A Closer Look At Plains All American Pipeline's 2011 Distributable Cash Flow

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In an article titled Distributable Cash Flow ("DCF") I present the definition of DCF used by Plains All American Pipeline L.P. (NYSE:PAA) and provide a comparison to definitions used by other master limited partnerships. Using PAA's definition, DCF for the 12-month period ending December 31, 2011, was $1,149 million ($7.66 per unit), up from $757 million in 2010 ($5.49 per unit). As always, I first attempt to assess how these figures compare with what I call sustainable DCF for these periods and whether distributions were funded by additional debt or issuing additional units.

The generic reasons why DCF as reported by the MLP may differ from sustainable DCF are reviewed in an article titled Estimating Sustainable DCF-Why and How. Applying the method described there to PAA results through December 31, 2011, generates the comparison outlined in the table below:

12 months ending: 12/31/11 12/31/10
Net cash provided by operating activities 2,365 259
Less: Maintenance capital expenditures (120) (93)
Less: Working capital (generated) (1,002) -
Less: Net income attributable to non-controlling interests (28) (9)
Sustainable DCF 1,215 157
Add: Net income attributable to non-controlling interests 28 9
Working capital used - 605
Risk management activities (56) 16
Proceeds from sale of assets / disposal of liabilities 44 21
Other (84) (51)
DCF as reported 1,149 757

Figures in $ Millions

How did net cash provided by operating activities in 2011 increase by $2,365 million in 2011 vs. an increase of only $259 million in 2010? The two major components of the answer are: (i) net income increased by $480 million; and (ii) working capital consumed $605 million in 2010 but generated $1,002 million in 2011, for a net difference of $1,607 million. These two items total $2,087 million. The balance is accounted for by other items

As explained in prior articles, in calculating sustainable cash flow I generally do not include working capital generated 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. When there are large swings in working capital, as is the case here, my approach results in large swings in coverage ratios based on sustainable cash flow, as seen in the following table:

12 months ending: 12/31/11 12/31/10
Distributions to unitholders ($ Millions) $831 $692
reported DCF per unit $7.66 $5.49
Sustainable DCF per unit $8.10 $1.14
Coverage ratio based on reported DCF 1.38 1.09
Coverage ratio based on sustainable DCF 1.46 0.23

In 2010, $605 million of cash was used to increase working capital (principally through a $365 million increase in inventory levels and a $210 million reduction in accounts payable). The DCF number reported by PAA ignores this amount. The sustainable DCF number does not, hence the low coverage ratio in 2010.

In 2011, $1,002 million of cash was generated by working capital. The two main components of this were the liquidation of $518 million of crude oil inventory that had been stored in the contango market (for an explanation of backwardated and contango markets click here) and a $401 million increase in accounts payable. I do not view these as sustainable sources of cash. The number reported by PAA ignores this amount because, under PAA's definition, reported DCF always excludes working capital changes, whether positive or negative.

PAA has increased its distributions per unit for the last 10 consecutive quarters, so the coverage ratios above, which are calculated based on distributions actually made during the relevant period, may be slightly overstated. Distributions actually made totaled approximately $3.905 per unit for the 12 months ended December 31, 2011, while the current distribution level is at $4.10 per annum. This ~5% increase does not materially reduce the very robust coverage ratio.

Other factors, however, could reduce coverage ratios in 2012. As previously mentioned, net income increased by $480 million. This 93% jump over 2010 results is so large that further analysis is required to assess the likelihood of 2012 results surpassing 2011. A useful starting point to assess this is the following table:

12 months ending: 12/31/11 12/31/10
Transportation segment profit 555 516
Facilities segment profit 358 270
Supply & Logistics segment profit 647 240
Total segment profit 1,560 1,026

Figures in $ Millions

The extraordinary growth in Supply & Logistics segment profit is attributed by management in one part to two main factors. One is the "…impact of higher volumes due to increased production related to the active development of crude oil and liquids-rich resource plays. The increase in volumes was primarily a result of increased drilling activities in the Bakken, Eagle Ford Shale, West Texas, Western Oklahoma and Texas Panhandle producing regions…" The other relates to "…increased margins related to production volumes exceeding existing pipeline takeaway capacity in certain regions and the associated logistics challenges". Management cautions that the margins delivered in 2011 may not be repeated: "…a normalization of margins may occur as the logistics challenges are addressed" (quotes are from PAA's 2011 10-K).

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 PAA:

Simplified Sources and Uses of Funds

12 months ending: 12/31/11 12/31/10
Net cash from operations, less maintenance capex, less net income from non-controlling interests, less distributions - (526)
Capital expenditures ex maintenance, net of proceeds from sale of PP&E (508) (356)
Acquisitions, investments (net of sale proceeds) (1,000) (159)
Debt incurred (repaid) (759) -
Other CF from investing activities, net (22) -
Other CF from financing activities, net (24) (3)
(2,313) (1,044)
Net cash from operations, less maintenance capex, less net income from non-controlling interests, less distributions 1,414 -
Debt incurred (repaid) - 734
Partnership units issued 889 296
Other CF from investing activities, net - 25
2,303 1,055
Net change in cash (10) 11

Figures in $ Millions

Net cash from operations, less maintenance capital expenditures, less cash related to net income attributable to non-controlling partners exceeded distributions by $1,414 million in 2011, and by $412 million if we exclude liquidation of working capital. Clearly PAA is not using cash raised from issuance of debt and equity to fund distributions. The $412 million excess enables PAA to reduce reliance on the issuance of units or additional debt to fund expansion projects.

In 2011, PAA spent $1.9 billion on growth capital projects and acquisitions. The total shown in the table above is $1.5 billion because $370 million of cash received for sale of non-controlling interests in subsidiaries ($268 million in 2010) is netted out. Of the $1.9 billion gross amount spent in 2011 on growth capital projects, 19% was funded by asset sales, ~47% was funded by the issuance of additional partnership units, and the balance was funded from internal cash flow. Cash generated by operations was also used in 2011 to reduce net debt outstanding by $759 million (from $5,957 million to $5,199 million). For 2012, PAA projects spending $2.5 billion on growth capital projects and acquisitions ($850 million on its expansion capital program and $1.7 billion on its pending $1.7 billion acquisition of BP's Canadian NGL business), and $140 million for maintenance capital.

Capital growth projects and acquisitions for 2012 have already been prefunded to the tune of ~$400 to $460 million via additional partnership units sold in March 2012. My hope is that PAA funds the balance with debt (which it can easily do without exceeding its announced credit profile parameters) and/or internally generated cash flow in order to minimize dilution to limited partners.

There is no reason to doubt PAA's ability to achieve an 8%-9% distribution growth in 2012, and even beyond, despite the fact that the general partner gets 50% of any distributions in excess of $2.70 per unit per annum. However, if a normalization of margins in the Supply & Logistics segment does occur, the quarterly results in 2012 may disappoint investors when compared with the prior-year period, especially in the last three calendar quarters. For a further drill-down that reviews the breakdown by quarter of the 2011 numbers in this report, click here. This may put pressure on PAA's unit price. Additional dilution would add to this concern, hence my hope that management will avoid it.

Disclosure: I am long PAA.