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Article Thesis
Enterprise Products Partners (NYSE:EPD) reported strong quarterly results. The company executes very well, has a fortress balance sheet, offers a nice income yield that is secure in all kinds of macro environments, and yet, EPD is not expensive at current prices — potentially making it the highest-quality midstream company investors can pick.
Irreplaceable Assets That Are In High Demand
The world is currently experiencing an energy crisis. Underinvestment in new production, due to government regulation, ESG mandates, an increasing focus on free cash generation by management teams and boards of directors, and so on has resulted in weak supply growth. At the same time, demand for oil has recovered strongly from the pandemic and will continue to climb in 2023 and beyond. OPEC is also flexing its muscles, and many countries want to become less dependent on Russian energy supplies. Overall, that has created an environment where markets are tight and where further production shortfalls are to be avoided. That means that US producers will have to keep producing as much as they can, both when it comes to oil and when it comes to natural gas. High energy prices in the US mean that the country benefits from domestic production, while overseas markets such as Europe also depend on American energy exports, primarily when it comes to LNG. That means that the infrastructure that is in place in the US that is needed for moving energy from production areas such as the Permian Basin to end markets and/or export terminals is extremely important — without it, both the US and allied countries such as in Europe would face massive problems.
Building new energy infrastructure, such as pipelines, has become incredibly hard, due to regulation, lawsuits, high costs for the required material, and so on. This leads to a situation where energy infrastructure spanning the US is very important, and very hard to build — existing assets are thus the only way to meet demand. That means that the companies that own and control these existing assets, such as Enterprise Products, are in a great position — their assets are worth a lot more than what they originally paid when they built or acquired these assets, and there is no foreseeable risk of either obsolescence or competition. Even if a peer was willing to build a pipeline next to one of EPD’s pipes to replace it, said pipeline would very likely face gigantic hurdles, making existing pipes in the ground very safe from competition.
Most of Enterprise Products’ business is not dependent on commodity prices, as its fee-based business model does not require oil or natural gas prices to be high. But thanks to some CPI-linked contracts and contract rates getting renegotiated at higher levels over time, EPD still sees its revenue and cash flow grow at existing assets. High energy prices make its customers more profitable, thereby reducing counterparty risks for Enterprise Products, and giving it more room to demand higher prices for transporting commodities from A to B, as its cash-flush customers are able to pay more than they did in the past.
Strong Results From EPD And Compelling Shareholder Returns
All in all, this results in a great environment for American energy infrastructure players, including Enterprise Products. The company has thus, not surprisingly, had a great third quarter.
Enterprise Products’ third-quarter revenue totaled $15.5 billion, which easily beat estimates and which was up 43% year over year. As commodity prices are a flow-through item for some of EPD’s business units, revenue growth at that level does not translate into similar profit and cash flow growth, as expenses grow as well. But EPD still managed to grow its EBITDA by a compelling 12% year over year, to $2.26 billion, or around $9 billion annualized. Thanks to some operating leverage, its distributable cash flows, which is adjusted operating cash flow minus maintenance capital expenditures, grew by 16% to $1.87 billion, or $7.5 billion annualized.
Distributable cash flow is the maximum sustainable payout an infrastructure company such as Enterprise Products can make over a prolonged period of time. In that scenario, a company does not spend anything on growth projects, debt reduction, or on share repurchases. That is usually not what companies pursue, and it’s also not what EPD is doing, but it’s still good to know that EPD could theoretically pay around $7.5 billion per year to its owners if the company were to only invest for maintenance, i.e. keeping existing assets in place, without expanding any of them or investing for growth in other ways.
Since EPD is currently valued at $54 billion, the company is thus trading at 7.2x the Q3 DCF run rate, which pencils out to a distributable cash flow yield of 13.9% — the theoretical maximum sustainable dividend yield EPD could offer at current prices. Enterprise Products is currently paying out $1.90 per share per year in dividends, which equates to company-wide dividends of $4.1 billion, based on a share count of 2.18 billion. So the dividend is covered at a rate of 1.83 as of the third quarter, which is equal to a DCF payout ratio of 55%, and which makes for excellent dividend coverage for an energy midstream name such as Enterprise Products. Between this strong dividend coverage and EPD’s great dividend growth track record — the company has increased its dividend for more than 20 years in a row, no matter what crisis the world was experiencing — we believe that EPD is at very low risk of cutting its dividend, making it a suitable buy and hold income investment.
At current prices, EPD’s dividend yield is 7.7%. That’s not the highest dividend yield in the energy midstream space, but still, a pretty high income yield that would allow for pretty solid total returns even without any dividend increases and no share price growth. Fortunately, Enterprise Products regularly serves up dividend increases. The last one was announced this summer, and EPD also increased its dividend at the beginning of the year. It would thus not be surprising to see the company increase its dividend again early next year, as this would keep the half-year cycle intact. It is, of course, also possible that EPD moves back towards a 1-year hiking cycle, but even then, the January dividend announcement could hold the next increase, as EPD has oftentimes announced its dividend increases at the beginning of the year in the past.
Enterprise Products’ enterprise value, which adds a company’s market capitalization and its net debt, stands at $84 billion right now. With EBITDA being forecasted at a little more than $9 billion this year, the company is thus trading at an EV/EBITDA multiple of around 9, which is far from expensive. Especially when we consider EPD’s great track record, its compelling cash flow growth, and its fortress balance sheet — quality factors that make the company stand out among energy midstream names — the valuation seems very undemanding. EPD’s management seems to believe this as well, which is why the company has been pursuing share repurchases in the recent past.
During the third quarter, Enterprise Products bought back 4 million shares. That pencils out to an annual buyback pace of around 1% of the company’s shares, which isn’t great, but which will nevertheless have a positive impact on cash flow per share growth over time. EPD has also been increasing the buyback spending over the last couple of quarters, thus I wouldn’t be surprised to see the company spend more on share repurchases over the next couple of quarters, at least when the valuation remains inexpensive. Since EPD’s leverage (3.1x EBITDA) is currently at the lower end of the target range, increased buybacks could also make sense from a financial leverage position, as further debt reduction isn’t in line with what management has been signaling they are comfortable with — and since EPD already has a fortress balance sheet with one of the lowest leverage ratios in the industry and hefty liquidity, there also is no need at all to reduce debt levels further.
Takeaway
Enterprise Products is a great energy midstream player. It has strong management, a large asset footprint that is more or less irreplaceable, its balance sheet is very strong, cash flow is growing at a compelling pace, and the company is returning billions of dollars to its owners. With a dividend yield of well above 7% and considerable dividend growth potential, EPD looks like a strong high-yield income pick. Between buybacks, organic growth, and multiple expansion potential, EPD could also deliver share price gains. If its valuation were to expand to a 10% DCF yield, which would still be far from expensive, shares would rise to around $34, more than 30% above current levels, for example. That’s not guaranteed, of course, but it shows that EPD has considerable upside potential on top of the compelling income it offers.
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