Enterprise Products Partners (EPD): How Safe is this High-Yield MLP’s Distribution?

Over the last few years, record low interest rates have made Master Limited Partnerships, or MLPs, one of the hottest high-yield equity classes on Wall Street.

 

While it’s true that this sector has its own risk factors that investors need to be aware of, certain midstream MLPs (those that operate gathering, processing, storage, and transportation infrastructure such as pipelines) can make compelling long-term, high-yield dividend growth investments.

 

Let’s take a look at one of the largest midstream MLPs, Enterprise Products Partners (EPD), to see if this high-yield energy stock is one of the few “sleep well at night” or SWAN names in its industry and a potential fit for our Conservative Retirees dividend portfolio.

 

More importantly, find out if Enterprise’s combination of world class conservative management, strong balance sheet, and solid long-term growth prospects make this a solid core holding for most diversified income portfolios, especially at today’s price.

 

Business Description

Enterprise Products Partners is North America’s third largest midstream operator, with nearly 50,000 miles of natural gas, oil, natural gas liquid (NGL), and refined product pipelines. Enterprise also owns a number of storage facilities, processing assets, and terminals.

 

The company’s network of assets helps move different types of energy and fuel from one location to another for upstream exploration and production (E&P) companies. Enterprise primarily makes most of its money from fees it charges E&P customers for its services.

 

As you can see from the map below, it is tied into America’s largest and most prolific shale oil & gas formations, including the Eagle Ford (east Texas), Permian basin (west Texas), Niobrara (Colorado), and the Marcellus and Utica shale gas fields (Pennsylvania and Ohio, respectively).

 

Source: Enterprise Products Partners Investor Presentation

 

Natural gas liquids transportation and processing provides the majority of the MLP’s gross margins, which Enterprise is doubling down on because the shale gas boom has resulted in such an abundance of NGLs (which are used to make plastics) that there is a massive and fast growing export market for refined NGL products such as Ethylene and Propylene in Asia and Europe.

 

 

Business Analysis

The pipeline business has a number of appealing qualities. For one thing, constructing a pipeline can cost billions of dollars and take years to complete, resulting in high barriers to entry.

 

Few companies have the capital and industry connections (e.g. oil & gas producers, regulators) to build and operator pipeline systems. Only so many pipelines are needed within a particular geographic area as well, resulting in a consolidated market.

 

Pipelines have few substitutes given their safety and cost-efficiency, along with geographical constraints. They also enjoy relatively stable demand patterns since most of the products that require refined oil and gas are non-discretionary in nature.

 

Enterprise Products Partners’ claim to fame is its unbeatable track record of stable and consistent growth through all manner of commodity/economic/interest rate environments.

 

That’s thanks to its business model, which is less sensitive to oil & gas prices than one might initially think. This is because Enterprise’s cash flow is protected by long-term, fixed fee contracts (with minimum volume guarantees) and annual rate escalators (to offset inflation).

 

In addition, many of its contracts guarantee a minimum gross margin, which helps to further stabilize cash flows even if energy prices collapse (as long as customers can still pay).

 

 

The key to Enterprise’s success mainly has to do with its industry-leading, conservative management team.

 

For example, the MLP has focused on diversifying its cash flow through enormous scale (which also helps with boost margins) and a broad range of customers. The company’s top 200 customers accounted for 95.7% of Enterprise’s 2015 revenue and 75.3% of these customers maintain an investment grade credit rating. Only 3.1% of the company’s revenue is from non-rated or sub-investment grade independent companies.

 

 

In addition, unlike other pipeline operators such as Kinder Morgan (KMI), which went debt crazy during the boom years of 2010 through 2014 (when oil was about $100 per barrel), Enterprise’s management has always been far more conservative in its growth approach.

 

It has chosen to retain far more distributable cash flow (over $6.2 billion since 2004), or DCF (the equivalent of free cash flow for MLPs, and what funds the distribution), which has allowed it to fund much more growth internally rather than depending on external debt and equity markets.

 

 

That in turn has meant less investor dilution and an easier time in growing its payout consistently, including its 58th consecutive quarterly increase of 5.2% year-over-year despite the worst oil crash in over 50 years. In other words, Enterprise Products Partners is effectively the dividend aristocrat of the MLP industry.

 

Part of the reason for this is also management’s extremely unit holder friendly, long-term focus. For example, in 2010 when its unit price was still depressed from the effects of the credit crisis, the MLP bought out its general partner’s incentive distribution rights, or IDRs, for $8 billion.

 

This brilliant move meant that rather than send 50% of marginal DCF to its management team (which would raise its cost of capital, and make future distribution growth more difficult), management instead ended up owning 33% of the MLP, and limited partners (retail investors) ended up with 100% of DCF and faster, more secure, and more consistent distribution growth.

 

 

Or to put it another way, management’s interests are now completely aligned with income focused investors, meaning that management only makes money as long as the payout continues growing steadily, and securely over time.

 

Key Risks

While Enterprise Products Partners may represent one of the seemingly lower risk midstream MLPs, there are still two main risks that investors need to be aware of.

