ETP – A Closer Look at Energy Transfer Partners’ Distributable Cash Flow as of 3Q 2013

Author: Ron Hiram

Published: November 12, 2013

This article analyzes the most recent quarterly and the trailing twelve months (“TTM”) results of Energy Transfer Partners, L.P. (ETP) and looks “under the hood” to properly ascertain sustainability of Distributable Cash Flow (“DCF”). The task is not easy because the definitions of DCF and “Adjusted EBITDA”, the primary measures typically used by master limited partnerships (“MLPs”) to evaluate their operating results, are complex. In addition, each MLP may define these terms differently, making comparison across MLPs very difficult.

ETP owns and operates approximately 43,000 miles of natural gas, natural gas liquids, refined products, and crude oil pipelines. Through a wholly owned subsidiary, ETP Holdco Corporation (“Holdco”), it owns Southern Union Company (“Southern Union”) and Sunoco, Inc. (“Sunoco”). ETP also has a 70% interest in Lone Star NGL LLC  (“Lone Star”), a joint venture that owns and operates natural gas liquids storage, fractionation and transportation assets in Texas, Louisiana and Mississippi. Regency Energy Partners (RGP), an MLP controlled by ETP’s general partner, owns the other 30% of Lone Star. ETP also owns the general partner and ~33.5 million common units in Sunoco Logistics Partners L.P. (SXL), which operates a geographically diverse portfolio of crude oil and refined products pipelines, terminals, and crude oil acquisition and marketing assets. ETP’s general partner is Energy Transfer Equity L.P. (ETE).

In the case of ETP, the level of complexity in evaluating is results and ascertaining DCF sustainability is particularly high for several reasons. One is that in 4Q12 management changed its definition of Segment Adjusted EBITDA to reflect amounts for less than wholly owned subsidiaries based on 100% of the subsidiaries’ results of operations. In prior periods, amounts for less than wholly owned subsidiaries were reflected in Segment Adjusted EBITDA based on ETP’s proportionate ownership, such that the measure was reduced for amounts attributable to non-controlling interests. In periods prior to 4Q12, NGL Transportation and Services was the only segment that included a less than wholly owned subsidiary – the Lone Star joint venture. Beginning in 1Q13, Segment Adjusted EBITDA includes not only 100% of Lone Star but also 100% of the Florida Gas Transmission Pipeline (“FGT”) and 100% of the Fayetteville Express Pipeline (“FEP”), even though ETP owns 50% of these latter two ventures and previously accounted for them using the equity method.

The structural changes ETP is undergoing adds another level of complexity and makes is exceedingly difficult to compare across periods, to say nothing of trying to draw forward looking conclusions based on ETP’s past performance. For example, ETP’s consolidated financial statements have been retrospectively adjusted to reflect consolidation of the Southern Union into ETP beginning March 26, 2012 and the consolidation of Sunoco, beginning October 5, 2012. These consolidations were enabled by the formation of a company called ETP Holdco Corporation (“Holdco”), an entity that was owned 40% by ETP and 60% by ETE, ETP’s general partner. On April 30, 2013, ETP acquired ETE’s 60% stake in Holdco for $3.75 billion (consisting of $2.35 billion in newly issued ETP common units and $1.4 billion in cash). Also on that date, Holdco spun out to RGP its interest in Southern Union Gathering Company (“SUGS”), one of Southern Union’s subsidiaries, for $1.5 billion (consisting of $750 million of newly issued RGP units, $150 million of new RGP Class F units, and $600 million in cash). Net of closing adjustments for these two transactions, ETP paid ~$800 million using its revolving credit facility.

Several significant transactions occurred in 3Q13. On July 12 ETP sold 7.5 million of the ~26.9 million shares of AmeriGas Partners, L.P. (APU) received (together with ~$1.46 billion in cash) upon the contribution of its propane business to APU in January 2012. On August 8, ETP and ETE announced ETE’s exchange of 50.16 million ETP units for 50.05% of the incentive distribution rights (“IDR”) held by the general partner of SXL who, as previously stated, is owned by ETP. The transaction was consummated n October 1, 2013. On September 1, 2013, Southern Union completed its sale of the assets of its Missouri Gas Energy division (“MGE”) to the Laclede Group, Inc. for $975 million.

