Author: Ron Hiram
Published: November 26, 2016
Summary:
- Lower Supply & Logistics continues to burden results; management attributed some of the 3Q16 segment loss to one-time events and is forecasting segment profit of ~$165 million in 1Q17.
- Coverage was below 1x i n 3Q16 and TTM; PAA funded distributions by issuing debt and equity; the Simplification Transaction reduces cost of capital and cuts distributions by ~$320 million.
- Total segment profit and Adjusted EBITDA have declined in 6 and 7 of the last 9 quarters, respectively; for the past 9 quarters, total dollars distributed grew faster than DCF.
- Management expects DCF coverage to improve to ~1.09x in 2017.
- Higher cash retention, asset sale proceeds, projects coming online, and lower 2017 capital expenditures, should reduce PAA’s high leverage ratio and allow maintaining its maintain investment grade rating.
This article analyses some of the key facts and trends revealed by 3Q16 results reported by Plains All American Pipeline L.P. (PAA).
PAA transports, stores and markets crude oil and refined products; it also transports, processes, stores and markets natural gas liquids (“NGL”) and owns and operates natural gas storage facilities. PAA’s operations are managed through three operating segments:
Transportation Segment: fee-based activities associated with transporting crude oil and NGL on pipelines, gathering systems, trucks and barges;
Facilities Segment: fee-based activities associated with providing storage, terminal and throughput services for crude oil, refined products, natural gas and NGL, NGL fractionation and isomerization services and natural gas and condensate processing services; and
Supply & Logistics Segment: margin-based activities associated with sale of gathered and bulk-purchased crude oil, sales of NGL volumes purchased from suppliers, and natural gas sales associated with natural gas storage operations.
On July 11, 2016, PAA and its general partner, Plains GP Holdings, L.P. (PAGP), entered into a “Simplification Agreement” pursuant to which PAA will issue approximately 245.5 million of its common units to PAGP and will assume PAGP’s outstanding debt (~$641 million as of November 15). In exchange, PAA will acquire PAGP’s incentive distribution rights (“IDRs”) and convert PAGP’s 2% economic general partner interest in PAA into a non-economic general partner interest. Concurrently, PAA announced it would reduce its quarterly distribution from $0.70 to $0.55 per common unit commencing with its third quarter distribution. Both PAA and PAGP will continue to be publicly traded. The number of PAA common units will increase from ~402 million to ~648 million.
Segment profits for recent quarters are presented in Table 1 below. Segment profit is one of the key metrics used by management to evaluate performance of its business segments. It is defined as revenues plus equity earnings in unconsolidated entities less: a) purchases and related costs, b) field operating costs and c) segment general and administrative expenses. It excludes depreciation and amortization.
Table 1: Segment Profit, excluding “Selected Items Impacting Profitability”; figures in $ Millions (except per unit amounts and % change). Source: company 10-Q, 10-K, 8-K filings and author estimates.
Total segment profit declined in 3Q16 and in 6 of the 9 most recent quarters when comparing each quarter to the prior year period.
In 3Q16, Transportation segment profit increased by 3% and total volume throughput increased 1% vs. 3Q15
The 18% increase in the Facilities segment profit was accompanied by a 4% volume increase. Improved performance is mainly attributable to contributions from the Western Canada NGL assets acquired in August 2016, higher fees from NGL storage and fractionation facilities, and lower rail terminal costs.
The declines in total segment profits are due to lower Supply & Logistics margins. Unlike the two other segments that are predominantly fee-based businesses, a substantial portion of Supply & Logistics is margin based and hence, as seen in Table 1, results are far more volatile. That segment swung from an $87 million profit in 3Q15 to a $6 million loss in 3Q16 with just a 1% drop in throughput volumes. Crude oil operations suffered from “increased competition, largely due to overbuilt infrastructure” and lower volumes. NGL operations were adversely affected by “higher storage and processing fees… and higher supply costs driven by competition” (PAA Form 10-Q, 9/30/16). The segment’s loss was also due to losses of approximately $30 million due to “delayed EBITDA recognition associated with NGL inventory costing and the timing of certain sales”; management expects these to be reversed in 4Q16 and 1Q17 and is forecasting segment profit of ~$165 million in 1Q17.
Earnings before interest, depreciation & amortization and income taxes (EBITDA) are shown in Table 2. Adjusted EBITDA declined in 7 of the last 9 quarters:
Table 2: Figures in $ Millions (except % change). Source: company 10-Q, 10-K, 8-K filings and author estimates.
Adjusted EBITDA, a key metric used by management to evaluate PAA’s results, can differ materially from EBITDA because significant items (such as equity-based compensation, inventory and foreign currency revaluations, acquisition related expenses, and derivative losses on commodity transactions) are added back. PAA refers to these adjustments as “selected items impacting comparability” and has wide latitude in deeming certain expenses as “ not indicative of core operating results and business outlook”. The differences between EBITDA and Adjusted EBITDA are summarized in Table 3:
Table 3: Figures in $ Millions (except % change). Source: company 10-Q, 10-K, 8-K filings and author estimates
Contract deficiencies are amounts billed to customers who have not met their minimum volume contractual commitments. They appear for the first time as a selected item in 1Q16 and are further explained in a prior article.
PAA derives distributable cash flow (“DCF”) by deducting interest expense, maintenance capital expenditures, provision for taxes, and distributions to non-controlling interests from Adjusted EBITDA, and by adding distributions in excess of equity earnings in unconsolidated entities.
Table 4: Figures in $ Millions (except % change). Source: company 10-Q, 10-K, 8-K filings and author estimates.
