Source: Kinder Morgan

At first glance, El Paso Pipeline Partners L.P. (UNKNOWN:EPB.DL) seems to be flirting with a dangerously high distribution payout ratio. As we see in the following chart, the company's payout ratio is an absurdly high 129%, suggesting that the company is paying out nearly 30% more than it earns.

EPB Chart

EPB data by YCharts

There's just one problem with that argument. A payout ratio isn't the number to look at for a master limited partnership like El Paso Pipeline Partners. Instead, we're more concerned with the distribution coverage ratio, which covers the company's actual cash flow and not its earnings, which are much lower due to depreciation charges among other things. However, we can use the screen as a starting point as we take a closer look at the numbers that really matter. 

Knowing the right numbers
Now, I realize that El Paso Pipeline Partners is in the process of being acquired by its parent Kinder Morgan Inc (NYSE:KMI). While that deal is likely to be completed, there's always a risk that it falls through. Further, Kinder Morgan investors need to know what they are getting themselves into when El Paso Pipeline Partners goes from a publicly traded subsidiary to a wholly owned entity.

Last quarter El Paso Pipeline Partners reported $130 million of net income; however, after subtracting Kinder Morgan's 2% general partner interest along with its incentive distribution rights, unit holders were left with net income of just $72 million or $0.31 per share. That's less than half of the $0.65 per unit the company paid out in distributions last quarter. Going back even further we see that through the first nine months of the year the company reported net income of $1.17 per unit but paid out $1.95 per unit in distributions. That would indicate danger if net income was the number that matters when it came to the El Paso Pipeline Partners' payout ratio.

Instead, we need to look closer at distributable cash flow. This adds back Kinder Morgan's cut as well as depreciation and amortization while taking out the capital spent to maintain the company assets. This pushes the company's actual cash flow last quarter to $150 million, or $0.65 per unit. This exactly matches what the company paid out in distributions and represented a 1.0 times payout ratio. Moreover, through the first nine months of the year the payout ratio is 1.04 times.

What the numbers mean
A distribution coverage ratio of 1.0 times is cutting things really close, and it's certainly a yellow flag. However, it's not the bright red flag that we thought we saw when looking at a more traditional payout ratio that covers net income. Ideally, we'd like to see the distribution coverage ratio of an MLP closer to 1.1 times as that gives it a little margin for error.

The less than ideal payout ratio is one of the reasons why Kinder Morgan is consolidating El Paso Pipeline Partners with its other MLP assets. Kinder Morgan knew that El Paso Pipeline Partners wasn't going to be able to grow its distribution to investors for at least the next few years because its coverage ratio was borderline and its growth prospects were limited until new projects came online in 2016. In fact, it only projected 1% distribution growth through 2016 and then 3% growth through the end of the decade if El Paso remained independent. 

While El Paso Pipeline Partners' payout ratio might first appear to be a big danger to investors, including parent Kinder Morgan, by digging deeper we see that the number that actually matters, the distribution coverage ratio, is much safer. That's good news for investors because it means that the company's cash flow is strong, suggesting that it won't drag down Kinder Morgan results after it acquires full control of the company.