I generally review trailing twelve months (“TTM”) data, but in ETP’s case a TTM comparison of historical data is not meaningful given the major changes in the businesses owned by ETP and the manner in which it accounts for them. For example, revenues in the 9 months ending 9/30/13 were ~$34.3 billion vs. $4.7 billion a year earlier on a historical basis. But this is not a meaningful comparison. It makes more sense to review ETP’s pro forma numbers for 3Q12 and the 9-months ending 9/30/12. These numbers are adjusted for the sale of the propane business, the Sunoco acquisition (historical amounts for 1/1/12 through 9/30/12 are included), the Southern Union acquisition (historical amounts for 1/1/12 through 3/25/12 are included), and the Holdco transaction. Pro forma data is available for selected metrics, some of which are presented in Table 1 below:

Table 1: Figures in $ Million except units outstanding

Table 1 shows income from continuing operations per unit, on a pro forma basis, declined in 3Q13 and in the 9-months ended 9/30/13 vs. the corresponding prior year periods.

Segment Adjusted EBITDA is a metric developed by ETP management to measure the core profitability of its operations. Segment Adjusted EBITDA forms the basis of ETP’s internal financial reporting and is one of the performance measures used by senior management in deciding how to allocate capital resources among business segments. Since pro forma information on this metric is not available, there is no alternative except examining the historical data. This data shows an increase in Segment Adjusted EBITDA on a TTM basis, both in absolute terms and on a per unit basis:

Table 2: Figures in $ Millions, except per unit amounts

Intrastate contribution to Segment Adjusted EBITDA decreased in the periods reviewed primarily due to lower gross margins.

Interstate contribution to Segment Adjusted EBITDA decreased in 3Q13 vs. 3Q12 due to a combination of lower volumes and lower rates. It increased on a TTM basis primarily due to the consolidation of Southern Union’s transportation and storage operations beginning March 26, 2012. The main asset purchased via the $2 billion Southern Union acquisition was a 50% joint venture interest in Citrus Corp. (“Citrus”), an entity that owns 100% of the FGT pipeline system (a 5,400 mile pipeline system that extends from south Texas through the Gulf Coast to south Florida). The other 50% of FGT is owned by Kinder Morgan, Inc. (KMI).

Midstream contribution to Segment Adjusted EBITDA decreased in the periods reviewed. Although volumes increased, gross margins did not.

NGL contribution to Segment Adjusted EBITDA increased in the periods reviewed primarily due to higher volumes and gross margins.

Segment Adjusted EBITDA contributed via the $5.3 billion Sunoco acquisition (consisting of 55 million ETP Common Units and $2.6 billion in cash) is split in two: “Investment in Sunoco Logistics” and “Retail Marketing”. The former includes the operations of SXL. The latter includes the Sunoco retail operations (gas stations and convenience stores in 25 states). ETP’s interests in SXL consist of a 2% general partner interest, 100% of the IDRs and ~33.53 million SXL units representing ~32% of the limited partner interests as of December 31, 2012. ETP’s share of SXL IDRs was reduced to 49.95% as of October 1, 2013, as noted above. Prior year numbers are not provided because the acquisition was consummated on October 5, 2012.

The “All other” segment includes ETP’s compression operations, its equity method investment in APU, Southern Union’s distribution operations, a ~30% non-operating interest in PES, a joint venture that owns a refinery in Philadelphia, and the wholesale propane businesses. In 3Q12 and the TTM ending 9/30/12 this segment consisted primarily of: 1) the natural gas compression operations; 2) Southern Union’s local distribution operations beginning March 26, 2012; 3) Sunoco’s ~30% non-operating interest in PES; and 4) the retail propane operations prior to its contribution to APU in January 2012 and the investment in APU for the balance of the period.

Overall, Table 2 shows no (or at best a very small) organic growth in Segment Adjusted EBITDA over the prior year periods.

The generic reasons why DCF as reported by an MLP may differ from what I call sustainable DCF are reviewed in an article titled “Estimating sustainable DCF-why and how”. ETP’s definition of DCF and a comparison to definitions used by other MLPs are described in an article titled “Distributable Cash Flow”. Using ETP’s definition, DCF for the TTM ended 9/30/13 was $2,321 million ($6.96 per unit), up from $1,391 million ($5.76 per unit) in the prior year period.

Table 3 below provides a comparison between sustainable DCF and the DCF number reported by management:

Table 3: Figures in $ Millions

The principal differences between reported DCF and sustainable DCF relate to working capital, to risk management activities and to a variety of items grouped under “Other”.

Under ETP’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 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. In the TTM ending 6/30/13 working capital consumed $645 million. Management adds back working capital consumed in deriving reported DCF while I do not.

The $147 million adjustment for risk management activities in the TTM ending 9/30/13 consists primarily of adjustments for derivative activities relating to interest rate swaps and commodity price fluctuations.

The $142 million adjustment for items grouped under “Other” items in the TTM ending 9/30/13 consists of deferred income taxes and amortization of finance charges.

