NGLS – A Closer Look at Targa Resources Partners’ Distributable Cash Flow as of 3Q 2013

Author: Ron Hiram

Published: November 24, 2013

This article analyzes the most recent quarterly and the trailing twelve months (“TTM”) results of Targa Resources Partners LP (NGLS), looks “under the hood” to properly ascertain sustainability of Distributable Cash Flow (“DCF”) and assesses whether NGLS is financing its distributions via issuance of new units or debt. 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. But it is an exercise that must be undertaken, in conjunction with evaluating an MLP’s growth prospects, because sustainable distributions coverage provides some protection in a downside scenario. When faced with such a scenario, MLPs that cannot maintain their distributions, or are totally reliant on debt and equity to finance growth capital, are likely to suffer significantly greater price deterioration.

Revenues, operating income, net income, earnings before interest, depreciation & amortization and income tax expenses (EBITDA), and DCF reported by NGLS for 3Q13, 3Q12, and the TTM ending 9/30/13 and 9/30/12 are summarized in Table 1 below. Given the seasonality of the businesses of some MLPs and given quarterly fluctuations in working capital needs and other items, a review of TTM numbers tends to be more meaningful than quarterly numbers for the purpose of analyzing changes in reported and sustainable distributable cash flows. However, I present both. Per unit EBITDA and per unit DCF improved in 3Q13 vs. 3Q12 but are still down on a TTM basis, as can be seen in Table 1 below:

Table 1: Figures in $ Millions, except units outstanding

NGLS derives its revenues principally from percent-of-proceeds (“POP”) contracts under which it receives a portion of the natural gas and/or natural gas liquids as payment for its gathering and processing services. POP contracts share price risk between the producer and processor. Operating income generally increases as natural gas prices and natural gas liquid prices increase, and decreases as they decrease.

In that context, it is important to note the growth in midstream services fee income:

Table 2: Figures in $ Millions, except percentages

The fee portion of the revenue stream is important because it serves to mitigate the impact of fluctuations in commodity prices on NGLS’ results and to enhance both gross and operating margin percentages. Also, a large portion of the fee income revenues flows through directly to the operating margin line.

NGLS operates in two primary divisions. The first, Natural Gas Gathering and Processing, gathers and processes raw natural gas (produced from oil and gas wells) into merchantable natural gas by extracting natural gas liquids (“NGLs”) and removing impurities. It consists of segments 1 and 2 outlined below.  The second primary division, NGL Logistics and Marketing (the Downstream Business), consists of segments 3 and 4 outlined below.

1. Field Gathering and Processing: this segment’s assets are located in North Texas, the Permian Basin of West Texas and New Mexico, and North Dakota. Crude oil and natural gas gathering, terminals and processing assets in North Dakota were added following the 12/31/12 Badlands acquisition.
2. Coastal Gathering and Processing: this segment’s assets are located in the onshore and near offshore regions of the Louisiana Gulf Coast and the Gulf of Mexico.
3. Logistics Assets: this segment transports, stores, and fractionates mixed NGLs into finished NGL products (ethane, propane, normal butane, isobutane and natural gasoline). It also provides logistics services for exporting Liquefied Petroleum Gas (“LPG”) and storing refined petroleum products and crude oil. This segment’s assets are predominantly located in Mont Belvieu, Texas and Southwestern Louisiana.
4. Marketing and Distribution: this segment markets and distributes raw and finished NGLs produced by Gathering and Processing. Its activities encompass marketing and purchasing NGLs; marketing and supplying NGLs for refinery customers; transporting, storing and selling propane and providing related propane logistics services to multi-state retailers, independent retailers and other end users.

Contribution to operating margin by each segment is shown in Table 3. Note that “Other” reflects results of commodity hedging activities included in operating margin.

Table 3: Figures in $ Millions

Higher margins were driven by increased volumes and higher natural gas prices in the Field Gathering and Processing segment and by higher fractionation fees and increased export activities in the Logistics and Marketing division; they were partially offset by lower NGL prices in the Coastal Gathering and Processing segment and by increases in operating expenses. The Logistics segment’s gross margin increased due to higher fractionation and export volumes, as well as higher fuel prices and increased LPG export volumes. The Marketing & Distribution segment also benefited from increased LPG export volumes, and from higher truck and barge utilization.

The 12/31/12, $976 million, Saddle Butte Pipeline acquisition (renamed Targa Badlands) positions NGLS to participate in the Bakken Shale infrastructure build-out and to generate fee-based revenue by gathering, processing and transporting natural gas and crude oil from the wellhead to various takeaway options (including LPG exports). Because the acquisition closed on December 31, 2012, Badlands did not contribute to operating margins in 2012.

In an article titled “Distributable Cash Flow” I present NGLS’ definition of DCF and also provide definitions used by other MLPs. Based on this definition, NGLS’ DCF per unit for the TTM ending 9/30/13 was $362 million ($3.55 per unit), down from $375 million ($4.26 per unit) in the prior year period. The growth in EBITDA and Adjusted EBITDA was not sufficient to offset the increase in units outstanding.

