NGLS – A Closer Look at Targa Resources Partners’ Distributable Cash Flow as of 3Q 2014

Author: Ron Hiram

Published: November 25, 2014

Summary:

• Impressive increases in operating margins and Adjusted EBITDA in the last 4 consecutive quarters.
• Very solid coverage of sustainable DCF in the TTM ended 9/30/14.
• Multiple of enterprise value to TTM EBITDA appears very reasonable relative to other MLPs with lower distribution growth prospects.
• APL acquisition should be immediately accretive to DCF. Combined partnership will be one of the largest diversified MLPs with pro forma enterprise value of $23 billion.

This article analyses some of the key facts and trends revealed by 3Q14 results reported by Targa Resources Partners LP (NGLS). It evaluates the sustainability of the partnership’s Distributable Cash Flow (“DCF”) and assesses whether NGLS is financing its distributions via issuance of new units or debt.

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.

Field Gathering and Processing 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. NGLS also has increasing fee-based revenues from natural gas treating and compression, natural gas gathering, and processing and crude oil gathering generated by its Bakken Shale assets. Contracts in the Coastal Gathering and Processing are primarily hybrid (percent-of-liquids with a fee floor) or percent-of-liquids contracts. For the years ended December 31, 2013 and 2012, percent-of-proceeds contracts accounted for ~48% and ~43%, respectively, of gathered natural gas volume.

Revenues for recent quarters and the trailing twelve months (“TTM”) ended 9/30/14 and 9/30/13 are presented in Table 1 below. They are driven primarily by commodity sales, principally NGLs and natural gas:

Table 1: Revenues; figures in $ Millions

Midstream services, 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.

Operating margin is one of the key metric used by management to evaluate performance of its business segments. Contribution to operating margin by each segment is shown in Table 2. Note that “Other” reflects results of commodity hedging activities included in operating margin.

Table 2: Figures in $ Millions

Favorable comparisons of operating margins between 3Q14 & 3Q13, and between the TTM periods ended 9/30/14 and 9/30/13, were driven by higher commodity sales prices, increased throughput volumes (Badlands crude oil and natural gas volumes increased significantly in 3Q14), increased LPG exports, higher fractionation fees, and the start-up of commercial operations of assets placed into production (e.g., the 200 million cubic feet per day North Texas Longhorn plant in May, and the 200 million cubic feet per day SAOU High Plains plant in June).

Higher operating margin drove improvements in operating income (operating margin differs from operating income in that it excludes expense depreciation and amortization, general and administrative, and certain other expenses), as well as in, earnings before interest, depreciation & amortization and income tax expenses (EBITDA).

Management makes certain adjustments to EBITDA aimed at better measuring the partnership’s ability to generate sufficient cash to support distributions. Adjusted EBITDA excludes items such as: gains or losses on asset disposals and debt repurchases/redemptions; non-cash risk management activities related to derivative instruments; changes in the fair value contingent consideration; and the non-controlling interest portion of depreciation and amortization expenses. The trend of significant improvements in Adjusted EBITDA per unit began in 3Q13, as seen in Table 3 below:

Table 3: Figures in $ Millions (except per unit amounts and % change)

Favorable comparisons of Adjusted EBITDA between 3Q14 & 3Q13, and between the TTM periods ended 9/30/14 and 9/30/13, were driven by the same factors that drove improvements in operating margins, including higher LPG export activity and fractionation activity in the Logistics and Marketing segments, a higher contribution from Badlands, higher volume throughput in the Field Gathering & Processing segment, and the placing into service of additional assets.

Based on the improved performance, with the publication of 2Q14 results management also increased its guidance for 2014 Adjusted EBITDA to $925-$975 million, up from the $820-$880 million guidance provided on 3/31/14, and up from the previous guidance of $715 million. There was no further increase following publication of 3Q14 results.

NGLS’ definition of DCF is presented in an article titled “Distributable Cash Flow”. The article also provides definitions used by other master limited partnerships (“MLPs”). Based on this definition, DCF reported by NGLS for the TTM ended 9/30/14 was $722 million ($6.37 per unit), up from $362 million ($3.55 per unit) in the corresponding prior year period, as shown in Table 4 below:

Table 4: Figures in $ Millions (except per unit amounts and % change)

Management’s projection that 2Q13 would be an inflection point for NGLS turned out to be on the money. The rapid increase in DCF per unit partly reflects the fact that while units issued in connection with the Badlands impacted unit count since December 2012, the acquisition began contributing to cash flows only in 2013. Badlands crude oil and natural gas volumes increased significantly as a result of continuing investments to expand and improve gathering and processing capabilities. Badlands thus provided significantly higher period-to-period contributions.

