A Close Look At PAA's Cash Flow

On August 6, Plains All American Pipeline L.P. (PAA) reported results of operations for Q2 2012. Revenues, operating income, net income and earnings before interest, depreciation & amortization and income tax expenses (EBITDA) were as follows:

Strong performance was exhibited by all segments, particularly Supply & Logistics:

Two Factors Drive Growth
The extraordinary growth in Supply & Logistics's segment profit is attributed by management to two main factors. One is the “…impact of higher volumes due to increased production related to the active development of crude oil and liquids-rich resource plays. The increase in volumes was primarily a result of increased drilling activities in the Bakken, Eagle Ford Shale, West Texas, Western Oklahoma and Texas Panhandle producing regions…” The other relates to “…increased margins related to production volumes exceeding existing pipeline takeaway capacity in certain regions and the associated logistics challenges”. Management cautions that the margins delivered in 2011 may not be repeated: “…a normalization of margins may occur as the logistics challenges are addressed” (quotes are from PAA’s 2011 10-K). Results for Q1 2012 indicated a 3.8% decline in that segment’s contribution compared to the prior year period (see my report on PAA dated May 19, 2012). However, in Q2 12, Supply & Logistics’s profit contribution jumped 81% over the prior year period.

Given quarterly fluctuations in revenues, working capital needs and other items, it makes sense to review trailing 12 months (“TTM”) numbers rather than quarterly numbers for the purpose of analyzing changes in reported and sustainable distributable cash flows.

In an article titled Distributable Cash Flow (“DCF”) I present the definition of DCF used by Plains All American Pipeline L.P. (PAA) and provide a comparison to definitions used by other master limited partnerships. Using PAA’s definition, DCF for the TTM ending 6/30/12 was $1,385 million ($8.86 per unit), up from $897 million in 2010 ($6.29 per unit) in the TTM ending 6/30/11. As always, I first attempt to assess how these figures compare with what I call sustainable DCF for these periods and whether distributions were funded by additional debt or issuing additional units.

The generic reasons why DCF as reported by the MLP may differ from sustainable DCF are reviewed in an article titled Estimating Sustainable DCF-Why and How. Applying the method described there to PAA results through 6/30/12 generates the comparison outlined in Table 3 below:

Big YoY Increase
Table 3 indicates net cash provided by operating activities in the TTM ending 6/30/12 increased by $793 million vs. the TTM ending 6/30/11. The three major components of the large increase are: (1) net income increased by $552 million; (2) there a $121 million inventory valuation adjustment in 2Q12 which reduced net income but involved no cash outflow; and (3) working capital was consumed in the TTM ending 6/30/11 but generated in the TTM ending 6/30/12, for a net difference of $111 million. These three items total $784. The balance is accounted for by other items. For the TTM ending 6/30/12 the difference between reported DCF and sustainable DCF is mostly in the “other” category and its largest component are non cash charges (such as the inventory valuation adjustment mentioned above) that management excludes from its definition of DCF. Also worth noting is that under PAA’s definition, reported DCF always excludes working capital changes, whether positive or negative.

Coverage ratios appear strong, as indicated in Table 4 below:

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. Here is what I see for PAA:

Net cash from operations, less maintenance capital expenditures, less cash related to net income attributable to non-controlling partners exceeded distributions by $725 million in the TTM ending 6/30/12 and by $109 million in the TTM ending 6/30/11. Clearly PAA is not using cash raised from issuance of debt and equity to fund distributions. Of the $3.2 billion gross amount spent in the TTM ending 6/30/12 on growth capital projects and acquisitions (net of sale proceeds), only $2.2 billion was funded by debt and the issuance of additional partnership units; the balance was funded from internal cash flow. This is an impressive achievement, as is the ability of PAA to generate net income in excess of distributions per unit every quarter so far since Q1 11.

Growth Outlook
Capital growth projects are forecasted to total $1,175 million in 2012, of which $511 million was expended in H1 12. My hope is that PAA funds the balance with debt (which it can easily do without exceeding its announced credit profile parameters) and/or internally generated cash flow in order to minimize dilution to limited partners. The fact that the general partner gets 50% of any distributions in excess of $2.70 per unit per annum pushes up PAA’s cost of capital and constrains the ability to increase distributions to limited partners. In the TTM ending 6/30/12, distributions per unit increased by 7%.

As of 8/15/12, PAA’s current yield of ~4.91% is higher than the ~4.64% yield of Magellan Midstream Partners (MMP) and the ~4.82% yield of Enterprise Products Partners L.P. (EPD), but lower than all the other MLPs I cover. For example: ~5.95% for Kinder Morgan Energy Partners (KMP), ~6.18% for Williams Partners (WPZ); ~6.24% for El Paso Pipeline Partners (EPB); ~6.37% for Targa Resources Partners (NGLS); ~7.87% for Buckeye Partner (BPL); ~7.83% for Boardwalk Pipeline Partners (BWP), and ~8.15% for Energy Transfer Partners (ETP).

PAA, EPD and MMP are all outstanding MLPs. The relatively low yields notwithstanding, their operational results have been excellent and have driven up unit prices, thus generating significant capital gains for the partners. They are a solid choice for more conservative MLP investors. The only reason I would favor EPD and MMP over PAA is the capital structure -- no general partner incentive distributions for EPD and MMP vs. 50% in the case of PAA.