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NRGY > SEC Filings for NRGY > Form 10-K on 16-Nov-2011All Recent SEC Filings

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Form 10-K for INERGY L P


16-Nov-2011

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.

Forward-Looking Statements

This report, including information included or incorporated by reference in this report, contains forward-looking statements concerning the financial condition, results of operations, plans, objectives, future performance and business of our company and its subsidiaries. These forward-looking statements include:

statements that are not historical in nature, but not limited to, our belief that our acquisition expertise should allow us to continue to grow through acquisitions; our belief that we will have adequate propane supply to support our retail operations; our belief that our diversification of suppliers will enable us to meet supply needs; our expectation that Inergy Midstream will complete the IPO in December 2011; our belief that the IPO will lower our cost of capital, enhance our ability to execute our growth strategy and strengthen our balance sheet; and our expectation that we will complete our development projects within budget by the anticipated in-service dates; and

statements preceded by, followed by or that contain forward-looking terminology including the words "believe," "expect," "may," "will," "should," "could," "anticipate," "estimate," "intend" or the negation thereof, or similar expressions.

Forward-looking statements are not guarantees of future performance or results. They involve risks, uncertainties and assumptions. Actual results may differ materially from those contemplated by the forward-looking statements due to, among others, the following factors:

weather conditions;

price and availability of propane, and the capacity to transport to market areas;

the ability to pass the wholesale cost of propane through to our customers;

costs or difficulties related to the integration of the business of our company and its acquisition targets may be greater than expected;

governmental legislation and regulations;

local economic conditions;

the demand for high deliverability natural gas storage capacity in the Northeast;

the availability of natural gas and the price of natural gas to the consumer compared to the price of alternative and competing fuels;

our ability to successfully implement our business plan for our natural gas storage facilities;

labor relations;

environmental claims;

competition from the same and alternative energy sources;

operating hazards and other risks incidental to transporting, storing and distributing propane;

energy efficiency and technology trends;

interest rates;

the price and availability of debt and equity financing; and

large customer defaults.

We have described under "Factors That May Affect Future Results of Operations, Financial Condition or Business" additional factors that could cause actual results to be materially different from those described in the forward-looking statements. Other factors that we have not identified in this report could also have this effect. You are cautioned not to put undue reliance on any forward-looking statement, which speaks only as of the date it was made.


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General

We are a Delaware limited partnership formed to own and operate a growing retail and wholesale propane supply, marketing and distribution business. We also own and operate a growing midstream business that includes five natural gas storage facilities (Stagecoach, Thomas Corners, Steuben, Seneca Lake and Tres Palacios), a natural gas liquids ("NGL") storage facility (the Bath storage facility), an NGL business on the West Coast, and a solution-mining and salt production company. We further intend to pursue our growth objectives in the propane and midstream business through, among other things, future acquisitions. Our propane acquisition strategy focuses on propane companies that meet our acquisition criteria, including targeting acquisition prospects that maintain a high percentage of retail sales to residential customers, operating in attractive markets and focusing our operations under established and locally recognized trade names. Our midstream growth objectives focus both on organically expanding our existing assets and acquiring future operations that leverage our existing operating platform, produce predominantly fee-based cash flow characteristics and have future organic or commercial expansion characteristics.

Over the past several years, we have transformed our company from a propane distribution company into a diversified master limited partnership with significant investment in both the propane and midstream sectors. We continuously evaluate the best way to grow our company and unlock value for our unit holders. For example, we announced a business restructuring in August that we expect to lower our cost of capital, enhance our ability to execute our growth strategy and strengthen our balance sheet. We expect to continue to evaluate transactions that both create investor value and grow our business, as it relates to both our propane and our midstream businesses.

Both of our operating segments, propane and midstream, are supported by business development personnel groups. These groups' daily responsibilities include research, sourcing, financial analysis and due diligence of potential acquisition targets and organic growth opportunities. These employees work closely with the operators of both of our segments in the course of their work to ensure the appropriate growth opportunities are pursued.

