By: Ron Hiram
Published:Dec 19, 2011
Most master limited partnerships (MLPs) provide detailed information about how they derive “Adjusted EBITDA”, a term they coin to denote the primary measure used to evaluate operating results, and DCF (distributable cash flow). Many investors and analysts focus primarily on Adjusted EBITDA and DCF. But to properly ascertain sustainability additional analysis is required, including looking “under the hood” to understand how the MLP defines Adjusted EBITDA and DCF.
Let’s focus first on DCF.
Typically the starting point for deriving DCF can be either EBITDA or net cash provided by operating activities. Both are GAAP terms and are part of the MLP’s quarterly and annual financial statements. From these starting points, various non-GAAP adjustments are made. Master limited partnerships have significant degrees of freedom as to what adjustments to make and consequently the adjustments are not always consistent across MLPs.
Using net cash provided by operating activities as a starting point, let’s look at the DCF of Buckeye Partners, L.P. (NYSE: BPL):
9 months ending: | 9/30/2011 | 9/30/2010 |
|---|---|---|
| Net cash provided by operating activities | 182.1 | 296.1 |
| Less: Maintenance capital expenditures | -36.6 | -18.5 |
| Working capital (generated) used | -52.9 | -86.5 |
| Risk management activities (net changes in fair value of derivatives ) | 150.4 | 16.2 |
| Other | 3.5 | -7.8 |
| DCF as reported | 246.5 | 199.4 |
| Distributions to unitholders | 254.4 | 182.0 |
| Coverage ratio | 97% | 110% |
Figures in $ Millions
Since BPL reconciles DCF to Net Income (rather than net cash from operations), the above reconciliation does not appear directly in the financial statements but can be manually computed. Note the $150.4m that is added in deriving DCF. This amount equals the decrease in value of futures contracts executed to hedge physical inventory. The addition reflects “an offsetting adjustment made to the value of inventory by adjusting inventory to current market prices”. We have here a strong indication that risk management results account for a very substantial portion of DCF and has become far more important than it previously was to sustaining BPL’s financial results.
Additional observations regarding DCF can be made based by focusing on Adjusted EBITDA as a starting point:
9 months ending: | 9/30/2011 | 9/30/2010 |
|---|---|---|
| EBITDA | 226.1 | 143.6 |
| Adjustments: | ||
| Net income attributable to noncontrolling interests affected by Merger (for periods prior to Merger) | - | 130.2 |
| Amortization of unfavorable storage contracts | -4.8 | - |
| Non-cash deferred lease expense | 3.1 | 3.2 |
| Non-cash unit-based compensation expense | 6.5 | 5.6 |
| Gain on sale of equity investment | -34.1 | - |
| Goodwill impairment expense | 169.6 | - |
| Adjusted EBITDA | 366.4 | 282.6 |
| Less: | ||
| Interest expense, net (cash) | -90.3 | -65.1 |
| Deferred Income tax expense | 0.2 | 0.4 |
| Maintenance capital expenditures | -36.6 | -18.5 |
| Other | 6.8 | 3.4 |
| Distributable Cash Flow as reported | 246.5 | 202.9 |
Figures in $ Millions
It is disturbing to see $169.6 million of goodwill impairment in the Natural Gas Storage business unit (acquired in 2008 for ~$440 million) in light of “the continued downward performance in operating income and Adjusted EBITDA in the Natural Gas Storage segment due to decreases in contracted storage prices relating to low volatility in natural gas prices and compressed seasonal spreads”. Although it is a non-cash item, writing off 100% of the goodwill booked on a fairly recent acquisition seems to require a closer look at sustainability of distributions.
”Sustainability” is not a clearly defined term and one has to settle on a subjective measure that one is comfortable with. My approach begins with the requirement that to be considered sustainable, an MLP’s net cash from operations should at least cover maintenance capital expenditures plus distributions over a 6-9 months measurement period. In periods where a large portion of net cash from operations is the result of working capital being generated rather than ongoing operations, I would take a close look at whether a downward adjustment should be made. I also find it helpful to net certain items (e.g., acquisitions against dispositions) and to separate cash generation from cash consumption.
Here is what I see for BPL:
SIMPLIFIED SOURCES AND USES OF FUNDS
9 months ending: | 9/30/2011 | 9/30/2010 |
|---|---|---|
| Net cash from operations, less maintenance capex, less distributions | -108.9 | |
| Capital expenditures ex maintenance, net of PP&E sale proceeds | -69.8 | -30.8 |
| Acquisitions (net of operating unit sale proceeds) | -1,084.6 | 7.7 |
| Debt incurred (repaid) | 0.0 | -90.6 |
| Other CF from investing activities, net | -0.5 | 0.0 |
| Other CF from financing activities, net | -10.9 | -7.8 |
| -1,274.7 | -121.5 | |
| Net cash from operations, less maintenance capex, less distributions | 0 | 95.6 |
| Debt incurred (repaid) | 538.0 | 0.0 |
| Partnership units issued | 739.2 | 4.3 |
| 1,277.2 | 99.8 | |
| Net change in cash | 2.6 | -21.7 |
Figures in $ Millions
Note that a goodwill impairment expense of $169.6m (which was deducted from net income in deriving net cash from operations) is added back in deriving Adjusted EBITDA. The two items somewhat offset each other – one being a non-cash charge and the other an adjustment to inventory and therefore also to DCF. I find it disturbing to have two such large adjustments within a short period (both occurred in 3Q11) even if they are offsetting.
What disturbs me most is that by my definition, sustainable cash flow decreased from a positive $95.6m in the 9 months ended 9/30/10 to a negative $108.9m in the 9 months ended 9/30/11. BPL has been increasing distributions at a CAGR of 5.7% since 2006. What I see for the 9 months ending 9/30/11 causes me concern regarding BPL’s ability to make distributions that are financed by operations, not by borrowings or sale of additional partnership units.