has been declining for the last five consecutive quarters vs. the corresponding prior year periods:

Table 1: Figures in $ Millions, except per unit amounts, % change and units outstanding (million). Source: company 10-Q, 10-K, 8-K filings and author estimates.

Adjusted EBITDA in 2Q16 vs. 2Q15 increased at the Intrastate segment primarily due to higher storage margins, decreased at the Midstream segment due to lower gross margins, and increased at the Liquids segment due to higher storage, transportation and processing margins driven by the higher volumes and higher rates. The Sunoco Logistics segment is ETP's investment in Sunoco Logistics Partners, L.P. (NYSE:SXL). The drop in Adjusted EBITDA vs. 2Q15 results from lower crude oil and NGL volumes as well as inventory valuation adjustments. The decline in Retail Marketing reflects the final dropdown to Sunoco LP (NYSE:SUN) of the remaining 68.42% interest in convenience store operator Sunoco LLC and 100% interest in the legacy SUN retail business that was completed in March 2016. The Retail Marketing segment has been deconsolidated and its results are now reflected as an equity method investment in limited partnership units of SUN. As of June 30, 2016, ETP owned 45.6% (43.5 million) of SUN's total outstanding units.

The inventory valuation adjustment at the Sunoco Logistics segment reversed a $60 million gain booked in 1Q16 due to the impact of SXL's last-in, first-out ("LIFO") method of accounting in an environment where commodity prices are falling. Management predicted this gain would be reversed. A $25 million inventory gain booked in 2Q15 makes the 2Q16 results appear more unfavorable by comparison.

The method used by ETP to derive Distributable Cash Flow ("DCF") is shown in Table 2. When measured on a per unit basis, this metric has been declining for the last six consecutive quarters vs. the corresponding prior year periods:

Table 2: Figures in $ Millions except units outstanding. Source: company 10-Q, 10-K, 8-K filings and author estimates.

DCF decreased 23% in absolute terms and 37% on a per unit basis in 2Q16 vs. 2Q15. Likewise, as seen in Table 1, Adjusted EBITDA decreased 8% in absolute terms and 20% on a per unit basis. In part, these differentials reflects the dilutive effect of the higher number of ETP units outstanding between those two periods (502.7 million vs. 436.3 million, a 15% increase mostly due to ETP's April 2015 merger with Regency Energy Partners L.P.). But there are also other factors at work, notably a $112 million tax benefit in 2Q15 vs. a $13 million tax expense in 2Q16.

Maintenance capital expenditures declined 22% in 2Q16 and 30% 1Q16 vs. the corresponding prior year periods and are down 10.6% measured on a TTM basis. I am somewhat surprised by this because ETP significantly increased its investment in property plant and equipment. Since expenditures on maintenance are comprised of a portion that is expensed and a portion that is capitalized, one possible explanation is that the portion expensed increased (management's disclosures did not cover this point). The other possible explanation is that not enough is being spent. Management currently estimates it will spend $328 million on direct maintenance capital expenditures in 2016 vs. $394 million in 2015. This is an item that bears watching in reports for subsequent periods.

Consolidated DCF includes amounts attributable to SXL and SUN. The manner in which Energy Transfer Equity, L.P. (NYSE:ETE), ETP's general partner. determines DCF attributable to ETP's partners and ETP's coverage ratio is presented in Table 3. Note that DCF attributable to, and distribution from, SUN subsequent to 6/30/15 is zero because SUN was deconsolidated and is now reflected as an equity method investment.

Table 3: Figures in $ Millions, except per unit amounts and ratios. Source: company 10-Q, 10-K, 8-K filings and author estimates.

ETP's DCF did not cover its distributions in the first two quarters of 2016. Nor did it do so on a trailing twelve months ("TTM") basis. Coverage for the TTM ending 6/30/16 stood at 0.92x, a considerable distance from the stated goal of 1.05x.

Distributions declared to the partners of ETP include those to which ETE receives by virtue of its general partner's ownership position, incentive distribution rights ("IDRs"), and Class H units. The allocation of distributions declared to all the partners of ETP indicates the holders of the limited partner units received ~59% of the total amount distributed by ETP in the TTM ending 6/30/16:

Table 4: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.

