The term “financially-engineered distribution” has increased in prominence as of late, as investors face an unprecedented swoon in the prices of master limited partnerships (AMLP). But what is a financially-engineered distribution and how does it differ from an organically-derived dividend, paid by Microsoft (MSFT) or Apple (AAPL), for example? We’ll cover this, and we’ll also talk about why we think Energy Transfer Partners’ debt is “junk.” We have to look at the SEC filings to help explain.
Let’s first start with our definition of a financially-engineered payout. Based on generally accepted accounting principles (GAAP), the cash flow statement breaks down into three distinct components: cash flow from operations, cash flow from investing and cash flow from financing activities. Bear with us. Energy Transfer Partners’ (ETP) cash flow from operations during the first nine months of the year was ~$2 billion, net cash from investing activities was a -$5.15 billion (negative), while net cash provided by financing activities was $3.35 billion. Distributions to partners plus distributions to non-controlling interests totaled -$2.5 billion for this time period (included in the financing section). It’s all in the MLP’s 10-Q.
In order for Energy Transfer Partners to make up the cash flow from operations shortfall relative to total distributions paid through the first nine months of the year, the financing section of the cash flow statement has to be accessed (external debt or equity)…hence, the term financially-engineered distribution. We typically define a financially-engineered distribution in much looser terms, however. Instead of comparing a company’s cash flow from operations to distributions (which completely ignores any capital spending, maintenance or otherwise), we typically compare a company’s traditional free cash flow, as measured by cash flow from operations less all capital spending, to its distributions over a specific time period. If this relationship is negative, then the company either has to access the balance sheet or external markets to keep paying the distribution. In the event of an overleveraged entity, external financing is required to maintain the payout, which is then considered to be “financially-engineered.”
Here are the numbers.
Energy Transfer Partners’ traditional free cash flow, as measured by cash flow from operations less all capital spending, is -$4.5 billion (negative), defined as ~$2 billion less $6.5 billion, through the first nine months of the year. In such a case, the cash flow from financing section (equity and debt issuance) is supporting both the cash flow from operations shortfall and cash outflows from the cash flow from investing section through the first nine months of the year. Because Energy Transfer Partners has a massive net debt position ($25+ billion) as opposed to a net cash position, we would then view its distribution as financially-engineered. As readers can understand, this is why we do not believe an equity valuation (“pricing”) paradigm based on an MLP’s distribution makes any sense at all — the distribution is not being paid out of earnings or traditional free cash flow, as measured by cash flow from operations less all capital spending, but instead, the external financing markets are in part supporting it. The payout is detached from the entity’s operating fundamentals.
By extension, we maintain our view that the industry’s definition of “cash flow” is not an appropriate way to look at an MLP’s pure free cash flow generating capacity and intrinsic valuation. For one, the industry’s definition of “cash flow” completely ignores the very growth capital spending that is used to propel future net income which is a core component of the measure itself. As a result, the use of the industry’s measure of “cash flow” had resulted in the systematic overvaluation of such securities (by effectively ignoring growth capital outlays), and only recently has the market started to treat such growth capital as shareholder money and not “free” capital. There’s nothing wrong with growth capital, per se, but it is a tangible cash outflow that is finally being factored into MLP valuations and one that has profound implications in dividend health. Our views on Energy Transfer Partners’ financially-engineered payout are clearly outlined in its cash flow statements, per GAAP, filed to the SEC.
On the other hand, in the event of an organically-derived dividend, the investor doesn’t have to look much further than the financial statements of Apple or Microsoft, for example. Both companies have substantial net cash positions and generate traditional free cash flow, as measured by cash flow from operations less all capital spending (including growth capital spending), well in excess of dividends paid. At the end of September, Apple had over $205 billion in cash, and $150+ billion on a net basis after long-term debt. In the twelve months ended September 2015, Apple hauled in over $81 billion in cash flow from operations and spent just over $11 billion in capital, good for ~$70 billion in traditional free cash flow. It paid just $11.6 billion in dividends during fiscal 2015, revealing substantial coverage. The situation with Microsoft is very similar, with the software giant boasting a $60+ billion net cash position, and traditional free cash flow generation a multiple of dividends paid.
Of importance, new readers should understand the extent to which the quality of the energy MLP space has been redefined in the eyes of investors during the past 12-18 months. The long-held view of the energy MLP space prior to the collapse in energy resource pricing was that it was almost entirely immune to energy resource pricing and that energy prices did not matter. In prior research pieces, we clearly outlined that midstream equities were not immune to energy resource pricing changes, and we continue to emphasize that the space is levered, if not directly, than through their upstream customer base, to energy resource pricing.
Of considerable importance, by comparing traditional organically-derived free cash flow, as defined by cash flow from operations less all capital spending, and comparing this measure to the cash obligations of an MLP’s distribution, our thesis clearly highlighted the severe capital market dependency of the group, and the significant vulnerability of their credit health in light of such weakening dynamics. That the MLP space’s credit health has deteriorated remains consistent with our prognostications, and that investors have now become concerned about rising defaults among their customer base has only supported our views. We think the industry’s definition of “cash flow” offered a false sense of security by completely ignoring key cash outflows and extreme degrees of leverage.
Perhaps of most importance, however, we outlined and described the artificial valuation (“pricing”) paradigm that has surrounded an MLP’s financially-engineered distributions, and how most energy MLP’s have been running at substantial free-cash-flow deficits by themselves, and especially after incorporating the large cash outflows associated with their distributions. We argued that using the industry’s definition of “cash flow” in the valuation context made little sense in the context of tried-and-true valuation techniques. That some midstream equities have cut their payouts and that many share prices have collapsed (as a result or in advance of cuts), remains consistent with our predictions. We believe most of the MLP space is now approaching levels that properly account for growth capital outlays and higher cost of capital assumptions – two dynamics that had been ignored as little as 12-18 months ago.
With respect to Energy Transfer Partners, we continue to believe we have an insightful, independent opinion about the credit quality of the entity, and we think an independent view of credit may be more valuable or as valuable as that of an NRSRO. From our perspective, Energy Transfer Partners is significantly leveraged, has a meager cash balance relative to its debt load, is experiencing operating income declines at a 20%-30% pace (as in its third quarter), as it burns through ~$4.5 billion in traditional free cash flow through the first nine months of the year, while continues to pay out billions in distributions to unitholders. Our opinion is that Energy Transfer Partners is far from an investment-grade entity, and we would not be surprised to see the NRSRO’s come around to this view.
It has been a terrible experience for MLP investors, and we continue to encourage executive teams to disclose prominently in all press releases non-GAAP free cash flow, as measured by cash flow from operations less all capital spending. Please contact Brian Nelson at brian@valuentum.com for any questions, comments or corrections.
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