Author: Ron Hiram
Published: August 22, 2015
Summary:
- NGLS provided very solid distribution coverage in the TTM ended 6/30/15.
- While exposure to gross margin from sale of commodities has been coming down over time, it is still substantial.
- Given that, and given that operating margin, operating income, Adjusted EBITDA and DCF are declining on a per unit basis, the sustainability of continued distribution growth should be questioned.
- But unit price declines have reached a point where investors brave enough to broaden their exposure to midstream energy MLPs should consider initiating, or adding to, positions in NGLS.
Targa Resources Corp. (NYSE:TRGP), the general partner of NGLS, uses non-GAAP financial metrics such as Operating Margin, Adjusted EBITDA and DCF to evaluate the partnership’s overall performance, evaluate performance of its business segments, evaluate business acquisitions, and set incentive compensation targets.
NGLS operates in two primary divisions, each of which operates in two segments as described in a prior article. Table 1 shows Operating Market by segment over the past 9 quarters:
Table 1: Figures in $ Millions (except units outstanding, per unit amounts and % change). Source: company 10-Q, 10-K, 8-K filings and author estimates.
Table 1 reflects the $5.3 billion acquisition of Atlas Pipeline Partners L.P. (“APL”) in February 2015. It was folded into NGLS’ Field Gathering and Processing segment.
Overall increases in Operating Margin year-to-date in 2015 were attributable to inclusion of APL’s operations, increased throughput related to expansion projects and increased producer activity, recognition of a renegotiated commercial contract and increased terminal and storage fees in the Logistics segment, partially offset by decreased commodity prices.
A significant portion of Operating Margin is affected by fluctuations in energy prices and levels of uncertainty as to future price movements. I estimate that in the quarter and trailing 12 months (“TTM”) ended 6/30/15, gross margin from sale of commodities accounted for 34.4% and 31.5%, respectively, of total gross margin. While this exposure has been coming down over time, it is still substantial.
To reduce exposure to commodity price risk and reduce operating cash flow volatility due to fluctuations in commodity prices, management hedges the commodity prices associated with a portion of expected equity volumes of natural gas, NGL, and condensate generated by the Field Gathering & Processing and the Coastal Gathering & Processing segments. The hedged positions move favorably in periods of falling commodity prices and unfavorably in periods of rising commodity prices. Their impact on Operating Margin is included under “Other” and was significantly positive in 2Q15 and 1Q15, as can bee seen in Table 1.
For the remainder of 2015, management estimates it has hedged 70% of natural gas volumes, ~60% of condensate volumes and ~30% of NGL volumes. For 2016, based on current projections of equity volumes, the percentages hedged are ~45%, ~35% and ~15%, respectively.
Operating margin per unit decreased in 2Q15 and 1Q15. This is attributable to the ~59.2 million units issued in connection with the APL merger and the ~6.8 million additional units issued by NGLS in the six months ended 6/30/15.
Another important non-GAAP financial metric used by management is earnings before interest, taxes, depreciation & amortization (EBITDA). Management makes certain adjustments to EBITDA aimed at better measuring the partnership’s ability to generate sufficient cash to support distributions. Adjusted EBITDA therefore excludes items such as: a) gains and losses on debt repurchases and asset dispositions; b) risk management activities related to derivative instruments, c) unit-based compensation expenses; d) transaction costs related to business acquisitions; e) earnings/losses from unconsolidated affiliates net of distributions; and f) the non-controlling interest portion of depreciation and amortization expenses.
EBITDA and Adjusted EBITDA over the past 9 quarters are shown in Table 2. As is the case with Total Operating Margin, the two most recent quarters show increases vs. the comparable prior year periods when measured in absolute terms, but a decrease when measured on a per unit basis.
Table 2: Figures in $ Millions, except per unit amounts and % change. Source: company 10-Q, 10-K, 8-K filings and author estimates.
The largest component of management adjustments in 2Q15 is a $24.8 million addition related to commodity hedges. Management adjustments in 1Q15 also exhibited a large year-to-year swing principally due to adding back $13.7 million of “non-recurring transactions costs related to business acquisitions” expenses incurred in 1Q15. Notwithstanding these additions, Adjusted EBITDA per unit declined in 2Q15 and in 1Q15 vs. the comparable prior year periods.
NGLS derives DCF by adding to net income depreciation and amortization, deferred taxes, non-cash interest expense, non-cash compensation, non-recurring transaction costs related to acquisitions, earnings from unconsolidated affiliates net of distributions, and adjustments for risk management activities related to derivative instruments, hedges, debt repurchases, redemptions and early debt extinguishments. It then deducts maintenance capital expenditures (net of any reimbursements of project costs) and any impact of non-controlling interests.
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“. NGLS’ definition of DCF and a comparison to definitions used by other MLPs are described in an article titled “Distributable Cash Flow”. Table 3 provides a comparison between the components of reported and sustainable DCF for the trailing 12-months (“TTM”) ended 6/30/15 and 6/30/14.
Table 3: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.
The comparison between reported and sustainable DCF presented in Table 3 indicates no material differences between reported and sustainable DCF for the TTM period ending 6/30/15.
NGLS increased 2Q15 distributions to $0.825 (up 0.6% from 1Q15 and up 5.8% from 2Q14). I calculate coverage ratios in Table 4 based on both reported and sustainable DCF. Table 4 indicates coverage in the periods under review was very solid.
Table 4: Figures in $ Millions, exceptper unit amounts and coverage ratios.Source: company 10-Q, 10-K, 8-K filings and author estimates.
Notwithstanding the 40% increase in total dollar terms of distributions declared, growth per limited partner unit in the TTM ended 6/30/15 was only 7.6%, as TRGP received the bulk of the increased distributions. For 2015, management is now guiding to the lower end of its 4%-7% range of per unit distribution growth. But going forward, the sustainability of even that should be questioned given that operating margin, operating income, Adjusted EBITDA and DCF have all been declining for the past two quarters.
Table 5 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:
Table 5: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.
Net cash from operations, less maintenance capital expenditures, less cash related to net income attributable to non-partners exceeded distributions by $222 million in the TTM ended 6/30/15 compared to $154 million in the corresponding prior year period. NGLS did not fund its distributions using cash raised from issuing debt and equity and from other financing activities. The excess cash enabled NGLS to reduce reliance on the issuance of additional partnership units that dilute existing holders, or issuance of debt to fund expansion projects.
Table 6 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.
Table 6: Enterprise Value (“EV”) and TTM EBITDA figures are 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 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.
Table 6 indicates that NGLS long-term debt stands at ~4.9x Adjusted EBITDA for the TTM ended 6/30/15. That may be somewhat overstated because the debt includes $1.8 billion assumed as part of the Atlas acquisition, while only 10 months of Atlas contribution to EBITDA are included. Still, it provides a more valid comparison to other MLPs than the 3.8x ratio provided by management because the latter includes estimated contributions from projects scheduled to be placed in service.
The decline in energy prices coupled with concerns regarding commodity price exposure caused sharper than average declines in NGLS and TRGP unit prices. In the latest 12 months NGLS is down 60.3% and TRGP is down 53.8% vs. a 34.6% drop for the Alerian MLP Index. Of the MLPs I follow closely, NGLS’ 11.8% current yield is the highest. No one knows whether the price declines have fully priced in the headwinds and risks facing this MLP, including a halt in growth (or even decline) in distributions. But it seems to me to have reached a point where investors brave enough to broaden their exposure to midstream energy MLPs should consider initiating, or adding to, positions in NGLS.