We have grown primarily through acquisitions. Since the inception of our predecessor in November 1996 through September 30, 2011, we have acquired 90 companies, including 82 retail propane companies and 8 midstream businesses, for an aggregate purchase price of approximately $2.9 billion, including working capital, assumed liabilities and acquisition costs.

On October 14, 2010, we completed our acquisition of TPGS, which owns and operates the Tres Palacios natural gas storage facility in Matagorda County, Texas. TPGS leases the surface and subsurface rights necessary to operate and expand the storage facility under an operating lease that expires on December 31, 2037, which is subject to automatic renewal for two 20-year extension periods unless TPGS elects not to extend the term of the lease. The lease payments vary based on the FERC-certificated working gas capacity of the caverns that are in service as well as an incremental payment for physical volumes of gas injected and/or withdrawn from the caverns in service. Based on our current estimates, which assumes a fourth cavern will be in service during the fourth calendar quarter of 2015, we anticipate that the contractual obligation as of September 30, 2011, to be the following (in millions, excluding the above mentioned incremental payments as future volumes are currently unknown):

Total Less than 1 year 1-3 years 4-5 years After 5 years $ 403.4 $11.4 $23.5 $29.0 $339.5

On October 19, 2010, we completed the acquisition of the propane assets of Schenck Gas Services, LLC ("Schenck"), located in East Hampton, New York. On November 15, 2010, we completed the acquisition of the propane assets of Pennington Energy Corporation ("Pennington"), headquartered in Morenci, Michigan.

On July 13, 2011, we closed on our acquisition of the Seneca Lake natural gas storage facility and two related pipelines for approximately $66.8 million from NYSEG. The natural gas storage facility and its West lateral were acquired by ASC and are subject to FERC jurisdiction. The East pipeline was acquired by Inergy Pipeline East, LLC and is subject to light-handed regulation by the NYPSC.


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The purchase price allocations for these acquisitions have been prepared on a preliminary basis pending final asset valuation and asset rationalization, and changes are expected when additional information becomes available. Changes to final asset valuation of prior fiscal year acquisitions have been included in our consolidated financial statements but are not material.

The retail propane distribution business is largely seasonal due to propane's primary use as a heating source in residential and commercial buildings. As a result, cash flows from operations are generally highest from November through April when customers pay for propane purchased during the six-month peak heating season of October through March. Our propane operations generally experience net losses in the six-month off season of April through September.

Because a substantial portion of our propane is used in the weather-sensitive residential markets, the temperatures realized in our areas of operations, particularly during the six-month peak heating season of October through March, have a significant effect on our financial performance. In any given area, warmer-than-normal temperatures will tend to result in reduced propane use, while sustained colder-than-normal temperatures will tend to result in greater propane use. Therefore, we use information on normal temperatures in understanding how historical results of operations are affected by temperatures that are colder or warmer than normal and in preparing forecasts of future operations, which are based on the assumption that normal weather will prevail in each of our operating regions. "Heating degree days" are a general indicator of how weather impacts propane usage and are calculated for any given period by adding the difference between 65 degrees and the average temperature of each day in the period (if less than 65 degrees). While a substantial portion of our propane is used by our customers for heating needs, our propane operations are geographically diversified and not all of our propane sales are weather sensitive. Together, these factors may make it difficult to draw definitive conclusions as to the correlation of our gallon sales to weather calculations comparing weather in a year to normal or to the prior year.

