Author: Ron Hiram
Published: August 20, 2016
Summary:
- Fee-based gross margin as a percent of total gross margin has declined for the last 4 consecutive quarters.
- Operating margin and Adjusted EBITDA declined in 2Q16 vs. 2Q15 in absolute terms and per share, primarily due to lower commodity prices; changes in throughput volumes were minor.
- Although total dividends/distributions declared decreased by ~6% in 2Q16 vs. 2Q15, coverage remained very thin, whether measured on a sustainable or as reported basis
- Dividend increases are unlikely before the debt-to-EBITDA ratio is reduced from 4.4x to around 3.5x. This could take several years.
- But in about 5 years, TRGP may become a cash taxpayer, reducing amounts available for dividends.
This article analyses some of the key facts and trends revealed by 2Q16 results reported by Targa Resources Corp. (TRGP).
As a reminder, on 2/17/16, TRGP closed its acquisition of all of the outstanding common units of Targa Resources Partners LP (“NGLS”) that it did not already own in a stock-for-unit transaction at a ratio of 0.62 common shares for each NGLS common unit. TRGP is now the general partner and sole limited partner of NGLS, whose common units no longer trade. However, TRGP did not acquire the 5 million 9% perpetual preferred units issued by NGLS in October 2015 at $25 per preferred unit. These remain outstanding and continue to receive dividends.
Concurrently, TRGP raised $994.1 million in cash (before paying $23.8 million in transaction fees) by privately placing 965,100 shares of Series A Preferred Stock with detachable Series A Warrants exercisable into a maximum of 13.55 million shares of common stock at $18.88 per share, and Series B Warrants exercisable into a maximum of 6.53 million shares of common stock at $25.11 per share. The Series A Preferred pay a 9.5% fixed quarterly dividend in cash or, at the company’s discretion, in kind. The warrants have a 7-year life.
TRGP operates in two main segments:
- Gathering and Processing: this segment is involved in “gathering of natural gas produced from oil and gas wells and processing this raw natural gas into merchantable natural gas by extracting NGLs and removing impurities” as well as crude oil gathering and terminal activities. Its assets are located “in the Permian Basin of West Texas and Southeast New Mexico; the Eagle Ford Shale in South Texas; the Barnett Shale in North Texas; the Anadarko, Ardmore, and Arkoma Basins in Oklahoma and South Central Kansas; the Williston Basin in North Dakota and in the onshore and near offshore regions of the Louisiana Gulf Coast and the Gulf of Mexico” (TRGP Form 10-K, 12/31/15).
- Logistics and Marketing: this segment is involved in transporting, storing, and fractionating mixed natural gas liquids (“NGLs”) and in terminal, storage and transport activities involving finished NGLs. These include services for exporting liquefied petroleum gas (“LPGs”). It also provides storage and terminal services for refined petroleum products. Its assets are “generally connected to and supplied in part by the Gathering and Processing segment and are predominantly located in Mont Belvieu and Galena Park, Texas, in Lake Charles, Louisiana and in Tacoma, Washington” (TRGP Form 10-K, 12/31/15).
This is TRGP’s second quarterly report after the acquisition. So far, quarterly data reflecting the acquisition is available only with respect to the first and second quarters of 2016 and 2015. Other quarterly data presented below (except for per share/unit amounts) reflects NGLS’ results prior to the acquisition. The differences between those results and TRGP’s consolidated results (which incorporated NGLS) should be sufficiently small to enable making reasonable comparisons across prior quarters.
Pro-forma per share metric comparisons for periods prior to the acquisition are more complicated to estimate. I derive my estimates of the number of TRGP shares that would have been outstanding each quarter had the acquisition been consummated in that quarter by adding 104.5 million shares (i.e., the number issued by TRGP in connection with the acquisition) to the number of TRGP shares that were outstanding in each quarter prior to the acquisition.
TRGP uses non-GAAP financial metrics such as Operating Margin, Adjusted EBITDA and DCF to evaluate the company’s overall performance, evaluate performance of its business segments, evaluate business acquisitions, and set incentive compensation targets.
Operating margin is up 3.7% in the trailing twelve months (“TTM”) ending 6/30/16 vs. the corresponding prior year period, but is down 8% in 2Q16 vs. 2Q15. Table 1 shows results by segment for the past 9 quarters:
Table 1: Figures in $ Millions (except units outstanding, per share amounts and % change). Source: company 10-Q, 10-K, 8-K filings and author estimates.
The Gathering & Processing segment’s operating margin in 2Q16 is down 4% vs. 2Q15 (which was the first quarter to incorporate results from the $5.3 billion acquisition of Atlas Pipeline Partners L.P. in February 2015). The Logistics & Marketing segment’s operating margin in 2Q16 is down 13% vs. 2Q15 “ due to the realization in 2015 of contract renegotiation fees related to our crude and condensate splitter project, lower LPG export margin, lower fractionation margin and lower terminaling and storage throughput” (TRGP Form 10-Q).