DCF is one of the primary measures typically used by a midstream energy master limited partnership ("MLP") to evaluate its operating results. Because there is no standard definition of DCF, each MLP can derive this metric as it sees fit; and because the definitions used vary considerably, it is exceedingly difficult to compare across entities using this metric. Additionally, because the DCF definitions are usually complex, and because some of the items they typically include are unsustainable, it is important (albeit quite difficult) to qualitatively assess DCF numbers reported by MLPs.

The generic reasons why DCF as reported by a master limited partnership ("MLP") may differ from what I call sustainable DCF are reviewed in an article titled " Estimating sustainable DCF-why and how". DCF definitions used by other MLPs are described in an article titled " Distributable Cash Flow".

Table 5 provides a comparison between the components of reported and sustainable DCF on a consolidated basis:

Table 5: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.

The variances between reported and sustainable DCF are magnified because of working capital fluctuations. DCF as reported for the TTM ended 6/30/16 and 6/30/15 ignores the $525 million and $1,619 million, respectively, of cash consumed by operating assets and liabilities (i.e., working capital). In calculating sustainable DCF, I deduct cash used for working capital because cash consumed is not available to be distributed. However, despite the apparent contradiction in the methodology, I ignore cash generated by liquidating working capital because I do not consider it a sustainable source. Over reasonably lengthy measurement periods, working capital is not typically a huge consumer of funds for MLPs. However, this has not been so in the case of ETP. Since January 2014, ETP has invested $1.78 billion (net) in working capital to support its organic and acquired operations.

The risk management line item consists primarily of adjustments for derivative activities relating to interest rate swaps and commodity price fluctuations. These totaled $246 million and $33 million for the TTM months ending 6/30/16 and 6/30/15, respectively. They consist mostly of losses resulting from decreases in interest rates that management adds back in deriving DCF; they are excluded from my calculation of sustainable DCF.

A variety of items are within the $219 million of "Other" in the latest TTM period, the most significant of which is a $148 million of additional income tax benefit, over and above the $44 million included within cash flows from operating activities in that period.

Table 6 compares the coverage ratio as reported by ETP to the coverage ratio based on sustainable DCF. There are material differences:

Table 6: Coverage ratios. Source: company 10-Q, 10-K, 8-K filings and author estimates.

Sustainable DCF in the TTM ended 6/30/16 was $2,718 million, substantially less than the $3,945 million of distributions in that period.

The simplified cash flow statement in Table 7 indicates net cash from operations less maintenance capital expenditures fell short of covering distributions (including distributions to non-controlling interests) by $1,343 million in the latest TTM period. In both TTM periods ETP funded distributions by issuing debt and limited partnership units, by selling assets sales, and by reducing cash reserves:

Table 7: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.

As pointed out in a prior article and indicated by the data in Tables 6 and 7, ETP requires assistance from ETE in the form of IDR relief to maintain distributions at the current level. In July, ETE agreed to reduce ETP's IDR payments by $720 million over a period of seven quarters, beginning with 2Q16 and ending 4Q17. Pursuant to this agreement,$75 million of this IDR reduction agreement was implemented in 2Q16 (i.e., the $1,025 million appearing in Table 6 reflects the initial reduction).

Management sees continued strong volume growth, especially natural gas liquids ("NGLs") from the Permian and Eagle Ford, as well as intra- and interstate opportunities and increased deliveries of NGLs to Mexico. And, as outlined in its recent Analyst Day presentation (November 2015), management is determined to press on with its growth plans, ambitiously targeting ~6-8x EBITDA multiples on $10 billion of committed projects scheduled for completion through 4Q17. In its analyst conference call discussing 2Q16 results, management stated that it "continues to foresee significant EBITDA growth in 2017 and 2018 from the completion of its project backlog".

ETP's cost of equity capital is high and it is constrained in terms of additional borrowings by a high leverage ratio. Hence, in addition to the IDR relief, ETP announced on August 2nd that it will generate ~$1.2 billion in cash by selling a portion of its stake in one of the growth projects (Bakken Pipeline). Further such steps may be necessary to avoid distribution cuts and bridge the gap until the new organic growth projects are placed in service and begin generating cash.

I no longer hold a position in ETP and ETE.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.