The retail propane business is a "margin-based" business where the level of profitability is largely dependent on the difference between sales prices and product costs. Propane prices continued to be volatile during 2010 and 2011. At the main pricing hub of Mount Belvieu, Texas ("Mt. Belvieu Price") during the fiscal year ended September 30, 2011, the average Mt. Belvieu Price was $1.42 with prices ranging from a low of $1.17 per gallon to a high of $2.29 per gallon and a price of $1.49 per gallon at September 30, 2011. Further, the average Mt. Belvieu Price in our fiscal years of 2008, 2009 and 2010 was $1.59, $0.77 and $1.12 per gallon, respectively. Our ability to pass on price increases to our customers and our hedging program has historically limited the impact that such volatility has had on our results from operations and we will continue to hedge virtually 100% of our exposure from fixed prices; however, those higher propane costs have led to higher selling prices by us and have negatively impacted our volume sales and may continue to do so in the future for reasons discussed below. While we have historically been successful in passing on any price increases to our customers, there can be no guarantees that this trend will continue in the future. In periods of increasing propane costs, we have experienced a decline in our gross profit as a percentage of revenues. In addition, during those periods we have historically experienced conservation of propane gallons used by our customers in addition to lesser gallon sales as a result of customers switching to lower price propane providers as well as alternative energy sources, all of which has resulted in a decline in gross profit. These trends generally increase in periods of sustained cost increases such as we have experienced in fiscal 2011. Further, improved technology in new appliances, including those using propane, has resulted in fewer gallons of propane used by our customers for their needs thus resulting in lesser gallon sales for us. In periods of decreasing costs, we have experienced an increase in our gross profit as a percentage of revenues. There is no assurance that because propane prices decline customers will use more propane and thus historical gallon sales declines we've attributed to customer conservation and losses will reverse. Propane is a by-product of both crude oil refining and natural gas processing and thus typically follows the same pricing pattern as these two commodities with crude oil pricing being the more influential of the two historically. The prices of crude oil and natural gas had maintained historically high costs in calendar years 2007 and 2008 before both began to fall rather dramatically in late 2008 and throughout the 2008-2009 winter season. While natural gas pricing has remained at historically low levels since this decline, crude oil costs leveled off in


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the spring of 2009 before beginning another increase that persisted through both winter seasons of 2009-2010 and 2010-2011 with propane prices following a similar pattern for the majority of this time. Further, propane has been exported from the United States in greater quantities in 2011 than in the past due to higher propane costs overseas, leading to sustained higher propane costs in the United States. As such, our selling prices of propane have been at higher levels in order to attempt to maintain our historical gross margin per gallon with these higher prices negatively impacting our volume sales for the reasons discussed above. We do not attempt to predict the underlying commodity prices; however, we monitor these prices daily and adjust our operations and retail prices to maintain expected margins by passing on the wholesale costs to end users of our product. We believe that volatility in commodity prices will continue, and our ability to adjust to and manage our operations in response to this volatility may impact our operations and financial results.

We believe that the economic downturn that began in the second half of 2008 has caused certain of our retail propane customers to conserve and thereby purchase less propane and in some instances shop for lower prices that may be available from other suppliers or shop for alternative energy sources to replace some or all of their propane usage. This trend is expected to continue throughout the life of the economic downturn. In addition, although we believe the economic downturn has not currently had a material impact on our cash collections, it is possible that a prolonged economic downturn could have a negative impact on our future cash collections.

We believe our wholesale supply, marketing and distribution business complements our retail distribution business. Through our wholesale operations, we distribute propane and also offer price risk management services to propane retailers, resellers and other related businesses as well as energy marketers and dealers, through a variety of financial and other instruments, including:

forward contracts involving the physical delivery of propane;

swap agreements, which require payments to (or receipt of payments from) counterparties based on the differential between a fixed and variable price for propane; and

options, futures contracts on the New York Mercantile Exchange and other contractual arrangements.

We engage in derivative transactions to reduce the effect of price volatility on our product costs and to help ensure the availability of propane during periods of short supply. We attempt to balance our contractual portfolio by purchasing volumes only when we have a matching purchase commitment from our wholesale customers. However, we may experience net unbalanced positions from time to time.

Our midstream operations primarily include the storage, transportation, processing, fractionation and sale of natural gas and NGLs and, to a lesser extent, the wholesale distribution of salt from solution mining operations of US Salt. The cash flows from these operations are predominantly fee-based under one to ten year contracts with substantial, creditworthy counterparties and, therefore, are generally economically stable and not significantly affected in the short term by changing commodity prices, seasonality or weather fluctuations.