Table 4 indicates that for the past 9 quarters, total dollars distributed have been growing more rapidly than DCF. It also shows that total distributions have been growing more rapidly than distributions to limited partners. As shown in Table 4, distributions have been growing much faster than DCF and the main beneficiary of the distribution growth has been PAGP.
A prior article covering 1Q15 results noted the decreasing coverage ratios and projected there would be no excess coverage in 2015. I viewed this as significantly increasing PAA’s risk profile and therefore reduced my position early that year. Then, in an article covering 3Q15 results, I suggested these trends might lead to the decision (subsequently announced on January 12, 2016), to halt distribution growth and the merger between PAA and PAGP. This was subsequently implemented via the previously noted the Simplification Agreement.
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 PAA’s results generates the following comparison between reported and sustainable DCF:
Table 5: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.
The variance between reported and sustainable DCF results, in part, from differing treatments of working capital cash flows. Over reasonably lengthy measurement periods, working capital is not typically a huge consumer of funds for MLPs. But management’s reported DCF numbers for the TTM ended 9/30/16 are derived after adding back funds invested in working capital amounting to $626 million. My sustainable DCF calculation deducts cash used for working capital because cash consumed is not available to be distributed. However, I ignore cash generated by liquidating working capital because I do not consider it a sustainable source. I acknowledge the apparent inconsistency in the methodology, but believe it results in a better approximation of sustainable DCF.
The variance between reported and sustainable DCF also results from risk management activities. These reflect fluctuations in the value of derivatives used to hedge exposure to commodity prices, interest rates and foreign currency. The sharp drop in net cash provided by operating activities shown in Table 5 for the quarter and TTM ended 9/30/16 is attributed by management partly due to “increased inventory levels and margin balances required as part of hedging activities that were funded by short-term debt” (PAA Form 10-Q, 9/30/16). I do not take cash flows from risk management activities into account when calculating sustainable DCF.
Coverage of distributions in the last quarter and TTM before implementation of the Simplification agreement remains substantially below 1x:
Table 6: $ millions, except ratios. Source: company 10-Q, 10-K, 8-K filings and author estimates. Coverage ratios exclude payments in kind to preferred unit holders.
Table 6 indicates PAA relied on non-sustainable sources to make payments to the limited partners.
PAA’s quarterly cash distributions will decline by ~$80 million as a result of the previously described Simplification Agreement. This decrease reflects the net effect of adding $135 million to distributions being made to LPs ($0.55 for each of the 245.5 million new common units being issued), eliminating $155 million of distributions to PAGP and ~$60 million of distributions to LPs (by cutting the quarterly per unit distribution from $0.70 to $0.55 on each of the 402 million units currently outstanding. Management expects that the annual cash distribution reduction of ~$320 million will reestablish greater than 1.00x annualized coverage.
Distributions declared to the partners of PAA include those to which PAGP is entitled by virtue of its ownership positions and general partner’s IDRs. The allocation of distributions declared to all the partners of PAA is shown below:
Table 7: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.
Table 7 illustrates the magnitude of the benefit of IDR removal resulting from the Simplification Transaction. PAA will also benefit from removal of a conflict of interest potential between PAA and its general partner.
A simplified cash flow statement in Table 8 below clearly demonstrates that PAA funded distributions by issuing debt and equity:
Table 8: Figures in $ Millions. Source: company 10-Q, 10-K, 8-K filings and author estimates.
Equity issued in the TTM ended 9/30/16 includes the January 28, 2016 issuance of 63.1 million 8% perpetual, convertible, Preferred A shares at a price of $26.25 per unit, for which PAA received net proceeds of ~$1,569 million.
Cash from operation less maintenance capital expenditures exceeded distributions by $1,163 million in the TTM ended 9/30/16, resulting in coverage ratios of less than 1x, as shown in Table 6. Management’s preliminary forecasts for 2017 include Adjusted EBITDA at $2.3 billion (vs. the $2,125 million currently expected for 2016) and DCF of $1,600 million ((vs. the $1,453 million currently expected for 2016). The coverage target for 2017, after factoring in the distribution reduction, is 1.08x-1.10x. The $1,425 million of projects scheduled for completion in 2016 are also factored into the preliminary guidance for 2017.
Long-term debt was at 5.3x EBITDA (4.6x Adjusted EBITDA) for the TTM ended 9/30/16, significantly higher than 3.4 where it stood two years ago (as of 9/30/14). Management is selling non-core assets and cutting growth capital expenditures to reduce leverage and maintain PAA’s investment grade. In the first nine months of 2016, the sales totaled $638 million and the growth capital budget for 2017 is down to $600 million. Distributions in excess of $0.55 per unit per quarter are, in my view, unlikely before leverage is substantially; it may take a while before distribution growth can resume
The May 2015 Line 901 Incident continues to plague PAA. Approximately 2,935 barrels were spilled, the cleanup cost is estimated at $280 million and insurance recoveries are estimated at $197 million. While reserves are probably sufficient and further P&L charges unlikely, the legal problems are not over. In addition to multiple civil lawsuits, criminal charges were filed in May 2016 by t he California Attorney General’s Office and the District Attorney’s office for the County of Santa Barbara. Additional investigations being conducted by the United States Attorney for the Department of Justice, Central District of California, Environmental Crimes Section, are still open.
Should business conditions improve, the turnaround at the Supply and Logistics segment could be dramatic. In that event, management’s assessment that PAA and PAGP represent inexpensive, low-risk, long-dated calls on U.S. crude oil production growth could prove accurate.
Early in 2015 I substantially reduced my position in PAA (for reasons outlined in an article covering 1Q15 results) and completed an exit from the position in November 2015. I am not currently considering reinvesting.
