Description

Enterprise Products Partners (EPD), a midstream MLP whose business is 85% fee based, reported earnings results on Monday.  Earnings were fine with 4.6% growth in DCF/share (distributable cash flow), and EBITDA up 6.3%. They set six operational records in the past quarter too, mostly related to pipeline and production volumes. 

I have owned this name for roughly two years now.  That is, since EPD slowed down their distribution growth rate.  At that time in the Fall of 2016, EPD stock dropped from $27 to 24.  It has yet to recover, trading in a tight $25 to $30 band ever since.  This is despite the fact that the company has grown DCF/share by over 50%, from $1.93 in 2016 to runrate levels of $3.00 this year.

Given that EPD on average trades at 19x earnings, and 14.6x DCF, the downside appears more than priced into virtually any scenario except perhaps another Great Recession.  At just average multiples, EPD would trade between $40 and $43 per share, upside of 55-60% including distributions in a year or two. (EPS is expected to be $2.20 in 2019, so trades at 12.3x this years earnings, an historic low).

The downside is likely $23-25 per share, assuming oil volumes and lower pricing impact DCF/share.  In the energy recession of 2014-2015, when oil prices sank from over $100 per barrel to $30 in early 2016 actually, DCF/share at EPD only fell from $2.06 to $1.93.  That is a 6% decline. EPS fell about 15% peak to trough (2014 to 2016).

In another recession or oil breakdown, even if we assume DCF falls 10%, to the $2.70 per share range, multiples of 8-10x still get us $22-26 in value.  The worst yield the equity has traded at is 7.5%, which implies $23.70. With coverage quite a bit better than December 2015 when this happened, it seems an extreme price too.

For the quants out there, EPD today trades 2.4 standard deviations cheap to historical trading patterns, quite a remarkable level given that SPY is hitting all time highs.  Not only that, but also EPS revisions are positive 3% (meaning they keep beating Street forecasts). With a nice 6.5% distribution yield, investors with just 2 years of patience likely will see little downside.

Capitalization

Note: EPD is an MLP.  I may use the terms equity or shares, but legally investors buy units and receive distributions as opposed to dividends.  Check with a tax advisor on whether these are appropriate investments; there are numerous fund limitations and IRA issues with MLP’s.  I own shares personally and in funds I manage.

Business

Enterprise Products Partners was founded in 1968 by Dan Duncan and IPO’d in 1998.  It has grown roughly 2/3s through organic growth projects, and 1/3 through acquisitions since then.  Management via Epco Holdings (which is mostly the Duncan family’s heirs) owns 31% of the units. Dan Duncan’s surviving daughter Randa Duncan is Chairman of the Board. 

There are no Incentive Distribution Rights or past issues with management not being aligned with publicly traded unitholders that I could find, except for a small secondary offering in 2009 by Epco to improve the balance sheet.  The days of the company paying out 100% of DCF and raising capital via the public markets to fund growth capex are long over. Even with terrible trading levels today, EPD stock has returned 16.4% for holders per year since it went public.

Asset wise, EPD today owns 49,000 miles of pipelines, 260MM barrels of storage capacity for natural gas liquids (NGLs) & crude, and 14Bcf of storage capacity of natural gas.  The company gathers, processes, stores and even exports various energy products.

The asset mix is heavily geared toward NGL’s (a by-product of natural gas production).  47% of Gross Operating Margin is related to NGL processing and pipeline and storage, with crude oil at 29% and natural gas at 12%.  With gas prices and production particularly challenged, and US feedstock advantaged with low NGL prices today, the company is in the right categories to continue growing both its top and bottom lines. The growth in the number of petrochemical plants along the US GOM should mean plenty of continued NGL demand.

Source: Presentation

Importantly, 85% of EPD’s Gross Margins are fee-based, long term contracts mostly with large cap, diversified energy companies like Chevron, Exxon and EOG Resources.  Falling oil and gas prices won’t have a material impact on earnings unless production declines. 