The majority of our operating cash flows in our midstream operations are generated by our natural gas storage operations. Most of our natural gas storage revenues are based on regulated market-based tariff rates, which are driven in large part by competition and demand for our storage capacity and deliverability. Demand for storage in our key midstream market in the northeastern United States is projected to continue to be strong, driven by a shortage in storage capacity and a higher than average annual growth in natural gas demand. This demand growth is primarily driven by the natural gas-fired electric generation sector and conversion from petroleum based fuels. Demand for storage in Texas is expected to strengthen driven primarily by growth in natural gas fired generation and increasing gas supplies from growing shale developments such as the Eagle Ford shale. Demand for storage can be negatively impacted during periods in which there is a narrow seasonal spread between current and future natural gas prices. The natural gas industry is currently experiencing a significant shift in the sources of supply with prolific new shale plays primarily, and this dramatic change could affect our operations.


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We believe our midstream operations could be negatively affected in the long term by sustained downturns or sluggishness in the economy, which could affect long-term demand and market prices for natural gas and NGLs, all of which are beyond our control and could impair our ability to meet our long-term goals. However, we also believe that the contractual fee-based nature of our midstream operations may serve to mitigate this potential risk.

Traditionally, supply to our markets is satisfied primarily by production from conventional onshore and offshore production in the lower 48 states, as supplemented by production from historically declining pipeline imports from Canada, imports of LNG from foreign sources, and some Alaska production. In order to maintain current levels of U.S. natural gas supply and to meet the projected increase in demand, new sources of domestic natural gas must continue to be developed to offset an established trend of depletion associated with mature, conventional production as well as the uncertainty of future LNG imports and infrastructure challenges associated with sourcing additional production from Alaska. Over the past several years, a fundamental shift in production has emerged with the contribution of natural gas from unconventional resources
(defined by the EIA as natural gas produced from shale formations and coal beds)
increasing from 6% of total U.S. natural gas supply in 2000 to 16% in 2008. In fact, according to EIA data, during the three-year period from January 15, 2007 through December 15, 2010 domestic production of natural gas increased by an average of approximately 4% per annum, largely due to continued development of shale resources. The emergence of shale plays has resulted primarily from advances in horizontal drilling and hydraulic fracturing technologies, which have allowed producers to extract significant volumes of natural gas from these plays at cost-advantaged per unit economics versus most conventional plays.

We have several significant capital projects under development related to our midstream operations, including:

the MARC I pipeline, which is a 39 mile, 30" bidirectional pipeline we propose to build in Bradford, Sullivan, and Lycoming Counties in Pennsylvania. The planned pipeline will extend between our Stagecoach south lateral interconnect with TGP's 300 Line near its compressor station 319 and Transco's Leidy Line near its compressor station 517. The MARC I pipeline is expected to have a minimum of 550,000 dekatherms per day of firm transportation capacity. We are awaiting FERC approval to construct the pipeline and currently expect to place the pipeline into service in mid-2012;

the Watkins Glen NGL storage development project, which involves the development into NGL storage service of certain caverns acquired in the acquisition of US Salt in August 2008. Specifically, the Watkins Glen project is expected to convert certain existing caverns into 2. 1 million barrels of propane and butane storage capacity. We are awaiting NYSDEC regulatory approval to build the storage facility and currently expect to place the project into service in June 2012;

the North/South II expansion project, which is expected to enable shippers to move natural gas bidirectionally through our Stagecoach facility from Millennium to TGP's 300 Line, and all points in between. As part of this expansion project, we intend to connect the Stagecoach north later to our Inergy East intrastate pipeline, which will further allow shippers to transport volumes from TGP's 300 Line (as well as intermediate points, including Millennium) to the point of interconnection between our Inergy East pipeline and the Dominion transmission system in Tompkins County, New York. We have not yet requested any of the regulatory approvals required to complete this expansion project; and

the Tres Palacios header extension project, which involves laying approximately 20 miles of pipeline to connect the Tres Palacios north header system to the tailgate of Copano's Houston Central gas processing plant in Colorado County, Texas. We have not yet requested the FERC authorization required to complete this project.

