Author: Ron Hiram
Published: March 10, 2017
- Despite spending ~$14.6 billion (net of dispositions) in the two-year period ended 12/31/16 (~$15.6 billion in the two year period ended 12/31/15), results have been dismal.
- Per unit Adjusted EBITDA in 2016 is roughly the same as it was in 2012; DCF per unit in 2016 was below its level in 2013.
- ETP has been funding distributions by issuing debt and limited partnership units, by selling assets sales, and by reducing cash reserves.
- Synergies from the merger are likely to be modest; leverage for the combined entity will remain high, as will cost of capital because the IDRs will still be in place.
- For many years I held positions in both ETP and ETE (significantly overweighed to the latter), but I lost confidence in management and no longer hold the units.
The merger between Energy Transfer Partners, L.P. (ETP) and Sunoco Logistics Partners, L.P. (SXL) is expected to close by mid-April. SXL is currently a consolidated subsidiary of ETP. The surviving consolidated entity for accounting purposes will be ETP (for legal and reporting purposes, SXL will be the surviving entity). The merger will be accounted for as an equity transaction and will be reflected in ETP’s financial statements as an acquisition of SXL’s non-controlling interest. The carrying amounts of SXL’s and ETP’s assets and liabilities will not be adjusted, nor will a gain or loss be recognized as a result of the merger.
The merger was initiated due to “the likelihood that ETP would not be able to sustain quarterly distributions at current amounts per unit, taking into account ETP management’s projections indicating increasing leverage, significant additional equity issuances, constrained cash flow, and a sub-1.0x distribution coverage ratio” (ETP Form 8-K, 12/22/16). The facts and trends underlying this statement, and their implications, are discussed in this article.
ETP operated in seven business segments through 3Q16, and in six as of 4Q16. The segments are described in a prior article that also provides ETP’s definition of Adjusted EBITDA. Management uses this non-GAAP financial metric to evaluate performance, allocate capital resources, evaluate business acquisitions, and set incentive compensation targets.
Adjusted EBITDA in 4Q16 increased by 5.4% in absolute terms over 4Q15, but decreased by 2.1% when measured on a per unit basis. Per unit Adjusted EBITDA has been declining for the last seven consecutive quarters vs. the corresponding prior year periods, as shown in Table 1:
Table 1: Figures in $ Millions, except per unit amounts, % change and units outstanding (million). Source: company 10-Q, 10-K, 8-K filings and author estimates.
Intrastate transportation gross margins increased by 8.5% despite no significant change in transported volumes in 4Q16 vs. 4Q15. The segment’s Adjusted EBITDA increased by $30 million (24.6%) primarily due to higher storage margins, realized gains on natural gas sales, and sale of fuel retained as a fee.
Interstate revenues and volume of natural gas transported both decreased by ~7% in 4Q16 vs. 4Q15, attributable primarily to “lower customer demand…weak transportation spread and lower contracted capacity”. This segment’s Adjusted EBITDA decreased by ~5% or $14 million.
Midstream segment’s gross margins increased 0.7% in 4Q16 vs. 4Q15, despite a 3.6% decline in gathered volumes. Adjusted EBITDA decreased by $2 million (0.8%) due to higher SG&A expenses that were only partially offset by lower operating expenses.
Liquids segment gross margins increased 25.4% in 4Q16 vs. 4Q15. This was driven by a 28% increase in transportation volumes and a 58% increase in NGL fractionation volumes. Management cited the placement into service of new crude pipelines and two new fractionators, as well as higher fractionation margins. Adjusted EBITDA increased $55 million (24.3%).
The Sunoco Logistics segment is ETP’s investment in SXL. ETP owns a 99.9% interest in the entity that owns the general partner interest and incentive distribution rights (“IDRs”) in SXL. By virtue of its ownership of the general partner, ETP consolidates the operations of SXL into its financial statements. ETP also owns 23% of the limited partner interests in SXL as of December 31, 2016. The $10 million (3.2%) increase in Adjusted EBITDA vs. 4Q15 reflects SXL placing into service new crude pipelines that was partially offset by lower NGL volumes and margins.
