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Author: Ron Hiram
Published: August 11, 2015
Summary:
- Coverage ratios have dropped below 1x on a TTM basis, the first time this has happened in over 4 years.
- PAA used cash raised from issuance of debt and equity to fund a small portion of its distributions in the latest TTM period.
- A 7% distribution growth rate cannot be sustained under current conditions; even the revised 6% target for 2015 will result in below 1x coverage.
- Management is anxious to maintain a coverage ratio of at least 1.05x and may keep distributions flat in 2016.
- Market reaction to management’s comments on distribution growth prospects was violent; at the current unit price level, I am not looking to further reduce my position.
This article analyses some of the key facts and trends revealed by 2Q15 results reported by Plains All American Pipeline L.P. (PAA). It also evaluates the sustainability of the partnership’s Distributable Cash Flow (“DCF”) and assesses whether PAA is financing its distributions via issuance of new units or debt.
PAA transports, stores and markets crude oil and refined products; it also transports, processes, stores and markets natural gas liquids (“NGL”) and owns and operates natural gas storage facilities. PAA’s operations are managed through three operating segments:
- Transportation Segment: fee-based activities associated with transporting crude oil and NGL on pipelines, gathering systems, trucks and barges;
- Facilities Segment: fee-based activities associated with providing storage, terminal and throughput services for crude oil, refined products, natural gas and NGL, NGL fractionation and isomerization services and natural gas and condensate processing services; and
- Supply & Logistics Segment: margin-based activities associated with sale of gathered and bulk-purchased crude oil, sales of NGL volumes purchased from suppliers, and natural gas sales associated with natural gas storage operations.
Segment profits for recent quarters are presented in Table 1 below. Segment profit is one of the key metrics used by management to evaluate performance of its business segments. It is defined as revenues plus equity earnings in unconsolidated entities less: a) purchases and related costs, b) field operating costs and c) segment general and administrative expenses. It excludes depreciation and amortization.
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Table 1: Segment Profit, excluding “Selected Items Impacting Profitability”; figures in $ Millions (except per unit amounts and % change). Source: company 10-Q, 10-K, 8-K filings and author estimates.
Segment operating profit declined 24% in 2Q15 vs. 2Q14 mainly due to lower Supply & Logistics margins. Unlike the Facilities and Transportation segments that are predominantly fee-based businesses, a substantial portion of Supply & Logistics is margin based and hence, as seen in Table 1, results are more volatile.
Total segment profit is roughly equivalent to earnings before interest, depreciation & amortization and income taxes (EBITDA). PAA applies some adjustments to get from the former to the latter. However, Adjusted EBITDA, a key metric used by management to evaluate PAA’s results, can differ materially from EBITDA because significant items (such as equity based compensation, inventory and foreign currency revaluations, acquisition related expenses, and derivative losses on commodity transactions) are added back. PAA refers to these adjustments as “selected items impacting comparability” and has wide latitude in deciding what to include (for example, items it deems not indicative of core operating results and business outlook).
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Table 2: Figures in $ Millions (except % change). Source: company 10-Q, 10-K, 8-K filings and author estimates.
EBITDA was adjusted to the tune of $114 million in 2Q15 through the addition of “selected items”, the principal component of which was a reversal of a $65 million provision for losses in the income statement related to the May 2015 oil spill in California. Losses on derivative activities, partly offset by inventory valuation adjustments, constituted the bulk of the balance.
As part of its 2Q15 earnings announcement on August 5, PAA decreased its Adjusted EBITDA guidance for the second half of 2015 by approximately $75 million from the guidance provided in May (this follows a $25 million downward adjustment in May). The main drivers of the recent decrease are lost revenue associated with the pipeline shutdown in California, lower rail volumes, lower volumes on several pipelines, higher operating expenses due to the shift in timing of integrity spending, and ~$10 million in costs related to a July oil spill incident. The effects of these are partially offset by better than previously forecasted margins expected in the Supply and Logistics segment.