As we execute on our strategic objectives, capital expansion projects will continue to be an important part of our growth plan. We have committed capital and investment expenditures at September 30, 2011, of approximately $29.9 million in our midstream operations. These capital requirements, along with the refinancings of normal maturities of existing debt, will require us to continue long-term borrowings. An inability to access capital at


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competitive rates could adversely affect our ability to implement our strategy. Market disruptions or a downgrade in our credit ratings may increase the cost of borrowing or adversely affect our ability to access one or more sources of liquidity. During the past several years, capital expansion projects have been exposed to cost pressures associated with the availability of skilled labor and the pricing of materials. Although certain costs have begun to decrease, there will be continual focus on project management activities to address these pressures as we move forward with planned expansion opportunities. Significant cost increases could negatively affect the returns ultimately earned on current and future expansions.

Our midstream operations in the United States are subject to regulations at the federal and state level. Regulations applicable to the gas and NGL storage industries have a significant effect on the nature of our midstream operations and the manner in which they operate. Changes to regulations are ongoing and we cannot predict the future course of changes in the regulatory environment or the ultimate effect that any future changes will have on our midstream operations.

Recent Developments

On August 9, 2011, we announced our intention to file a registration statement with the SEC for the IPO of a minority interest of a new master limited partnership formed to initially own and operate our Northeast natural gas and NGL midstream storage and transportation business. We intend to use all cash proceeds received in the IPO to repay indebtedness.

Results of Operations

Fiscal Year Ended September 30, 2011 Compared to Fiscal Year Ended September 30, 2010

The following table summarizes the consolidated income statement components for the fiscal years ended September 30, 2011 and 2010, respectively (in millions):

                                                Year Ended
                                               September 30,                         Change
                                           2011            2010           In Dollars         Percentage
Revenue                                  $ 2,153.8       $ 1,786.0       $      367.8               20.6 %
Cost of product sold                       1,476.0         1,165.9              310.1               26.6

Gross profit (excluding depreciation
and amortization)                            677.8           620.1               57.7                9.3
Operating and administrative expenses        323.3           310.7               12.6                4.1
Depreciation and amortization                191.8           161.8               30.0               18.5
Loss on disposal of assets                     8.2            11.5               (3.3 )            (28.7 )

Operating income                             154.5           136.1               18.4               13.5
Interest expense, net                       (113.5 )         (91.5 )            (22.0 )            (24.0 )
Early extinguishment of debt                 (52.1 )            -               (52.1 )                *
Other income                                   1.2             2.0               (0.8 )            (40.0 )

Income (loss) before income taxes             (9.9 )          46.6              (56.5 )           (121.2 )
Provision for income taxes                     0.7             0.2                0.5              250.0

Net income (loss)                            (10.6 )          46.4              (57.0 )           (122.8 )
Net loss attributable to
non-controlling partners                      28.2            15.4               12.8               83.1

Net income attributable to partners      $    17.6       $    61.8       $      (44.2 )            (71.5 )%

* Not meaningful


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The following table summarizes revenues, including associated volume of gallons sold, for the years ended September 30, 2011 and 2010, respectively (in millions):

                                                           Revenues                                                  Gallons
                                          Year Ended                                                Year Ended
                                         September 30,                    Change                   September 30,                 Change
                                      2011          2010         In Dollars       Percent        2011        2010        In Units        Percent
Retail propane                      $   858.6     $   796.5     $       62.1           7.8 %      325.6       340.2          (14.6 )         (4.3 )%
Wholesale propane                       603.3         475.9            127.4          26.8        422.8       415.3            7.5            1.8
Other retail                            212.2         194.5             17.7           9.1           -           -              -              -
Storage, fractionation and other
midstream                               479.7         319.1            160.6          50.3           -           -              -              -

Total                               $ 2,153.8     $ 1,786.0     $      367.8          20.6 %      748.4       755.5           (7.1 )         (0.9 )%

Volume. During the year ended September 30, 2011, we sold 325.6 million retail . . .

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