The “All Other” segment includes natural gas marketing and compression operations, and ETP’s 33% non-controlling investment in a joint venture that owns a refinery in Philadelphia. Commencing 4Q16, it also includes what was previously the Retail Marketing segment. Adjusted EBITDA for the “All Other” segment decreased by $6 million (3.9%) in 4Q16 vs. a 4Q15 total that also includes Retail Marketing. The drop in Adjusted EBITDA was due to a “decrease in revenue-generating horsepower and lower project revenue from compression operations and unfavorable results from natural resources operations” (ETP Form 8-K 2/22/17).
Retail Marketing was dropped down to Sunoco LP (SUN) and consists of interests in a convenience store operator (Sunoco LLC) and the legacy SUN retail business. It has been deconsolidated and its results are now reflected as an equity method investment in limited partnership units of SUN. As of December 31, 2016, ETP owned 44.3% (43.5 million) of SUN’s total outstanding units. For purposes of calculating adjusted EBITDA, ETP includes its proportionate share of SUN’s adjusted EBITDA, after deducting the general partner’s IDRs.
The method used by ETP to derive Distributable Cash Flow (“DCF”) is shown in Table 2. When measured on a per unit basis, this metric has been declining for the last eight consecutive quarters vs. the corresponding prior year periods:
Table 2: Figures in $ Millions except units outstanding. Source: company 10-Q, 10-K, 8-K filings and author estimates.
DCF decreased 9.5% in absolute terms and 15.9% on a per unit basis in 4Q16 vs. 4Q15. On a TTM basis, the declines are 9.9% in absolute terms and 22.8% on a per unit basis. The steeper decline on a per unit basis is in part due to the increase in the number of ETP units outstanding between those two periods (523 million vs. 486 million, a 7.6% increase).
Maintenance capital expenditures declined between 22% and 30% in each of the last 4 quarters vs. the corresponding prior year periods. They are down 24.1% measured on a trailing twelve months (“TTM”) basis. Although some of this may be due to the deconsolidation of the Retail Marketing segment, I am surprised by the magnitude because ETP significantly increased its investment in property plant and equipment. Since expenditures on maintenance are comprised of a portion that is expensed and a portion that is capitalized, one possible explanation is that the portion expensed increased (management’s disclosures did not cover this point). The other possible explanation is that not enough is being spent.
Energy Transfer Equity, L.P. (ETE), ETP’s general partner, determines DCF attributable to ETP’s partners and calculates ETP’s coverage ratio as shown in Table 3. ETE is also SXL’s general partner. Note that DCF attributable to, and distribution from, SUN subsequent to 6/30/15 is zero because SUN was deconsolidated and is now reflected as an equity method investment.
Table 3: Figures in $ Millions, except per unit amounts and ratios. Source: company 10-Q, 10-K, 8-K filings and author estimates.
ETP’s DCF did not cover its distributions for the last six consecutive quarters. Coverage for the TTM ending 12/31/16 stood at 0.87x, a considerable distance from the stated goal of 1.05x.
Distributions declared to the partners of ETP include those to which ETE receives, by virtue of its general partner’s ownership position, IDRs and Class H units. The allocation of distributions declared to all the partners of ETP shows the extent of the IDR burden:
Table 4: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.
DCF is one of the primary measures typically used by a midstream energy master limited partnership (“MLP”) to evaluate its operating results. Because there is no standard definition of DCF, each MLP can derive this metric as it sees fit; and because the definitions used vary considerably, it is exceedingly difficult to compare across entities using this metric. Additionally, because the DCF definitions are usually complex, and because some of the items they typically include are unsustainable, it is important (albeit quite difficult) to qualitatively assess DCF numbers reported by MLPs.
Table 5 provides a comparison between the components of reported and sustainable DCF on a consolidated basis:
Table 5: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.