The calculation of DCF coverage is not simple. This is due to the fact that DCF as reported in Table 3 is attributable not only to the partners of ETP (limited and general), but also to other stakeholders such as SXL partners and RGP (owner of 30% of Lone Star). I prefer a broader definition of coverage, one whose numerator is total DCF generated and whose denominator is the total of all distributions made to all the stakeholders (i.e., including distributions to SXL partners and RGP). The impact of doing so is shown in Table 4 below:

Table 4 ($ millions, except ratios)

ETP reports coverage based on a narrower definition. The numerator is DCF attributable to the partners of ETP (i.e., after deducting distributions to SXL and RGP) and the denominator is distributions made to the partners of ETP.  The manner in which ETP determines coverage ratio is presented in Table 5 below:

Table 5 ($ millions, except ratios)

A comparison of Tables 4 to 5 shows that the coverage ratio is lower when measured based on my definition of sustainable DCF. However, the $618 million and $2,321 million of DCF reported in 3Q13 and the TTM ended 9/30/13 (see Table 3) translate into coverage ratios that are a little lower when calculated based on the narrower vs. the broader definition (1.14 and 1.02 for the periods ending 9/30/13 vs. 1.17 and 1.07 for the periods ending 9/30/12).

Distributions, whether measured based on amounts actually made as shown in Table 4 or on the amounts declared to the partners of ETP as shown in Table 5, increased substantially in terms of total dollars in the periods under review. But distributions per units increased just very slightly in those periods (from $0.89375 to $0.905 per unit in 3Q13). This is due to three main factors. First, the number of ETP units outstanding has increased by ~52% between 3Q12 and 3Q13; second, the increasing amount that must be distributed to joint venture partners (the non-controlling interests); and third because the amount now includes SXL distributions (~$85 million in 1Q13 and ~$91 million in 2Q13).

Although sustainable DCF coverage in the TTM ended 9/30/13 remains below the 1x threshold number (principally due to $803 million investment in working capital, mostly in 4Q12, 1Q13 and 3Q13), it improved compared to the prior year period. Coverage also improved in 3Q13 vs. 3Q12. This is encouraging.

Table 6 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 6: Figures in $ Millions

Net cash from operations, less maintenance capital expenditures, less net income from non-controlling interests fell short of covering distributions by ~$516 million in the TTM ended 9/30/13 and by ~$378 million in the prior year period. Even if you add net amounts received from unconsolidated affiliates (primarily AmeriGas, Citrus, FEP and RGP), there is still a shortfall. So for these TTM periods distributions were partially funded by issuing debt and limited partnership units, and through asset sales. But encouragingly that was not the case in 3Q13 or 2Q13.

The October 2013 retirement of 50.16 million ETP units held by ETE in exchange for 50.05% of the SXL IDRs held by ETP is positive news, despite ETP forgoing potential increases in SXL IDR distributions. My rough calculations are outlined below.

The SXL IDRs generated $84 million in the 9 months ended 9/30/13, or ~$112 million per annum, so a 50% reduction costs ETP ~$56 million a year. Over the next 3.5 years, ETP will also forgo ~$329 million of prior IDR subsidies previously agreed to by ETE in connection with various acquisitions, an average of ~$94 million per annum during this period. The total cost to ETP therefore seems to be ~$150 million per annum, on average, for the next few years. On the other hand, by retiring 50.16 million units ETP saves ~$3.62 per unit per annum in regular distributions to ETE and ~$2.12 per unit per annum in IDR distributions to ETE; this reduces the cash outflow by ~$288 million per year. On balance, ETP appears to save ~$138 million per annum for the next 3.5 years and ~$194 million thereafter.

Nevertheless, some concerns regarding ETP remain: 1) sustainable DCF is still not consistently covering distributions; 2) the structural complexity (although recent transactions are a step forward); 3) the IDR burden is still high: 4) the October 2013 acquisition of a ~300 convenience stores for ~$400 million in cash indicates the non-core Sunoco retail operations are here to stay for a lot longer than I thought; 5) the still high ratio (>4.3x) of long-term debt to TTM EBITDA (although that has come down from the >5 level in 2Q13); 6) declines in per unit income from continuing operations; and 7) no organic growth in Segment Adjusted EBITDA over the prior year periods (or at best a very small improvement).

A comparison of ETP’s current yield to that of other MLPs I cover is provided in Table 7 below:

Table 7

ETP provides a generous current yield. Investors pushing for steady distribution growth (at a rate higher than the recent token 1.2%) on top of that are, in my view, acting against their own best interests. Despite the >1 coverage ratio in 3Q13 and 2Q13, recent results don’t yet justify it. I would prefer to forgo increases and have ETP deploy the excess cash to reduce future unit issuances, at least until a substantial margin of safety is established.