 

First, the long-term growth story for Enterprise is tied to that of the U.S. shale industry. This means that, although the short-term price of Enterprise’s units, which generally trade along with oil prices, doesn’t affect its cash flow, the MLP’s ability to continue finding profitable projects to invest in and thus grow its DCF does require an eventual recovery in oil & gas prices.

 

Since pipelines have high fixed costs, their profitability is sensitive to the amount of fees they charge and how much product volume they are able to move. If energy production were to fall, the need for pipelines could theoretically decline and E&P customers might not be able to pay the fees outlined in their contracts with Enterprise Products Partners and other midstream MLPs. The long-term growth rate of MLPs has come into question for some of these reasons, resulting in the sharp sell-off that has taken place since late 2014.

 

Take a look at U.S. natural gas production, which increased nearly 50% in less than a decade. More recently, natural gas production has started declining. Year-to-date, U.S. natural gas production is down about 1%, including 2-3% year-over-year declines in June, July, and August.

 

Source: U.S. Energy Information Administration

 

The picture for U.S. crude oil is similar. Production nearly doubled over the last five years but has slumped 5%+ year-over-year in recent weeks. Average daily U.S. crude oil production is expected to fall by 6.4% in 2016 and 1.1% in 2017, according to the U.S. Energy Information Administration.

 

Source: U.S. Energy Information Administration

 

Ironically enough, the problem for the U.S. energy industry is that the oil crash has forced it to become so much more efficient, optimizing fracking techniques though things like multiple wells per drill pad, longer horizontal laterals, multiple fracking stages, and greater use of frack sand.

 

This has greatly lowered the breakeven price for various shale formations over the last two years.

 

 

 

This means that there is a risk that when oil prices rise above $50 we’ll see U.S. production actually start rising again which could cap the ultimate long-term price of oil, hurting the financial health of this debt-laden industry and limiting Enterprise’s ultimate growth potential.

 

For example, oil and gas prices are already up to $47.5 and $2.95, respectively. And in recent months the recovery in energy prices off its January 2016 lows has resulted in a steady rise in drilling rigs.

 

In fact, just last week Baker Hughes (BHI) reported the number of rigs drilling in the U.S. rose by 20, the largest weekly increase in two years. That puts the current rig count up nearly 50% off its lows and might signal that U.S. shale producers, eager for additional cash flow to service their debts, might end up stalling the recovery at much lower prices than otherwise would have occurred.

 

While that’s not necessarily a bad thing for Enterprise in the short to medium-term, since its assets would see growing demand, it might make it harder for oil & gas producers to find sufficient low cost funding in coming years, since banks are less likely to lend money at attractive rates if oil prices remain around $55 to $60 for several more years.

 

Enterprise is better positioned to take on this risk than many of its peers thanks to its focus on investment-grade rated customers who are more likely to be able to pay their contracts, but it’s still something to pay attention to.

 

That’s especially true if interest rates continue to rise, as they have sharply over the last few weeks. This brings me to the second major risk for Enterprise, rising interest rates.

 

Fortunately Enterprise’s massive scale and best-in-the-industry BBB+ credit rating means that it isn’t likely to be priced out of the debt markets in the coming years. After all, the MLP has been steadily growing since 2004 and management has successfully navigated interest rates as high as 6.25%. Furthermore, over 90% of Enterprise Products Partners’ debt has fixed rates, and the average maturity of its debt is 17.1 years.

 

But we have to remember that as an MLP, Enterprise Products Partners pays out the vast majority of its cash flow as distributions and thus must periodically turn to equity markets to raise growth capital.

 

If interest rates rise steadily over the next few years, then the massive amounts of yield-starved capital that fueled the MLP boom of the last few years could end up shrinking substantially.

 

For example, currently the Federal Reserve is forecasting interest rates rising by 2.75% through the end of 2020. That would likely mean investors would be able to buy long-term Treasuries (risk-free bonds) with yields of 5% to 6%.

 

This in turn would mean that Enterprise, with its current 6.4% yield, would be far less attractive. Rather it’s likely that investors would demand a higher risk premium for its units, meaning an 8% to 9% yield. That could result in higher costs of capital going forward, as well as higher dilution, which makes future payout growth harder to achieve.

 

Dividend Safety Analysis: Enterprise Products Partners

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their track record has been, and how to use them for your portfolio here.

 

Enterprise Products Partners has a Dividend Safety Score of 52, which indicates that its payout is reasonably secure. However, the company’s score is relatively high compared to most MLPs, which require special analysis.

 

That’s due to the nature of the MLP industry, which is massively capital intensive, as well as the business model of MLPs, which is based on paying out most DCF (EBITDA minus maintenance capex) to investors and funding growth with external capital.

 

In other words, traditional metrics such as EPS and free cash flow (EBITDA minus all capital expenditures), aren’t necessarily the best metrics to use when determining how safe the payout is.

 

This is because GAAP earnings require a company to account for non-cash charges such as depreciation and amortization of its assets (MLPs have significant fixed assets).

 

Free cash flow is distorted by a company’s total capital expenditures, which bundle growth expenditures and maintenance expenditures together. For example, Enterprise expects 2016 capital expenditures to be close to $3.1 billion.