The variances between reported and sustainable DCF are magnified because of working capital fluctuations. For example, DCF as reported for the TTM period ended 12/31/16 ignores (i.e., adds back) $117 million of cash consumed by working capital. In calculating sustainable DCF, I deduct cash used for working capital because cash consumed is not available to be distributed. However, despite the apparent contradiction in the methodology, I ignore cash generated by liquidating working capital because I do not consider it a sustainable source. Over reasonably lengthy measurement periods, working capital is not typically a huge consumer of funds for MLPs. However, this has not been so in the case of ETP. In the last 4 years ETP has invested ~$2 billion (net) in working capital to support its organic and acquired operations.
The risk management line item consists primarily of adjustments for derivative activities relating to interest rate swaps and commodity price fluctuations. The $143 million for the TTM ended 12/31/16 consists mostly of losses resulting from decreases in interest rates that management adds back in deriving DCF; they are excluded from my calculation of sustainable DCF.
For purposes of deriving DCF, management adds back $180 million (net) of various, mostly non-cash, items “Other” in the TTM ended 12/31/16; they are excluded from my calculation of sustainable DCF.
Table 6 compares the coverage ratio as reported by ETP to the coverage ratio based on sustainable DCF. There are material differences:
Table 6: Coverage ratios. Source: company 10-Q, 10-K, 8-K filings and author estimates.
Sustainable DCF in the TTM ended 12/31/16 was $3,070 million, substantially less than the $4,023 million of distributions in that period. The gap between distributions and reported DCF is lower, but still very large.
A simplified cash flow statement is provided in Table 7:
Table 7: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.
Table 7 indicates net cash from operations less maintenance capital expenditures fell short of covering distributions (including distributions to non-controlling interests) by $1,088 million in the latest TTM period. In both TTM periods ETP funded distributions by issuing debt and limited partnership units, by selling assets sales, and by reducing cash reserves.
Despite spending ~$14.6 billion (net of dispositions) in the two-year period ended 12/31/16 (~$15.6 billion in the two year period ended 12/31/15), results have been dismal:
- Per unit Adjusted EBITDA has declined for the last seven consecutive quarters vs. the corresponding prior year periods;
- Per unit Adjusted EBITDA in 2016 ($11.09) was lower than 2015 ($13.18), lower than 2014 ($17.16), and lower than 2013 ($11.51). In fact, it is back to its 2012 level;
- Reported DCF declined 9.9% in absolute terms and 22.8% on a per unit basis in 2016, and sustainable DCF is significantly lower; in 2016 it was lower than it was in 2013;
- DCF did not cover its distributions for the last six consecutive quarters, even as distributions have been held flat and maintenance capital expenditures sharply declined;
- Coverage ratio in 2016 it was lower than it was in 2013;
- For the last 5 years ETP funded distributions by issuing debt and limited partnership units, by selling assets sales, and by reducing cash reserves; and
- From the beginning of July 2014, when energy price began their downward spiral, through March 10, 2017, holders of units in the Energy Transfer entities have experienced losses similar to that of the Alerian price index: the index declined 37.3%, ETP also declined 37.3%, ETE declined 36.6%, and SXL declined 48.1%. Unit holders of best-of-breed MLPs fared considerably better.
I view the proposed merger of ETP and SXL as principally another financial maneuver that shifts ownership of the same set of assets between entities within the Energy Transfer group. Such related party transactions occurred frequently in the past and the conflict of interest potential always concerned me. The synergies are likely to be modest at best, and will take time to realize. Leverage for the combined entity remains high (above 5.4x). Data as of 9/30/16 pro forma for the SXL merger shows long-term debt at $30.4 billion and Adjusted EBITDA at $5.6 billion (ETP Form 8-K 12/22/16 and ETP Investor Presentation 11/21/16). Cost of capital will also remain elevated because the IDRs will still be in place. ETP unit holders will suffer a 27.5% drop in quarterly distributions (from $1.055 to $0.765).
For many years I held positions in both ETP and ETE (significantly overweighed to the latter), but I lost confidence in management and no longer hold the units