The MLP industry appears to be moving closer to better disclosures for investors... will other executive teams follow ONEOK and provide non-GAAP free cash flow on press releases?

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For beginners, Investopedia has a video about free cash flow here : cash flow from operations less all capital expenditures. It would be a huge step forward for executive teams to put this measure on all MLP press releases, in our view. 

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We’re very happy to announce that ONEOK (OKE/OKS) has released a form of a non-GAAP measure of free cash flow in its 2016 outlook press release. Even though we still would like more clarity around the measure (stand-alone capital spending, etc.), we applaud management’s step forward in disclosing additional information to investors.

Valuentum has been calling for the disclosure of non-GAAP free cash flow, as measured by cash flow from operations less all capital spending, in press releases for some time (in addition to other measures management would like to release: distributable cash flow, etc.), and we’re happy that ONEOK Partners appears to be the first, from what we can tell, to take the step forward to help MLP investors better understand free cash flow.

In ONEOK’s case, why not – traditional free cash flow less expected distributions is fantastic (relative to peers, of course)! -- see table below.

We believe the news this week represents a victory for MLP investors when it comes to additional disclosures. Here’s what we’re talking about. These are the measures disclosed in ONEOK’s most recent press release, the 2016 outlook, released December 21, 2015 (note the measure of free cash flow):

ONEOK and ONEOK Partners have disclosed in this news release expected 2016 cash flow available for dividends, free cash flow, dividend coverage ratio, adjusted EBITDA, distributable cash flow and cash distribution coverage ratio, which are non-GAAP financial metrics, used to measure ONEOK's and ONEOK Partners' financial performance.

Please compare this to ONEOK’s disclosures in the third-quarter results, released November 3:

ONEOK Partners has disclosed in this news release adjusted EBITDA, DCF, distributable cash flow to limited partners per limited partner unit and cash distribution coverage ratio, which are non-GAAP financial metrics used to measure the partnership's financial performance.

ONEOK’s “free cash flow” guidance doesn’t go so far as to say whether they are deducting all capital expenditures, as it defers to “standalone capital spending,” nor does it actually use cash flow from operations, but we like the step forward in any case. The closer the industry moves to offering investors non-GAAP free cash flow, as measured by cash flow from operations less all capital spending, the better decisions investors can make, in our view, as it relates to assessing the risks of the business, not the least of which is capital-market dependency. Though ONEOK’s measure appears to fall short from standard measures of non-GAAP free cash flow, we’re still pleased – as long as investors understand that the disclosure is still not traditional non-GAAP free cash flow (and it doesn’t lead to more confusion).  

We think it is worth mentioning that ONEOK Partners’ (OKS) expected performance in 2016 appears to be the exception, not the norm when it comes to MLPs. For one, management noted that it expects adjusted EBITDA at ONEOK Partners (OKS) to be ~$1.88 billion for 2016 and both growth and maintenance capital spending of ~$460 million and ~$140 million at the entity, totaling about ~$600 million in total capital spending for the year. If we assume that EBITDA can be considered a proxy in part for cash flow from operations, assuming neutral working capital movements, after deducting such capex, we’re looking at non-GAAP “free cash flow” of close to ~$1.28 billion for the year. Cash distributions were $1.05 billion, $909.7 million, and $760.9 million in 2014, 2013, and 2012 at Oneok Partners, respectively -- meaning traditional free cash flow, by our translation of cash flow from operations less all capital spending, will likely cover distribution payments alone in 2016. 

This is fantastic compared to its peers. From our perspective, we don’t understand why analysts were saying that ONEOK Partners would be in trouble?

Based on its guidance for 2016, the distribution at ONEOK Partners is one of the strongest out of all the MLPs – the entity literally looks like it will cover distributions with traditional free cash flow generation for the year -- not to mention that the equity markets appear open to the company as it sits on substantial liquidity. It is not surprising why shares have spiked considerably! Unfortunately, however, ONEOK Partners is the exception. For most MLPs, and almost all in our coverage universe, traditional free cash flow generation, as measured by cash flow from operations less all capital spending is substantially lower than distributions paid. In some cases, traditional free cash flow is materially negative. 

Here is a table that shows traditional free cash flow less distributions, dividends through the first half of 2015 for our MLP coverage universe, for example (note: energy resource pricing has deteriorated since the end of the second quarter) -- the column called free cash flow after distributions, dividends is the one to pay attention to (this is through the first half of 2015 -- we expect to update this table following 2015 results): 

Image Source: Valuentum Securities

We hope the news this week is a step forward by executive teams to help investors better understand traditional free cash flow, as measured by cash flow from operations less all capital spending, and not the beginning of just throwing around the word “free cash flow” to add further confusion to the mix. In Valuentum’s view, the best measure of free cash flow is one that deducts all capital spending (both growth and maintenance) from cash flow from operations. Thank you for reading!