 

However, only $250 million is for sustaining capital expenditures. Enterprise would be throwing off substantial free cash flow if it wasn’t investing for future growth, but instead its reported free cash flow year-to-date is slightly above zero.

 

Or to put it another way, if you are only looking at GAAP EPS or FCF/share, then the payout for almost all MLPs, including best in class names such as Enterprise Products Partners, will appear alarmingly high.

 

However, when we look at the distribution coverage ratio, or DCR (distribution/DCF), the picture looks very different.

 

Specifically, Enterprise reported $3.1 billion in DCF for the first three quarters of 2016, which means a DCR of 1.22. In the MLP industry, anything over 1.0 is thought to be sustainable, and 1.1 is considered secure.

 

And with $5.6 billion in projects currently under construction (to be completed through 2018), Enterprise should have no trouble continuing to provide secure and steadily growing income for long-term investors throughout this time horizon.

 

And then there’s the MLP’s strong balance sheet to consider.

 

 

At first glance, Enterprise’s high debt load might not appear all that safe. However, you need to remember that the midstream MLP industry is incredibly capital intensive, which means that high absolute debt loads are to be expected. This is why we need to look at these numbers in context.

 

When you compare Enterprise Product Partners credit metrics to its peers, you can see that the MLP actually has one of the strongest balance sheet’s in its industry. This explains why it has the highest credit rating of any MLP (actually it’s tied with Magellan Midstream Partners (MMP)).

 

MLP	Debt / EBITDA	EBITDA / Interest	Debt / Capital Ratio	Current Ratio	S&P Credit Rating
Enterprise Products Partners	4.47	5.22	45%	0.76	BBB+
Industry Average	9.14	NA	62%	0.75	NA

Source: Morningstar

 

That helps keep its access to cheap credit plentiful, such as the current $3.5 billion in liquidity that ensures the MLP has enough capital to bring online its various growth projects, grow its DCF, and keep the payout highly secure in the coming years.

 

Dividend Growth Analysis

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

Enterprise Products Partners has a below average Dividend Growth Score, which seems to somewhat underplay the MLP’s strengths and continued ability and commitment to growing the payout.

 

For example, Enterprise Products is on the forefront of many of the greatest growth opportunities in the oil & gas industry, including exports of US crude oil, refined NGL products and liquefied natural gas, or LNG.

 

These are all huge potential growth runways for the entire oil & gas industry that could see production of both US oil & natural gas continue growing strongly for the next 10 to 15 years.

 

For example, the U.S. Geological Survey just announced the discovery of the single largest oil field in US history, in Texas’ Wolfcamp shale formation. This 20 billion barrel oil field, which also holds an estimated 16 trillion cubic feet of natural gas, is part of the larger Permian Basin, which is estimated to hold 75 billion barrels of recoverable oil.

 

Enterprise Products Partners is already one of the largest infrastructure providers in these areas, where there are about $4 trillion in oil & gas (at today’s prices) just waiting for U.S. shale producers to extract. That’s especially true given the highly favorable economics of these formations, meaning high internal rates of return if energy prices increase by just a little from today’s levels.

 

This creates a massive growth runway that should allow Enterprise Products Partners to realistically continue growing its DCF and its highly secure payout by around 5% over the next decade.

 

Enterprise Products’ quarterly distribution has been increased 58 times since the partnership went public in 1998, including 49 consecutive quarterly raises. As seen below, the partnership’s distribution has reliably compounded by 5-6% per year over most time periods, which is in line with my best guess of 5% annual dividend growth going forward.

 

 

Valuation

The best way of valuing an MLP is based not on earnings but on cash flow and yield, since these are the most crucial metrics that directly apply to the very reason that investors own these securities.

 

Enterprise Products Partners is currently trading at 13.9 times operating cash flow, which is a bit higher than its historical norm of 10.4. However, when you look at the current yield of 6.3% things look somewhat different.

 

For example, over the past 13 years Enterprise’s yield has ranged from 3.42% to 11.67%, with a median of 5.77%. So the current yield is about 9% higher than its historic norm. Enterprise also looks relatively undervalued when you consider that the midstream MLP industry median yield is 5.7%.

 

However, much of the company’s future ultimately hinges on the success of its growth projects and how the domestic energy landscape evolves. Given management’s track record, the stock appears to be reasonably priced, if not perhaps somewhat undervalued.

 

Conclusion

At the end of the day, even conservative midstream MLPs such as Enterprise Products Partners are at the mercy of capital markets and commodity prices, if for no other reason that demand for their growth projects require higher oil & gas prices. Energy prices also impact customers’ ability to pay their bills and honor their contracts with midstream operators.

 

However, with its strong balance sheet, best-in-class management team, long growth runway, and solid track record of paying a secure and growing distribution in many different economic / interest rate / energy price environments, Enterprise Products Partners appears to represent one of the safer high-yield MLPs in the market.

 

If you understand and are comfortable with the risks involved with investing in MLPs and desire exposure to the energy sector, Enterprise Products Partners is an interesting candidate to consider as part of a well-diversified income growth portfolio.