Co-produced with Long Player

The midstream sector is full of challenges, and the current uncertainties are very tough on this sector. There are many reasons for this which includes a rapidly slowing U.S. oil and gas production which could negatively impact many midstream companies. Therefore, in this sector, income investors are clearly best served by investing in the best company with the best management. Clearly the best-of-breed is Enterprise Products Partners (EPD). We explain later in this report on why EPD is one of the best high-yielding companies to buy and hold for the very long term.

Tax Note: EPD issues a K-1.

Recent Performance

The energy sector remains out of favor by investors. However, during the past several months, EPD has been a leader in the industry. It has strongly outperformed all the energy indexes including Energy Index (XLE) and the midstream index (AMLP) over the short-term and long-term periods. During the past six months, EPD has returned 20% including dividends.

ChartData by YCharts

Importantly for income investors, we are patient. We are happy to collect high income from super solid companies until Mr. Market realizes that this is one of the best companies to buy and hold for the long run.

For investors, the good news is that EPD trades at very cheap valuations. EPD shares still have a long way to go to approach historical valuations while still offering a sustainable and growing 11% yield. The appreciation potential for EPD is very rare for an income type investment. When one also considers that EPD traditionally grows at a decent pace, these shares could offer a retiree that unusual combination of appreciation and growing generous distributions for the foreseeable future.

Long-Term Debt

This company has felt the pressure to lower debt levels as have many competitors in the industry. The COVID-19 pandemic resulted in demand destruction which is the second economic tidal wave to engulf the industry in the last 15 years. Many would have thought of the 2008 crisis as a one-time event. But the second time will now affect how business operates in general. Investors should expect far more conservative financial strategies in the future until it’s apparent that the economy will not have any future “tidal waves.”

This company has a long-term debt-to-EBITDA of 3.4 times and an investment-grade rating. Having an IG rating in the midstream world is very rare!

Source: EPD September 2020 Investor Presentation

Therefore, the market will be open to refinancing debt at favorable interest rates. Management has taken advantage of this to both lower the debt relative to EBITDA over time while refinancing the debt long term at favorable rates. The financial strength gives this company a competitive advantage over many customers in that the low cost of debt enables greater profitability of projects.

The emphasis on fee-based businesses and customer diversification has protected the cash flow from bearing the brunt of these latest business cycles.

At EPD, the erosion of business, particularly cash flow from operating activities, during times of industry stress has been fairly muted. That process recently repeated itself when the shares took a severe dive earlier in the year in anticipation of some poor results that never happened. Business did decline, but key ratios have remained well within investment-grade ratings.

Similarly, the chart below shows that return on capital remained relatively steady throughout the business cycles.

Source: EPD September 2020 Investor Presentation

Far more importantly, management has kept the distribution at a level that is maintainable when the economy has gone through its periodic crashes.

Notice from the chart below that the dividend always had a huge coverage even during the worst of times.

Source: EPD September 2020 Investor Presentation

This chart also reinforces the idea of the midstream business being a haven for money in both good and bad times. This is very rare for any company nowadays.

The Opportunity

Still, an investing opportunity for contrarian investors arises as Mr. Market has yet to learn that the midstream business is not affected by the price of oil and natural gas nearly as much as the upstream operations. Such industry conditions as the current set of conditions would have to last for several years before there would be a permanent material effect to future profits. The reason is that typical midstream contracts last several years. Therefore the amount of business exposed to the current weak pricing is relatively small. It would take several “smalls” to become large enough to affect key debt ratios and the distribution.

The opposite also is true as near the top of the market these midstream companies tend to become fully priced (and then some) so that those investors that wish to “play” the oil and gas cycles can do so while being paid handsomely to hold the securities. Meanwhile long term, retirees can obtain a fairly secure income vehicle at current prices. EPD still yields 11% and this is a great opportunity.

The Business

The first thing that needs to be considered is the fast changing nature of the upstream industry which has a high break-even cost for oil price (USO) in the United States. The information in the chart below is likely already far too conservative. But the good news is that much of the industry can “make do” if oil pricing steadies in the $40 to $50 range.

Source: EPD September 2020 Investor Presentation

That’s actually going to be changing to lower prices in the future as the industry continues to innovate. We follow companies that are reporting well breakeven points below WTI $30. So there is likely to be considerable breakeven pricing improvement in the future.

That means that the next industry cycle will likely be a declining cost-based profitability cycle as the last few have been. That type of industry recovery cycle should continue until technology changes slow. Any serious oil or natural gas pricing rally would be met with increasing activity so that a rally is unlikely to last for a significant amount of time.

Those declining costs are good news for the midstream industry. That means volumes will be increasing through the midstream transportation on lower oil pricing than the market is expecting. These last few months have enabled managements to compare notes on drilling methods and completion techniques (usually through suppliers). Therefore, when companies decide to resume drilling, the latest wells will be more profitable than ever before.

Currently the demand for many of the products serviced by EPD are growing. Ethane, for example, gets converted to ethylene which is experiencing very strong demand growth into many “green” products. That plastic has to come from somewhere and it generally comes from natural gas. It turns out the demand for petroleum products for fuel is a relatively small part of the equation. Even if fuel for cars and trucks was eliminated tomorrow, the demand for all these other products would continue well into the future. The future of the petroleum business actually is rather bright at the current time.