For beginners, Investopedia has a video about free cash flow here : cash flow from operations less all capital expenditures. Why can’t we get this measure on all MLP press releases?

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1. Kinder Morgan’s Credit Should Be Junk Status

The corporate’s investment-grade credit rating does not add up.

On a reported basis, adjusted for impairments, our estimate for Kinder Morgan’s leverage is 7 times annualized first-half EBITDA, nearly a half turn greater than that of perhaps its closest peer Energy Transfer Equity, which is rated Ba2/BB/BB (Stable) by the credit rating agencies.

That’s two full notches below the lowest level of investment grade and Kinder Morgan’s credit rating, despite Kinder Morgan’s dividend obligations being $350 million more during the first half of this year alone (~$750 million annualized) relative to Energy Transfer Equity, and its absolute level of debt standing above any other on this list. Kinder Morgan’s plans to raise its dividend at a 10% annual clip each year through 2020 should make the corporate’s credit quality worse in this comparison, not better.

As a second data point, Standard & Poor’s assigns a corporate credit rating of BB+ for Williams Co, a company that we estimate as roughly 7+ times net debt to annualized EBITDA on the basis of first-half results. Though Fitch believes Williams’ credit is improving (BBB- ‘Rating Watch Positive’) and Moody’s has Williams’ Co’s ‘Ratings Under Review’ (Baa3), Kinder Morgan’s leverage metrics fall in between ETE’s BB and WMB’s BB+, yet the company is granted a BBB- rating.

Here’s where to find what we’re looking at. To locate Energy Transfer Equity’s (not Energy Transfer Partners) credit rating, go to page 3 of the presentation at the June 23, 2015, Credit Suisse conference (a) and underneath Energy Transfer Equity’, L.P, you’ll see the ratings by the agencies, Ba2/BB/BB (Stable). The first-half EBITDA information can be found by downloading each firm’s respective 10-Q, here (b) and here (c), for Kinder Morgan and Energy Transfer Equity, respectively. We add back impairment charges and D&A-related items to operating income to arrive at our measure of adjusted reported EBITDA. Go to William Co’s latest 10-Q (d) to get its data; its corporate credit ratings can be found on page 50. These links are at the end.

All in, at ~7 times net debt-to-annualized adjusted EBITDA, and with double-digit growth in cash dividend obligations expected through 2020, Kinder Morgan’s credit should be rated junk, in our view, especially when compared to Energy Transfer Equity’s metrics, which are a full two notches below those of Kinder Morgan, and those of Williams Co, which are split among the agencies. We’re talking 7 turns of leverage on a company that has commodity-price exposure (e). From an external investor’s perspective, asset quality can probably only be viewed as questionable at best in light of recent pipeline failures at the company specifically (here and here).

2. Once Bitten, Cash Flow Lessons Are Learned, But Only Then

Those MLPs that have cut their payouts have been the best cash managers.

What we find to be the most interesting development across the equity pipeline universe is that those that have demonstrated the best cash management through the first half of 2015 have been entities that have disappointed investors with respect to the distribution in the past.

On this list, only two master limited partnerships have generated positive free cash flow (after dividends/distributions paid), and both of these entities have cut their distributions to investors. Linn Energy recently cut its distribution, despite generating nearly $45 million in free cash flow (after distributions) during the first half of this year, and Boardwalk Pipeline, which slashed its payout in early 2014, generated nearly $100 million in free cash flow (after distributions). We find that after the “MLP game” has played out for certain equities, executive teams tend to transform into better cash managers, opting to not throw away capital at any and all growth projects in hopes of having EBITDA finally catch up to a respectable fraction of their corresponding net debt loads.

From our perspective, the industry appears far from healthy. Barron’s reported (f) that Magellan Midstream and Plains All American are witnessing heightened competition across the space due to pipeline overbuilding, so it would seem that M&A may be operators’ only avenue to delever, as crazy as that sounds. But when entities that are 6.6 times leveraged seek to acquire firms that are more than 7 times leveraged, it speaks more of desperation than consolidation. We’re talking about Energy Transfer Equity’s recent bid for Williams. Combining two cash-deficient, overleveraged entities won’t make one cash-rich, financially-sound player. It doesn’t work that way.