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”. Applying the method described there to BPL’s results generates the comparison between reported and sustainable DCF presented in Table 4 below:

Table 4: Figures in $ Millions

The principal differences between reported and sustainable DCF for the periods reviewed are attributable to working capital consumed and various items grouped under “Other”. See a prior article for an explanation of why I exclude working capital consumed from my definition of sustainable DCF. Under “Other” I group items such as non-cash compensation and accretion of retirement obligations that management adds back to derive reported DCF but I do not included in my definition of sustainable DCF.

Distributions, reported DCF, sustainable DCF and the resultant coverage ratios are as follows:

Table 5: Figures in $ Millions, except per unit amounts and coverage ratios

In a prior article I noted that NGLS was acquiring Targa Badlands at an expensive EBITDA multiple and that the effect would be dilutive. Management expected distribution coverage to be ~ 0.9x in the first half of 2013 (the actual figure came in at 0.88) and expects coverage to average 1.0x in 2013 due to the dilutive effect of Badlands. This dilutive effect can be seen in the pro-forma results that show net income in the 9-months ending 9/30/12 would have been $125 million had Badlands been acquired on 1/1/12. Actual net income for the period was ~$141 million. So Badlands would have had a detrimental effect. However, management expects Badlands to be accretive in 2014 and beyond.

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 cash related to net income attributable to non-partners fell $19 million short of covering distributions in the TTM ended 9/30/13; this compares to a $184 million excess that was generated in the prior year period. NGLS therefore funding distributions in part, albeit a small part, using cash raised from issuing debt and equity and from other financing activities. It is not yet generating excess cash that would enable it to reduce reliance on the issuance of additional partnership units that dilute existing holders, or issuance of debt to fund expansion projects.

Table 7 below compares NGLS’ current yield of some of the other MLPs I follow:

Table 7

The midpoint of the 2013 Adjusted EBITDA guidance is $625 million. Through 3Q13, Adjusted EBITDA totals ~$415 million, so to achieve guidance NGLS must generate $210 million in 4Q13. That seems a tall order, and indeed management recently guided to the low, rather than mid-point, of the range. This would require NGLS to generate Adjusted EBITDA of $180 million in 4Q13. This would require surpassing the record quarterly Adjusted EBITDA level achieved in 3Q13, a feat made more difficult by the fact that the 3Q13 number was aided by a one-time adjustment of $9.1 million.

The above-mentioned adjustment reflects a reversal of a contingent liability booked in connection with the Badlands acquisition. This acquisition is subject to a contingent payment of $50 million if aggregate crude oil gathering volumes exceed certain stipulated monthly thresholds during the period from January 2013 through June 2014. If the threshold is not attained during the contingency period, no payment is owed. A $15.3 million liability, determined by a probability-based model measuring the likelihood of the contingent payment threshold being met, was established in December 2012. As of September 30, 2013, the contingent consideration was re-estimated to be $0, resulting in an increase in Adjusted EBITDA of $9.1 million for 3Q13 and $15.3 million year-to-date 2013. The elimination of the contingent liability reflects management’s updated assessment, with only nine months remaining on the contingency period, that the stipulated volumetric thresholds will not be met. This could be an indication that Badlands is not yet achieving the high-end of management’s original expectations.

Management provided midpoint Adjusted EBITDA guidance of $750 million for 2014 based on commodity price assumptions for next year of $3.75 per million British thermal units (“MMBtu”) for natural gas, $95 per barrel for crude oil and, on average, $0.90 per gallon for NGLs. Under these assumptions, a $0.05 per gallon change in the price of NGLs would correspondingly change 2014 Adjusted EBITDA by approximately 2%. NGLS expects distribution coverage to be approximately 1.0x in 2014. This coverage incorporates targeted increases in distributions of 7%- 9% in 2014 compared to 2013.

Approximately $1.9 billion in growth capital investments will have been placed in service in 2013 through 2014, of which ~72% are expected to provide primarily fee-based margin. The $750 million Adjusted EBITDA target for 2014 is $235 million above the level actually achieved in 2012 ($515 million). The $1.9 billion in growth capital investments placed in service in 2013-2014 will therefore generate, on average, an 8x EBITDA multiple. Growth capital expenditures are expected to total $900 million in 2013 and $590 million in 2014.

My concerns regarding NGLS center on the expensive acquisition, the low coverage ratio, the high cost of the Incentive Distribution Rights payable to Targa Resources Corp. (TRGP), the general partner, and the still significant exposure to commodity prices. I also believe developing the infrastructure for the Bakken shale is more risky than the Texas shale plays and the Marcellus shale. While management’s claim that 2Q13 is an inflection point for NGLS seems to be correct, the unit price seems to already reflect this.