Total operating margin in the two most recent quarters is lower vs. the comparable prior year periods, both in absolute terms and on a per share basis. This is primarily due to lower commodity prices which drove down gross margins. Throughput comparison of 2Q16 to 2Q15 indicates the volume of natural gas processed (MMcf/d) was unchanged, the volume of natural gas sold (BBtu/d) excluding producer take-in-kind volumes) was down 2%, and the volumes barrels of crude oil gathered and condensates sold were both down 1%.
TRGP defines operating margin as gross margin less operating expenses. Gross margin is generated by fee-based activities and the sale of commodities. The latter is greatly affected by fluctuations in energy prices and levels of uncertainty as to future price movements. Although gross margin from the sale of commodities contributes less than fee-based activities, it still accounts for a significant portion of the total. In fact, fee-based gross margin as a percent of total gross margin has declined for the last 4 consecutive quarters:
Table 2: Figures in $ Millions (except percent). Source: company 10-Q, 10-K, 8-K filings and author estimates.
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 Gathering & Processing segment. 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” in Table 1.
For the remainder of 2016, management estimates it has hedged ~70% of natural gas volumes, ~60% of condensate volumes and ~20% of NGL volumes. For 2017, based on current projections of equity volumes, the percentages hedged are ~45%, ~45% and ~10%, respectively (source: 2Q16 earnings call transcript).
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 used to hedge risk resulting from fluctuations in commodity prices and interest rates , 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 3. The two most recent quarters show decreases vs. the comparable prior year periods measured in both absolute terms and on a per share basis:
Table 3: Figures in $ Millions, except per unit amounts and % change. Source: company 10-Q, 10-K, 8-K filings and author estimates.
Asset impairments in Table 3 reflect goodwill reductions in the Field & Gathering segment. A provisional impairment recorded of $290 million was recorded during the fourth quarter of 2015, and a further $24.0 million was recorded in the first quarter of 2016.
TRGP derives DCF by deducting from Adjusted EBITDA the cash portion of its interest expense, maintenance capital expenditures, net income attributable to the 9% perpetual preferred units issued by NGLS, and adjusts for other items (e.g., by adding back a portion of maintenance capital expenditures attributable to non-controlling interests):
Table 4: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.
Coverage ratios shown below are calculated based on the dividends/distributions declared to common shares/units after publication of each quarter’s results. For the two most recent quarters, the calculation also incorporates dividends declared to the Series A Preferred. Accrued dividends on restricted stock and restricted stock units that are payable upon vesting are also included (the amounts are very small). To avoid double counting in the quarters preceding the acquisition, I exclude distributions from NGLS to TRGP because those funds were, by and large, paid out as dividends to TRGP shareholders.
Table 5: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.
Reported DCF may differ substantially from sustainable DCF for a variety of reasons. These are reviewed in an article titled “Estimating sustainable DCF-why and how”. But this is not the case for TRGP in the periods under review. Table 6 shows variance between reported and sustainable DCF in 2Q16 and the TTM ending 6/30/16 are not material.
Table 6: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.
Coverage ratios based on both reported and sustainable DCF are shown in Table 7. It generally makes sense to focus more on TTM c overage ratios because seasonal fluctuations are neutralized (some of TRGP’s businesses, notably wholesale propane marketing, are seasonal). However, the periods reviewed are an exception because the latest TTM numbers include only one quarter of preferred dividends and none were paid in the prior year TTM:
Table 7: Figures in $ Millions, except per unit amounts and coverage ratios. Source: company 10-Q, 10-K, 8-K filings and author estimates.
Comparing 2Q16 to 2Q15 we see that although total dividends/distributions declared decreased by ~6%, coverage remained very thin, whether measured on a sustainable or as reported basis.
The simplified cash flow statement in Table 8 indicates net cash from operations less maintenance capital expenditures exceeded distributions and that TRGP did not fund its distributions using cash raised from issuing debt and equity and from other financing activities:
Table 8: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.
A plunge in LPG prices has prompted some companies to cancel cargo loadings from terminals on the Texas Gulf Coast in July. In its conference call discussing 2Q16 results, TRGP disclosed that customers recently cancelled three LPG contracts (one in June and two in July, for which it received cancellation fees), that it is working with customers to mutually agree to defer cargoes to later delivery dates when necessary and for additional fees, that LPG volumes in Q3 are likely be lower than in Q1 and Q2, but that in aggregate “volume guidance for 2016 is unchanged”.
TRGP’s debt-to-TTM EBITDA ratio stood at 4.4x as of 6/30/16, an improvement over 4.7 as of 6/30/15. But it is still significantly higher than 3.5 where it stood as of 6/30/14. In the conference call discussing 2Q16 results, management implied dividend increases are unlikely before the 3.5x level it is reached because it provides “an appropriate long-term balance sheet position to have access to the capital needed to grow the company and provide the company with the ability to pay attractive dividends to our shareholders, while protecting our shareholders from some of the volatility associated with commodity price cycles”.
Growth capital expenditures in 2016 are expected to total $525 million, down 23% from 2015.
Management does not intend to raise additional equity capital, so leverage reduction depends on generating significant excess amounts of net cash from operations over maintenance capital expenditures and distributions. As can be inferred from Table 8, this could take several years and bring longer-term investors closer to the point, currently estimated at about 5 years hence, when DCF is reduced by virtue of TRGP becoming a cash taxpayer.