3. Distributable Cash Flow is Not To Be Used In Valuation

The difference between cash flow from operations and distributable cash flow is astounding in some cases.

Distributable cash flow has the same initials as discounted cash flow (DCF), but these two measures cannot be more different. Distributable cash flow, for one, is a non-GAAP measure that executive teams across the pipeline universe disclose in their quarterly press releases, while discounted cash flow is used within the valuation process, traditionally as a form of enterprise free cash flow or free cash flow to the firm (FCFF). Annual enterprise free cash flow is calculated as earnings before interest (EBI), after taxes, less net new investment (total capex less depreciation) +/- operating working capital changes.

The reason why distributable cash flow, or the measure disclosed in press releases, cannot be used in valuation is at least three-fold:

1. It does not take into account growth capital spending. Within the valuation context, growth in any cash flow metric cannot be incorporated unless the growth capex associated with such growth is also deducted. It is a law of valuation, or else an imbalance exists within the framework. Distributable cash flow does not include growth capex, and therefore is not an appropriate valuation measure.

2. Distributable cash flow picks up near-term, unsustainable nuances that aren’t part of a company’s enterprise free cash flow stream over the long haul. For example, in Kinder Morgan’s case, the corporate’s distributable cash flow includes cash tax savings, which should not be factored into a perpetuity valuation, as Kinder Morgan will eventually pay taxes (just like any corporate). A long-term intrinsic value estimate considers a long-term cash tax rate, even if present results are artificially and temporarily bolstered by a lower cash tax bill. This is why relative valuation tables aren’t applicable in situations where long-term dynamics change across entities. You got it—Kinder Morgan’s long-term EBI needs to be tax-effected at the statutory rate within the valuation context.

3. Working capital changes matter. The team at Berkshire Hathaway (BRK.A) is famously against the use of EBITDA, oftentimes using colorful language to explain the measure’s pitfalls, and we agree. EBITDA is a horrible proxy for any form of cash flow (it considers no capex), and it certainly is a horrible proxy for operating cash flow, at least within the pipeline arena. Just look at the accounts receivable boost in Kinder Morgan’s first half (+$366 million, was $94 million), and the line item ‘Cash flow in operating assets and liabilities, net of effects of acquisitions and deconsolidations’ in Energy Transfer Partners first half (-$938 million, was +$361 million). What we find astounding is Energy Transfer Partners’ first-half GAAP net cash provided by operating activities is just $1.1 billion, compared to the $1.7 billion in distributable cash flow attributable to the partners of ETP, as adjusted. The timing of working capital shifts is important, and we have generally accepted accounting principles (GAAP) that define what ‘cash flow from operations’ is or should be.

Hope you enjoyed reading about these anomalies. I can be reached at [email protected] for any questions or comments. 

Thank you for reading!

(a) Credit Suisse conference slide deck Energy Transfer Equity 

(b) Kinder Morgan 2Q 10-Q

(c) Energy Transfer Equity 2Q 10-Q

(d) Willaims Co 2Q 10-Q

(e) “For 2015, the company estimated that every $1 per barrel change in average WTI crude oil price will impact KMIs distributable cash flow by approximately $10 million, and each $0.10 per MMBtu change in the average price of natural gas will impact distributable cash flow by approximately $3 million.” – KMI second-quarter release

A myopic view on the energy sector may lead one to ask the question whether the distributions of energy master limited partnership are safe. A broadminded view would answer that question in two words: absolutely not.

Through the first six months of 2015, almost every energy-related MLP has spent more in total capital expenditures and distributions than they generated in cash flow from operations. Business models with financials such as these cannot be sustainable over the long haul without infinite access to capital via the debt or equity markets. We learned that housing prices don’t always go up (and that they can fall on a national scale) during the Financial Crisis, and we’ll eventually learn that debt-infused business models that collectively spend more in capital and dividends than they generate in operating cash flow have limits, too.  

From our point of view, dividend safety stems from significant free cash flow generation, as measured by cash flow from operations less all capital spending, and a pristine balance sheet that is flush with net cash. The financial structures of MLPs offer investors distribution risk, not distribution health. A view of the dichotomy we speak of is evident in looking at financial performance of asset-light, cash-rich entities such as Apple, Microsoft, and MasterCard, as shown in the table above. If investors are truly looking for strong cash-flow generation and pristine balance sheets, such a combination that translates to dividend health is simply difficult to find within the energy sector.

We’re starting to see cracks in the business models of MLPs. Literally.

