Most MLP investors have two main concerns: the preservation of capital and reliable income — in that order. These two objectives are, of course, closely linked. An MLP that treats its investors to negative distribution surprises is likely to be an MLP that does a poor job of preserving capital. For example, Eagle Rock Energy Partners (Nasdaq: EROC) has lost 25 percent of its value since announcing a distribution cut in late October.

But how does an investor judge whether an MLP is at risk of a surprising distribution cut? As we discussed recently in The Unkindest Cut for MLPs, some classes of MLP are more susceptible to cuts than others. For variable distribution MLPs, it’s par for the course. Distributions go up, and they go down — depending on market conditions. MLPs focused on upstream oil and gas operations are also at greater risk of a distribution cut during periods of softening oil and gas prices.

However the vast majority of MLPs are in the midstream segment. Midstream MLPs own pipelines, energy storage systems, and energy processing facilities. Most revenues from midstream MLP assets are fee-based and are not directly affected by energy prices. Under most contracts of this type the customer pays whether or not they use the pipelines, energy storage or processing facility.

Investors want such MLPs to have a track record of consistently growing distributions over time. The longer the track record, the more at ease the investor, though some MLPs have increased distributions even when the underlying fundamentals weren’t strong enough to support an increase. If that situation persists, the MLP may eventually have to cut the distribution. The key is to look at the distributable cash flow (DCF) and the coverage ratio.

Distributable cash flow is the cash available for distribution to unitholders. However, DCF is not a Generally Accepted Accounting Principles (GAAP) measure, and different MLPs define the term in different ways. From an investor’s point of view, you simply want to have some level of confidence that over the long-term there is enough excess cash being generated to pay the distribution.  

Enterprise Product Partners (NYSE: EPD) is the largest MLP, and recently announced its 37th consecutive quarterly cash distribution increase. EPD defines DCF as follows:

“We define distributable cash flow as net income or loss attributable to partners adjusted for: (1) the addition of depreciation, amortization and accretion expense; (2) the addition of operating lease expenses for which we do not have the payment obligation; (3) the addition of cash distributions received from unconsolidated affiliates less equity earnings from unconsolidated affiliates; (4) the subtraction of sustaining capital expenditures and cash payments to settle asset retirement obligations; (5) the addition of losses or subtraction of gains from asset sales and related transactions; (6) the addition of cash proceeds from asset sales or related transactions; (7) the return of an investment in an unconsolidated affiliate or related transactions (if any); (8) the addition of losses or subtraction of gains on the monetization of derivative instruments recorded in accumulated other comprehensive income (loss); (9) the addition of net income attributable to the noncontrolling interest associated with the former public unitholders of Duncan Energy Partners L.P. (“Duncan”), less related cash distributions paid to such unitholders; and (10) the addition or subtraction of other miscellaneous non-cash amounts (as applicable) that affect net income or loss for the period.”

Such definitions may be intimidating to most investors. As a result, some investors have attempted to simplify the definition of distributable cash flow to the most important variables. One way to do this is to start with net income from the Cash Flow Statement, and then add back depreciation, amortization, depletion, and non-cash items, and then subtract the maintenance capital expenditures for the period.  

In the case of EPD, the net income for the trailing twelve months (TTM) at the end of Q3 2013 was $2.51 billion. Depreciation, amortization, depletion add back $1.19 billion to arrive at $3.70 billion. This accounts for most of the cash flow for the past year, but final adjustments to net income and changes in other operating activities (as shown on the Cash Flow Statement) result in a Total Cash Flow From Operating Activities (TTM) of $3.64 billion. We can now subtract maintenance capital of $297 million for the period (available from EPD’s quarterly reports) to arrive at $3.34 billion of DCF for the past 12 months.

EPD’s reported DCF for the period was actually $3.62 billion, about 8 percent more than the number calculated above. The difference is imparted by EPD’s definition of DCF, which adjusts for changes in working capital, risk management activities (such as gains or losses from hedging), and proceeds from sale of assets. Some have argued that, since these categories will add little to the bottom line over the long run, the stripped-down calculation in the previous paragraph is more indicative of the long-term ability to issue distributions.

The actual distribution to unit holders by EPD for the past 12 months was $2.35 billion. Thus the coverage ratio, even based on the more conservative DCF calculation, is $3.34 billion/$2.35 billion = 1.42. That’s more than respectable, and should give investors confidence that EPD can continue to grow its distribution.

While MLPs will sometimes have quarterly coverage ratios that fall below 1 for any number of reasons, an MLP whose coverage ratio is consistently below 1.0 deserves much closer scrutiny, and even more so if the subpar coverage persists for an entire year. MLPs that consistently distribute more than their distributable cash flow are in danger of having to cut distributions, which will generally entail a decline in the unit price.  

(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)

Portfolio Updates

Crestwood Midstream on Sale

Crestwood Midstream Partners (NYSE: CMLP) is down 7 percent over the last two trading sessions, surrendering the bulk of its November relief gains after issuing financial guidance for the next year on Thursday.

Investors must be wondering what’s gone wrong, and yet Crestwoood’s forecast was right in line with its long-term strategic goals. These include annual distribution growth of 6 to 10 percent, and that’s exactly what management has promised for 2014. Some may have been put off by aggressive investment plans to improve the partnership’s midstream infrastructure in the Bakken and Marcellus shales, yet these improvements are the key to Crestwood’s long-term success.

The lower end of the guidance range offered by Crestwood would give it a prospective 2014 yield of 8.2 percent at the current unit price. That looks quite rich for a growing midstream gatherer with strategic assets in two premier and fast developing shale plays. Continue buying CMLP below $25.

— Igor Greenwald