Management indicated that their customers expect to cut capital spending by roughly 10%, but at the same time intend to increase production by 10%.  There are significant drilled but uncompleted well (DUCs), as well as efficiencies that E&P companies intend to wring out of their systems. Only one customer of EPD’s suggested that production would fall, but only for natural gas, not crude.

Above you can see where EPD operates.  They mostly collect fees at various stages of oil and gas production.  After natural gas is processed (meaning the natgas or methane is separated from the components of NGL’s like ethane and butane and propane), it is stored, piped and even crude and NGL’s are exported to various international destinations. 

Some of their contracts are commodity based, whereby say EPD processes natural gas, and then keeps the NGL stream (called a keep whole contract), or a percentage of proceeds contract where the company receives a fixed percentage of the hydrocarbons processed.  That is about 4% of GM’s this year to date, meaning that even a 25% drop in oil and gas prices would reduce gross margin by only 1% overall.

In other cases, EPD capitalizes on differentials, which can be regional or in-product differentials  This comprises about 11% of GM year to date. Specific to EPD, they capture natgas spreads, spreads on propylene, and spreads on RBOB vs Butane.  I find it virtually impossible to predict these refinery type spreads.

At the bottom in 2015, differential income was 5% of total GM, meaning there could be a 6% hit to earnings should differentials evaporate to historical low levels. 

Together this might explain roughly the 6% hit to DCF/share that impacted EPD in 2014 and 2015.

Here is an old slide illustrating that the company continued to grow DCF/share at a 4.1% CAGR during the rough years of 2011 to 2016:

Source: Presentation

The company’s balance sheet is solid, at 3.5x debt/EBITDA.  They are BBB+ rated and have $6.0BB of liquidity. Growth has been organic almost exclusively since 2013, except for the occasional tuck in deal.  There are no empire builders at Enterprise like Kelcy Warren. 

With a total of $9.1BB in growth capital projects under construction, there really is no need to acquire either.   Scale has become important in this business, and with EPD offering smart management, on time construction, and a large diversified mix of capabilities, the energy conglomerates are awarding projects to these guys more often than not.

Of that 9.1BB in growth projects, $3BB of these will come online within the next 6 months.  Note that their Shin Oak pipeline and Orla gas plant also recently began operating and continue to ramp up. 

Some specifics are below:

Financial Model

While it is somewhat an imprecise exercise to model this company given its size and complexity, the big picture looks promising.  Gas and oil prices are depressed, but at levels that continue to encourage decent production growth. The company is spending $4BB growth capex in 2019, and $3.0-4.0BB next year, implying at least $800mm of incremental EBITDA from growth projects once they ramp up.  Management won’t give specific project return expectations, but targets 10-15% ROICs. One project the Midland to Echo pipeline (Permain to Houston, and actually 4 pipelines) looks to be at the high end of this range.

With US oil production forecasted to be up 7% in 2020 (assuming 2.1% GDP growth) according to the IEA, and NGL production up 10%, the outlook continues to look pretty good.  Even gas supply is forecasted by the IEA to be up 2% next year. Of course, gas is more weather dependent, so a cold winter would be helpful.

Here is my summary model:

I took a conservative view on growth here.  With production growth of say 3%, and growth capex likely adding $1BB to EBITDA by 2022, I essentially cut these figures in half to come up with my expected $3.10 and $3.30 in DCF/share in 2020 and 2021. 

Typically a sub 10x multiple on DCF implies a company this is facing secular decline issues, or is trading at a cyclical peak.  With commodity prices somewhat depressed already, US GDP growth continuing, and OPEC production cuts likely to offer share gains for US oil producers, the backdrop does not appear as dire as EPD’s stock price implies.

Valuation and MLP Discount

The elephant in the room here of course is the fact that EPD is an MLP.  Somehow this is a huge negative to all energy MLP unit prices, across the board.  Names like Oneok (OKE) and Targa (TRGP) converted to corporations a few years ago, and they trade at 12x and 15x multiples of DCF, as well as almost 16x EBITDA. 

