Author: Ron Hiram
Published: December 3, 2015
Summary:
- Distribution coverage is solid on a TTM basis; but operating margin, operating income, Adjusted EBITDA and DCF all declined on a per unit basis for the past three quarters.
- The proposed acquisition of NGLS by TRGP entails a ~32% cut in NGLS distributions (from $0.825 per unit to $0.5642 per share).
- Since the announcement, TRGP shares declined by 36.6%, and NGLS units declined by 29.3% vs. a 13.7% drop in the Alerian index over the same period.
- The premium offered to NGLS unit holders has shrunk from $5.60 to $1.30.
- NGLS and TRGP investors wishing to keep their exposure to MLPs unchanged should consider selling and using the proceeds to buy other MLPs.
This article focuses on some of the key facts and trends revealed by3Q15 results reported by Targa Resources Partners LP (NGLS). It evaluates the sustainability of the partnership’s Distributable CashFlow (“DCF“) and assesses whether NGLS is financing its distributions via issuance of new units or debt.
Targa Resources Corp. (TRGP), the general partner of NGLS, usesnon–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, the recognition of are negotiated commercial contract and offsets resulting from significantly lower commodity prices impacting the gathering and processing operations, and lower export margins and fractionation spreads impacting the Logistics and Marketing segments.
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 9/30/15, gross margin from sale of commodities accounted for 32.4% and 31.7%, respectively, of total gross margin(vs. 31.6% and 37.9% in the corresponding 2014 periods). Whilethis 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 3Q15,2Q15 and 1Q15, as can bee seen in Table 1.
For the remainder of 2015, management estimates it has hedged~65% of natural gas volumes, ~55% of condensate volumes and~20% of NGL volumes. For 2016, based on current projections of equity volumes, the percentages hedged are ~40%, ~40% and~20%, respectively.
Operating margin per unit decreased in 3Q15, 2Q15 and 1Q15. This is attributable to the ~58.6 million units issued in connection with the APL merger and the ~7.6 million additional units issued by NGLS in the nine months ended 9/30/15.
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 inTable 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 components of management adjustments in 3Q15 and 2Q15 are $21.8 million and 424.8 million, respectively, additions related to commodity hedges. Notwithstanding these additions,Adjusted EBITDA per unit declined in 3Q15, 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 3–months and trailing 12–months (“TTM”) ended 9/30/15, and the corresponding prior year periods.
Table 3: Figures in $ Millions. Source: company 10–Q, 10–K, 8–Kfilings 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 9/30/15.
I calculate coverage ratios in Table 4 based on both reported and sustainable DCF.
Table 4: Figures in $ Millions, except per unit amounts and coverage ratios. Source: company 10–Q, 10–K, 8–K filings and author estimates.
Table 4 indicates coverage was very solid on a TTM basis. However,the sustainability of the coverage should be questioned given that operating margin, operating income and Adjusted EBITDA declined on a per unit basis for the past three consecutive quarters. DCF per unit, as reported, has also declined for the past three consecutive quarters (-29% in 3Q15, –23% in 2Q15 and –18% in 1Q15 compared to the comparable prior year periods).
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 $242 million in the TTM ended 9/30/15 compared to $140 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 higher (see 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.
The decline in energy prices, concerns regarding commodity price exposure and the 11/2/15 announcement of the acquisition of NGLS by TRGP in a unit–for–unit transaction at a rate of 0.62 TRGP shares for each NGLS unit have caused sharper than average declines in the share and unit prices, as shown in Table 6. The acquisition entails a~32% cut in NGLS distributions (from $0.825 per unit to $0.5642per share) but seemed to provide a premium to NGLS unit holders in that, as of 11/2/15, for each NGLS unit valued at $30.49 they were to receive $36.09 (0.62 TRGP shares at $58.21). Market reaction has been decidedly negative. Since the announcement, TRGP shares declined by 36.6%, and NGLS units declined by 29.3% vs. a 13.7%drop in the Alerian index over the same period. The premium has shrunk from $5.60 to $1.30.
My review of NGLS results for 2Q15 concluded that the sustainability of continued distribution growth should be questioned but added that, in view of the magnitude of the drop in price per unit, investors brave enough to broaden their exposure to midstream energy MLPs should consider initiating, or adding to, positions in NGLS. I did indeed subsequently purchase NGLS units but sold them at a small loss them after the merger announcement was made. If I had any NGLS units or TRGP shares and wished to keep my exposure to MLPs unchanged, I would sell and use the proceeds to buy MLPs such as EPD, MMP or BPL.