By: Ron Hiram
Published: Dec 18, 2011
As an investor seeking the high yields being offered by master limited partnerships (MLPs), I look carefully at what portion of the distributions being received are really “earned” and generally seek to avoid or reduce positions in MLPs that fund distributions with debt or through issuance of equity (i.e., sale of additional partnership units). Since money is fungible and the MLP financial statements are voluminous and not always easy to read, ascertaining whether you are genuinely receiving a yield on your money (rather than a return of your money) can be a complicated endeavor.
In addition, it is important for a conservative investor to understand how safe is the current return before tackling the question of what are the master limited partnership’s growth prospects. Sustainable distributions provide some protection in that under a downside scenario those MLPs that cannot maintain their distribution rates are likely to suffer significantly greater price deterioration.
Distributable cash flow (DCF) is a quantitative standard viewed by master limited partnerships investors and analysts as an indicator of the MLP’s ability to generate cash flow at a level that can sustain or support an increase in quarterly distribution rates. Since DCF is a non-GAAP measure, its definition is not standardized. In fact, each MLP may define DCF differently (see article on DCF). Investors face two challenges in this regard: first, how do you to compare different MLPs based on their DCF; second, how does the MLPs definition of DCF compare with the investor’s own definition of what can sustain current levels of, or support increases, in quarterly distribution rates.
I use the term sustainable DCF, as distinguished from reported DCF, to highlight differences between the distributable cash flow number reported by an MLPs and that which I calculate. Since “sustainability” is not a clearly defined term, my definition is clearly a subjective one. In that respect, it is not different. But by minimizing deviations from the GAAP term net cash from operating activities, I create a measurement tool that provides better consistency in evaluating an individual MLP’s performance (e.g., by allowing fewer “one-time” adjustments) and provides a common yardstick to enables comparison between different MLPs.
There are a variety of factors causing distributable cash flow (DCF) as reported by the MLP to differ from sustainable DCF as I calculate it. These include cash generated from working capital, asset write-downs, risk management activities, proceeds from asset sales, amounts attributable to non-controlling interests, transaction expenses, incentives paid to bondholders for early debt repayment, and other factors.
For example, in periods where a large portion of net cash from operations is the result of changes in working capital rather than ongoing operations, I take a close look whether and what adjustments should be made. Generally I do not include working capital generated 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 MLP should, on the one hand, 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.
Another example is risk management. Cash inflows and outfows from risk management activites are hard to classify into sustainable and non-sustainable categories because they encompass many kinds of items, including:
(i) Net changes in fair value of derivatives (ii) Amortization of net losses related to monetization of derivative instruments (iii) Currency hedges and valuations (iv) Unrealized gains on non-hedged interest rate derivatives (v) Unrealized (gains) losses on commodity risk management activities (vi) (Gains) losses on non-hedged interest rate derivatives (vii) Proceeds from termination of interest rate derivatives. Gains or losses on non-hedged interest rate derivatives could reflect floating-to-fixed swaps used to hedge interest rates associated with anticipated note issuances. I would not consider this a sustainable item. I have not yet developed a methodology for reliably differentiating between the various risk management items.Therefore I exclude the from my analysis at this point. An investor adopting a different approach can easily use my tables to incorporate risk management activies into the definition of sustainable DCF.
Other factors causing reported DCF to differ from sustainable DCF include items such as proceeds from asset sales and other items that management adds or subtracts in deriving its reported DCF number. I take a close look on a case-by-case basis to see whether, and if so which items, should be excluded in deriving sustainable DCF.
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 measurement period of at least 9 months and then adjust for any items that appear to me to be non-sustainable. I then compare my results to DCF as reported by the MLP and review the adjustments made by the MLP in deriving that number. Finally, I narrate what I see as the key differences and explain why I believe my measure better captures truly sustainable DCF. As part of this latter step, I find it helpful to look at a simplified cash flow statement by netting certain items (e.g., acquisitions against dispositions) and by separating cash generation from cash consumption. This, together with the calculation of sustainable DCF, helps create a clearer picture of a master limited partnership’s cash flows.