The same pipeline and storage type assets at EPD are fetching a mere 10x multiple of 2019 EBITDA.  The irony is that, while LP’s have limited control rights, MLP’s actually pay fewer taxes than a corporation does.  Theoretically, an MLP should trade at a HIGHER multiple of EBITDA, as more of that cash flow is able to be distributed to the limited partner.  There is no double taxation issue.

I understand that we live in a world without a lot of rationality.  Retail investors are scared to touch MLP’s after the disastrous sell off of 2014 to 2016.  Index funds cannot own MLP’s, and institutions often have caps preventing owning over a certain percentage of assets in partnerships.

So, the good news is, we can buy EPD at an exceedingly cheap price.  I am not going to pretend to know when this revalues back to a normal level, but I like to think that a blue chip name like this should get some valuation support below 10x cash flow.

Energy Transfer appears pretty cheap at 9.9x this year’s EBITDA, and 8.7x 2020 EBITDA (proforma for the Semgroup purchase).  

I am not a big fan of Kelcy Warren, after seeing his numerous attempts to buy other company’s at big multiples with stock.  WMB comes to mind in particular. Plus ET is 5.6x levered on a D/EBITDA basis proforma for the SEMG deal. This is after he promised to de-lever.  The units are cheap at 6x DCF, but riskier given leverage/management. At about the same EBITDA multiple, I like the lower risk name.    

By the way, here is a graph of EPD’s DCF/share growth since 2011:

With a $1.77 distribution, coverage looks pretty good (1.7x year to date DCF).

On a compounded basis, EPD has grown DCF/share at 8.25% since 2011. 

Below is a chart of where EPD has trade on multiple of DCF since 2011. I used average unit prices here.

Even in a bad cycle, EPD probably continues to earn $2.70 in DCF/share, down 10%.  Should the economy and production continue to grow for 2-3 years, and the market decide to reprice these to just 12x, then I see upside of almost 60%.

On an EV/EBITDA basis, I recall Buffett (or rather Berkshire Hathaway) buying a pipeline from Williams back in 2002, during a very distressed energy cycle.  Williams was on the brink of bankruptcy, and Buffett paid 7.5x EBITDA for one of their FERC regulated pipelines. The commentary at the time was, “record low valuation” and “he’s paying that because he knows they are worth 10x EBITDA.” 

Even using 9x as a distressed level (where TallGrass is selling), and EBITDA down 10%, I get a $17 stock.  I think that is highly unlikely scenario given EPD’s solid balance sheet, growth projects and limited commodity price exposure. 

On the upside, at a 12-13x multiple of EBITDA, about where most MLP’s have traded historically, EPD offers 36% to 64% upside. 

Here are some multiples of DCF scenarios.

Final Thoughts

This is probably the stock I worry least about owning in my portfolio.  After seeing EPD fall today on solid earnings, it seemed beyond comprehension.  There have been dozens of insider purchases in the past couple of years, mostly grouped around the $25-26 level.  To me that is probably the downside without a recession.

The CEO Jim Teague is the kind of operationally, FCF focused manager you want running a company too.  I like listening to him speak – he is a no BS kind of guy who knows his stuff. He personally added 20,000 shares at the end of 2018 and has a nice pile of $50mm worth of equity. 

With 22 years of consecutive dividend growth, soon they will become a Dividend Aristocrat.  Maybe an index fund or three will choose to buy it.

It is unclear that the company will raise the distribution growth rate back to its prior 5% type level (its 3% now), but as leverage gets to 3x, coverage almost 2x, and growth projects roll off, they have to do something with their FCF.

Catalyst

Management actually has a $2BB buyback plan in place

Earnings growth from new projects coming online

Re-rating of MLP's 

Increasing distribution growth rate in 2020 is a possibility