The Plains All American crude oil spill near Santa Barbara, California has garnered a fair share of news as of late, and it has become apparent that the pipeline was not in proper operating condition. The entity has reported that it will incur a net charge of $65 million in its second quarter related to the incident ($257 million in total offset by $192 million in insurance), but in its second-quarter earnings call, management stated that it would not raise its maintenance capital expenditures in 2015. This comes even after a second, smaller spill took place in southwest Illinois.

Plains All American is not the only major pipeline operator to have its infrastructure fail in recent months. Most recently, Kinder Morgan had a natural gas pipeline rupture--not its first major infrastructure failure this year--sending thousands of pounds of highly volatile gases into the air in rural Texas, and Energy Transfer Partners experienced a much larger natural gas rupture accompanied by a fireball shooting into the Texas countryside in mid-June. Despite these recent events, the companies have done little in their quarterly reports to acknowledge the developments, let alone plan an increase in maintenance spending to ensure they or a more serious event--like this one in 2010--do not happen again.

Investors like to champion the low maintenance requirements of pipeline operators, but are pipelines truly low maintenance? Or are operators just not spending enough to prevent such disasters? Our view is that investors really don’t know the quality of the assets in the ground, and we fear that they’re holding aged infrastructure in need of massive reinvestment in coming years. The events of just the past few months support this view.   

Plains All American shocked MLP investors when it said on its second-quarter conference call that it may have to potentially defer distribution growth until 2017. The MLP had been targeting 7% distribution growth in 2015 (now 6%), but its $660 million in cash flow from operations through the first half of 2015 was far less than the near ~$1.3 billion in capex and ~$550 million in distributions it paid during the same period. Only Kinder Morgan has both a greater cash shortfall during the first six months of the year and more leverage on the balance sheet (net debt/annualized CFO). If Plains All American will have trouble sustaining a high-single-digit pace of distribution growth over the next two years, we think Kinder Morgan’s plans to fund 10% annual growth in its dividend through 2020 is a pipe dream.

We second Plains All American’s “desire to inject caution.” From our perspective, Linn Energy changed the game MLPs were playing. Not only was Linn one of the only MLPs, if not the only MLP, that generated positive traditional free operating cash flow less distributions paid during the first half of 2015, but it was the only one on this list that suspended its distribution! We reiterate our opinion that the artificial valuation paradigm centered on debt-infused financially-engineered dividends won’t last, and we think bankers have already started to tighten the noose on overleveraged entities as losses on debt paper across the energy sector mount.

There is a limit to an entity’s debt capacity, and we’ve already passed it in this cycle with respect to most pipeline operators, in our view. The MLP business model is weakening, much like the walls of their failing pipelines, and we think the equity fall-out has only started to begin. Investors simply don’t know the quality of the assets in the ground, and the operators’ financials aren’t much to speak of in light of much safer dividend growth opportunities elsewhere. We prefer organically-driven dividends, not financially-engineered ones. Buyer beware.  

The Game Is Nearing an End for MLPs... - Valuentum Securities Inc.

The game is nearing an end for master limited partnerships (MLPs) in this energy cycle, in our view.

We no longer feel comfortable, if we ever did, including any MLP in the Dividend Growth Newsletter portfolio. Linn Energy, of the upstream variety, may have taken on far too much debt as an E&P entity, but its free-cash-flow management during the first half of 2015 has actually been decent...stronger than better-known upstream and midstream operators.

Yet, despite Linn’s positive free-cash-flow execution, even after distribution payments, the entity’s bankers appear to be circling like sharks, ready to take a further bite out of its borrowing capacity (due to lower energy resource pricing). Fairly, the company simply can’t afford to take any chances and is flat-out worried that banks will cut its borrowing base yet again; this time to $1 billion at year-end.

Though we’d never in a gazillion years lever up as much as Linn had done (a big mistake in a commodity-producing industry), we can’t disagree with management’s decision to cut the distribution. Management is now running the company for survival, not to pad unitholders’ accounts with a distribution, though a strong and growing distribution had once been its goal.

Linn, having already disappointed income investors in cutting the payout prior to the news last week, was not getting what we would describe to be a “Kinder Morgan effect” with the valuation of its shares. We define a “Kinder Morgan effect” as a situation where a company is valued solely on the basis of its dividend, irrespective of actual free-cash-flow fundamentals or whether the dividend is organically generated (as opposed to financially-engineered).

Where Kinder Morgan is yielding ~5%, Linn Energy had been fetching a yield of 15% or higher, even as it generated positive free cash flow after paying distributions, unlike many, if not all, of its MLP peers. Since Linn’s high payout had not been facilitating a high share price at which capital could be raised (i.e. the “Kinder Morgan effect”), then there would be no point in paying the distribution...at all.