Reported DCF may differ from sustainable DCF for a variety of reasons. These are reviewed in an article titled “Estimating sustainable DCF-why and how”. Applying the method described there to NGLS’ results generates the following comparison between reported and sustainable DCF:

Table 5: 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”.

Under NGLS’ definition, reported DCF always excludes working capital changes, whether positive or negative. In contrast, as detailed in my prior articles, I generally do not include working capital generated in the definition of sustainable DCF but I do deduct working capital invested. Despite appearing to be inconsistent, this makes sense because in order to meet my definition of sustainability the master limited partnerships should generate enough capital to cover normal working capital needs. On the other hand, cash generated from 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. I therefore do not add the $101 million of working capital consumed to net cash provided by operating activities in deriving sustainable DCF for the TTM ended 9/30/14.

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.

NGLS increased 3Q14 distributions to $0.7975 (up 2.2% from 2Q14 and up 8.9% from 3Q13). I calculate coverage ratios in Table 6 below in two ways: first based on the actual distributions made in the period; second, based on distributions declared in the period (and paid the following quarter).

Table 6: Figures in $ Millions, except per unit amounts and coverage ratios

NGLS provided very solid coverage of sustainable DCF in the TTM ended 9/30/14.

Table 7 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 7: Figures in $ Millions

Net cash from operations, less maintenance capital expenditures, less cash related to net income attributable to non-partners exceeded distributions by $140 million in the TTM ended 9/30/14; this compares to a small shortfall in the prior year TTM period. NGLS is not funding its distributions using cash raised from issuing debt and equity and from other financing activities. In the TTM ended 9/30/14 the partnership generated excess cash that enables it to somewhat reduce reliance on the issuance of additional partnership units that dilute existing holders, or issuance of debt to fund expansion projects.

Table 8 provides selected metrics comparing NGLS to some of the other MLPs I follow

Table 8: Enterprise Value (“EV”) and TTM EBITDA figures in $ Millions

EBITDA data in Table 7 is as of September 30, 2014 (except that SPH cash and debt data used to calculate EV are as of June 30). For RGP I use Adjusted EBITDA due to factors specific to that MLP. Where available, I have included 2014 guidance. Note that BPL, EPD, MMP and SPH are not burdened by general partner incentive distribution rights (“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 7, 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.

On October 13, 2014, NGLS and Targa Resources Corp. (TRGP), its general partner, announced an agreement to acquire Atlas Pipeline Partners, L.P. (APL) and Atlas Energy, L.P. (ATLS). In the first step, NGLS will acquire APL for $5.8 billion, including $1.8 billion of debt as of September 30, 2014. Each APL unit holder will be entitled to receive 0.5846 TRGP units and a one-time cash payment of $1.26 per APL unit. As a second step, following the spin-off by ATLS of its non-midstream assets, TRGP will acquire ATLS for $1.869 billion (consisting of ~10.35 million TRGP shares valued at $1.259 billion based on the October 10 closing price) and $610 million in cash.

The acquisition will enhance NGLS’ aready strong positions in the Permian and Bakken shale formations and provide an entry into the Midcontinent region (Mississippi Lime shale) and the South Texas region (Eagle Ford). The combination of APL’s NGL production with NGLS’ downstream NGL assets is expected to generate additional revenue along the NGL value chain, create additional attractive growth capital expenditure projects and accelerate current growth capital expenditure projects. The $950 million EBITDA guidance for 2014 indicated in Table 8 does not reflect this acquisition. Combined, the pro forma 2014 EBITDA guidance increases by ~$400 million to ~$1.35 billion and NGLS will become will be one of the largest diversified MLPs with pro forma enterprise value of $23 billion.

The acquisition should be immediately accretive to DCF. Assuming a 1Q15 close, NGLS estimates full year 2015 pro forma distribution growth over full year 2014 of 11% – 13%, and expects distribution coverage to be 1.1x – 1.2x. Should that occur, TRGP estimates its 2015 dividends will increase by ~35% (full year 2015 pro forma dividend growth over full year 2014).

To facilitate the transaction, TRGP agreed to reduce its IDRs for the four years following closing by fixed amounts of $37.5 million, $25 million, $10 million and $5 million, respectively.

My concerns regarding NGLS are centered on the burdened imposed by the high cost of the IDRs (NGLS pays TRGP 48% of each marginal dollar of DCF it generates), and NGLS’ still significant exposure to commodity prices, Despite these concerns, I noted on February 17, 2014, that it was an opportune time to add to, or initiate, positions in NGLS or, alternatively, in TRGP whose dividends are projected to increase at a much faster rate. While the NGLS unit price subsequently increased significantly (from $55.32 to above $70, with a high of $81.55), the decline in oil prices seems to have caused a significant pullback due to concerns regarding NGLS’ commodity price exposure. Again, this may be an opportune time to add to, or initiate, positions in NGLS or, alternatively, in TRGP.