Evaluating Master Limited Partnerships (MLP) in the Energy Sector
When assessing the performance of any public company for investment purposes, a logical first question is: “How profitable is it?”
There are several ways a company’s performance can be evaluated in terms of profit generation or operational efficiency that results in cash for the company. Net Income is a logical starting point in many cases. Cash flow from operations can provide insight into a company’s operational status. From an accounting perspective, bottom line numbers such as Net Income and Cash Flow from Operations do a good job of telling the story of a company’s profitability.
But in the MLP sector, investors tend to be yield oriented. So a primary point of interest is how much cash the company is generating, and more importantly for an MLP, how much of the cash is available for distribution to the Limited Partners?
To answer this question, to show just how much cash is available for distribution, MLPs will often generate a number that they consider their Distributable Cash Flow.
What is the Right Formula for Distributable Cash Flow?
Distributable Cash Flow can be an effective measure for determining whether an MLP is a good investment. But this metric is not governed by a Generally Accepted Accounting Principles (GAAP) standard, and the way it is calculated can vary widely between companies, sending mixed signals if not fully evaluated.
Given that Distributable Cash Flow is not a GAAP accounting standard, there are differences in the ways this number is calculated. Similar to a cash flow statement, some companies start with Net Income and back out the non-cash associated items, one-time expenses or gains, and maintenance capital (more on maintenance capital later). Others begin with EBITDA or adjusted EBITDA and continue down a similar line, eliminating non-cash items.
Yet another way is to begin with Cash Flow from Operations and make any one-time adjustments from there.
MLPInvestor.com defines Distributable Cash Flow as:
Maintenance capital is an important component to Distributable Cash Flow. But what is maintenance capital? This is a company’s measure of the portion of their capital expenditures that goes towards maintenance of their existing facilities, including repairs and integrity management. The remainder of capital expenditures is generally considered growth Capex.
Why Is It Important to Separate Growth and Maintenance Capex?
According to CSinvesting.org, an independent depository of financial case studies, in most cases, growth capex is an investment, while maintenance capex is a cost. If a business decided to suspend its growth operations, its capital expenditures would quickly decline and the result would be increased free cash. The key is to make sure that the reinvested capital is earning a sufficient rate of return to justify the growth expenditures.
Distributable Cash Flow can be used to determine a company’s coverage ratio. Taking Distributable Cash Flow and dividing that by the total dividend amount paid over the reporting period can give investors an idea of how much money the company has available to distribute, relative to the dividend they are paying. Excess over several periods could indicate that a company has the financial means to raise dividends, while a deficiency could signal the possibility for the dividend to be reduced.
Since the MLP investment arena is largely driven by yield, knowing the amount of cash flow that is available for distribution to its investors makes Distributable Cash Flow useful to know, but it’s worth repeating that since this metric is not governed by a GAAP standard, investors should look carefully at the calculation on a case by case basis.
Sustainability of Dividend
A comparison of Distributable Cash Flow to the actual dividend paid for a given MLP can be an effective indicator of the sustainability of the dividend payment and the operational efficiency of that MLP.
The chart below compares the Distributable Cash Flow to actual distributions paid for Calumet Specialty Products Partners, L.P. (ticker: CLMT), Western Gas Equity Partners LP (ticker: WGP), Plains All American Pipeline, L.P. (ticker: PAA) and Targa Resources Partners LP (ticker: NGLS), four of the MLPs covered in the EnerCom “MLP Scorecard” weekly MLP report compiled by EnerCom Analytics.
For a detailed comparison of 33 financial metrics for 71 MLPs operating in the midstream, E&P and other services sectors, subscribe to EnerCom’s free weekly distribution – “MLP Scorecard”—here.
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