PAA derives DCF by deducting interest expense, maintenance capital expenditures, provision for taxes, and distributions to non-controlling interests from Adjusted EBITDA, and by adding distributions in excess of equity earnings in unconsolidated entities. For the past 8 quarters, the steady growth in total dollars distributed has not been matched by growth in DCF. Indeed, for the trailing twelve months (“TTM”) ended 6/30/15 DCF was down slightly vs. the corresponding prior year period ($1,531 vs. $1,541 million), while distributions increased to $1,545 million from $1,273 million:
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Table 3: Figures in $ Millions (except ratios and % change). Source: company 10-Q, 10-K, 8-K filings and author estimates.
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“. PAA’s definition of DCF and a comparison to definitions used by other MLPs are described in an article titled “Distributable Cash Flow”.
Table 4 provides a comparison between reported and sustainable DCF.
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Table 4: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.
Net cash from operation in the TTM ended 6/30/15 is derived, in part, by reversing from net income a portion of a $289 million inventory adjustment that reflects a write-down of crude oil, NGL and natural gas inventory due to declines in prices. Of that amount, $85 million is excluded because it is deemed to be long-term inventory, leaving a $204 million that is treated as though it were a cash adjustment that reduces DCF.
Sustainable DCF in the TTM ended 6/30/15 is lower than reported DCF mainly due to cash generated by reducing working capital. The other factors at work are risk management and a variety of smaller items.
Under PAA’s definition, reported DCF always excludes working capital changes, whether positive or negative. My definition of sustainable DCF only excludes working capital generated (I deduct working capital consumed). Despite appearing to be inconsistent, this makes sense because in order to meet my definition of sustainability an MLP should generate enough capital to cover its normal working capital needs. On the other hand, cash generated by an 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. In the TTM ended 6/30/15, working capital consumed cash amounting to $207 million. Management added back this amount in deriving reported DCF. I do not add it back when deriving sustainable DCF.
Risk management activities mostly reflect gains or losses generated by hedges put in place to offset energy price fluctuations.
Coverage ratios for the latest TTM periods are provided in Table 5:
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Table 5: $ millions, except ratios. Source: company 10-Q, 10-K, 8-K filings and author estimates.
Below is 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:
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Table 6: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.
Net cash from operations, less maintenance capital expenditures, fell short of covering distributions by $75 million in the TTM ended 6/30/15. This is the first TTM period in over 4 years in which PAA used cash raised from issuance of debt and equity (albeit not a large amount) to fund distributions and is a worrying milestone.
Management recognizes that a 7% distribution growth rate cannot be sustained under current conditions. In the conference call discussing 2Q15 results, management revised the distribution growth rate target for 2015 down to 6%, but pointed out that this would still leave PAA with below 1x coverage (i.e., reliant on non-sustainable sources to make payments to the limited partners).
Management is anxious to maintain a coverage ratio of at least 1.05x and conceded it is”…waffling, quite candidly, on whether there’s going to be any distribution growth in 2016″. Given the list of headwinds cited, I would not be surprised if it holds distributions flat (or close to flat) starting in the third and fourth quarters of 2015 and through year-end 2016. That list includes low prices for oil, gas & NGLs, aggressive competition from overbuilt infrastructure that could adversely affect PAA’s margins and volumes, as well as regional market differentials and credit risks associated with ship-or-pay commitments.
In a prior article covering 1Q15 results I noted the decreasing coverage ratios over the past several quarters and projected there would be no excess coverage in 2015. I viewed this as significantly increasing PAA’s risk profile and therefore reduced my position. Clearly I should have sold more. Market reaction to management’s comments was violent (15% drop in unit price).
Table 7 provides selected metrics comparing the MLPs I follow based on the latest available TTM results. Of course, investment decisions should be take into consideration other parameters as well as qualitative factors. Though not structured as an MLP, I include KMI as its business and operations make it comparable to midstream energy MLPs.
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Table 7: Enterprise Value (“EV”) and TTM EBITDA figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.
Note that BPL, EPD, KMI, MMP and SPH are not burdened by general partner incentive distribution rights (“IDRs”) that siphon off a significant portion of cash available for distribution to limited partners (typically 48%). Hence multiples of MLPs without IDRs can be expected to be much higher (see Table 4, column 5). In order to make the multiples somewhat more comparable, I added column 6, a second EV/EBITDA column. I derived this column by subtracting IDR payments from EBITDA for the TTM period. Other approaches can also be used to adjust for the IDRs of the relevant MLPs.