That’s why it cut the distribution entirely. For Linn, the dividend is a waste of cash without a “Kinder Morgan valuation paradigm.” In the words of Linn CFO Kolja Rockov: “we’re not getting much credit for paying the dividend.” But it’s now clear that the distribution had been supporting the price of the stock, at least in the context of the sell-off this past week.

Our guess is that Linn’s management thought the news of the positive free cash flow generation through the first half of 2015 would more than offset the unitholder disappointment regarding the distribution suspension. This is logical, and it probably should have. Plus, Linn’s management had been scooping up its debt at distressed prices prior to announcing the distribution cut, and this might have been partial motivation for making the move. For one, reducing cash payments to unitholders enhances credit quality and improves the recovery value of debt to creditors, a move that also increases the market value of debt. Ever-higher distributions/dividends reduce an entity’s credit quality, all else equal.

In this uncertain energy-resource price environment, we wouldn’t go near a company such as Linn Energy that has $10 billion in net debt and has only generated modest free cash flow generation through the first half of the year. From our perspective, ExxonMobil is the only investable consideration within the upstream and midstream segments of the energy sector on the basis of its free cash flow (CFO less Total Capex; see above) generating capacity and manageable financial leverage. Holding 15% on ExxonMobil within it, the Energy Select SPDR will soon be our only exposure to the energy sector in the Dividend Growth Newsletter portfolio, and it’s a very small holding at that. We’ve been telegraphing our move to remove Energy Transfer Partners from the portfolio for some time, and we’ll do so early next week.

We’ve never liked the financial-engineering involved in the generation of an artificial valuation paradigm surrounding an MLP’s distribution rather than its free cash flow stream, and we still don’t. From the Dividend Growth Newsletter portfolio, we removed ConocoPhillips in May 2013 at $62.81 (now shares are at ~$50 each), Chevron in March 2015 at $102.36 (now shares are under $90 each), Kinder Morgan in June 2015 at $40 (now shares are under $35), and Energy Transfer Partners next week. Barron’s didn’t highlight Valuentum as a ‘Survival Guide for Oil Investors’ for no reason. We’ll likely include the ETP alert in the Friday weekly recap email to make sure that members don’t miss it. If you’re not yet a member, please see here.

The energy sector was the most active in the options market on Friday after the huge drop in oil prices last week (around 13%).

1.  XLE – XLE declined over 6% for the first time since August 2011.  Total volume was over 40 million shares even though Friday was only a half-day session.  One trader rolled the Dec5th 83 puts down to the Jan15 75 puts.  The Dec5th 83 puts traded over 120k at an average price of 3.05, and the Jan15 75 puts traded over 110k at an average price of 1.33.  XLE has not traded below $75 since April 2013.

2.  AMLP – The MLP ETF declined 3.5% on Friday, but actually remains positive on the year, in contrast to most energy-related sub-sectors.  Buyer of over 30k of the Jan15 17 puts for an average price of 0.345 throughout the morning.  AMLP’s low in October was $16.63.

3.  LINE – LINE made a new 5 year closing low on Friday, ending the day down 16%.  The April 23 / 17 1×2 put spread traded 8,500 x 17,000 in the morning at $1.80, in what looks like a trader rolling down puts from the 23 strike to the 17 strike.

4.  DO – Diamond Offshore closed at a new 10 year low on Friday.  The Jan15 29 / 26.75 put spread traded 10,900 times for 1.05.  DO is down 45% year-to-date.

5. SLB - The stock made fresh 52 week intra-day lows before closing near the highs of the day, but still closing down 7.4%.  Total options volume ran 3x average daily, with Dec 82 and 90 puts most active. When the stock was $86.43 a trader apparently rolled down near term protection or an outright bearish bet by selling 7,000 of the Dec 90 puts at 5.40 to close and buying 8,000 of the Dec 82 puts to open for 1.35.

6..  HLF – Herbalife shares have rebounded in the past 2 weeks after making a new 18 month low of $36.97 on November 12th.  10,500 of the Jan15 50 puts traded at 8.80 on Friday.  That strike still has over 60k of open interest with 1.5 months until expiration.

7. FCX -  shares closed at new 52 week, and nearly new five year lows. When the stock was $26.84 it looked a like a roll down an out of the money bullish play where a trader sold 9,000 Jan 30 calls at .24 to close and bought 9,000 Jan 29 calls to open for 44 cents.