Source: EPD September 2020 Investor Presentation

As a simple example, the industry cannot build “crackers” fast enough. The tremendous growth in the demand for ethylene shows no sign of slowing down anytime soon. Shell (NYSE:RDS.A) (NYSE:RDS.B), as shown above, will be one of the first to build one of these plants near the Marcellus Basin and contract for ethane from the natural gas producers in the area. This could give that plant a natural profit advantage due to the lower transportation costs inherent in such a location.

Location

The majority of operations are located in energy-friendly states.

Source: EPD September 2020 Investor Presentation

As was previously discussed, this company has a lot of investment-grade customers and partners that will be less affected by industry conditions than some of the smaller industry players. This accounts for the relative lack of volatility in the cash flow. Furthermore, the obvious emphasis on both the Permian and the Eagle Ford basins affords the company a location advantage. Some of the assets, like the pipelines through New York, are extremely valuable as that state does not really “in practical terms” allow competitive expansion into the state.

This company, like many competitors, has cancelled some previous growth projects and extended others out further than the original completion dates due to current industry conditions. Therefore there will be a lull in future growth during the industry recovery. But that temporary absence of growth will likely not last. It’s actually a good thing as it will allow for EPD to absorb better its past growth projects.

The growing demand for petroleum-based products is simply too ingrained in our economy for demand to cease permanently. Then there’s a big chunk of the rest of the world where petroleum products represent a step forward from the current situation of the population. In this area, petroleum products will be growing significantly while advancing the population to a better situation than they were in compared to recent history. The demand for exports will resume as the world recovers from the current situation.

Latest Financial Results

The latest financial results show the company is in an excellent position to report results close to the previous fiscal year despite the miserable second quarter experienced by much of the industry. Distributable cash flow was at $3.1 billion for Q1 and Q2, which is almost half of what was reported in 2019 of $6.6 billion for the entire year.

Clearly this year will not show fiscal growth. But the year is positioned to be far from the disaster experienced by many companies in many industries. The second quarter of the fiscal year will most likely be regarded as an outlier when doing comparisons in the future. Still the six-month results show little deterioration from the previous fiscal year, also if we look at “cash flow from operations” which amounted to $1.2 billion for the first 6 months of 2020, compared to $2.4 billion for the full year 2019. This is very remarkable.

In the case of EPD, free cash flow will probably increase as the recovery proceeds because capex will remain low for the foreseeable future. Management will do necessary projects while waiting for demand to pick up. Furthermore, investors should realize that high debt levels move in the opposite direction of free cash flow as lenders can often pressure the company to reduce debt as the debt market raises the cost of new debt offerings due to increased credit risk. Free cash flow can definitely be impacted by the lending market conditions, but fortunately for EPD, this risk is almost non existent. This is due to both low leverage and an investment-grade credit rating.

Guidance

Management has given guidance for the rest of the year 2020:

  1. The company’s expansion will be slow and prudent and will mostly involve the expansion of the current facilities.
  2. However, the balance sheet strength allows for a rapid buildup of activity if that appears to be needed.
  3. Target leverage will remain low at 3.5 times EBITDA which is a great plus.
  4. The distribution coverage (or dividend coverage) will remain very high. Based on the mid-year results, the payout ratio is only at 62% which will allow EPD to continue to grow its dividend in the future.

Note that the cash flow and relatively low debt will give this management the flexibility to respond as needed when the inevitable recovery resumes. Demand for natural gas has been rising for some time and that growth is likely to continue into the future. For cars in particular, the natural gas engine technology is available, dependable, and cheap. Therefore, natural gas is making some serious inroads into various transportation modes because it decreases pollution when compared to a gasoline combustion process. Out in many areas in California for example, UPS, buses, trucks and city fleets have all converted to natural gas.

Another example is Chart Industries (GTLS) – a company we follow which sells the equipment needed for both sellers and users of natural gas. They have reported several years of rapid growth up to the time of the coronavirus demand destruction. They are still reporting a lot of opportunities to grow in the future. The natural gas industry is here to stay for decades. EPD will get its share of the future business.

Value and High Insider Ownership

Obviously, any time a company of this stature yields double digits then the shares are cheap. EDP common shares should probably be yielding about 6%, which is within their historical norms. The company has 21 consecutive years of distribution increases, and an average 12% return of capital over the past 10 years. Importantly, management is aligned with shareholders because they own 32% of the common shares of EPD. This is huge!

Source: EPD September 2020 Investor Presentation

EPD’s valuation today is only about 8 times enterprise value/adjusted EBITDA. This is still another measure of how undervalued this company is. Furthermore, the cash flow from operating activities further confirms the EBITDA figure. The enterprise value is slightly more than 10 times cash flow from operating activities.

Considering that this company consistently raised distributions for two decades prior to the pandemic, this company will again have premier pricing compared to many in the industry. The financial figures speak for themselves and the bottom line the results were barely impacted in 2020.

Even if the distribution was not increased, the common shares could appreciate about 80% to get to that historical 6% yield norm while investors collect a 11% dividend yield.

Bottom Line

As an income investor, I personally care more about the a steady and consistent dividend yield of 11% rather than capital gains, but capital appreciation would be a great plus. Any return to historical growth would increase that appreciation potential level. To historical norms it would imply a 10% in dividends plus another 10% in capital appreciation per year. The compound return (if dividends were reinvested) exceeds most stocks, yet EPD is one conservative company with an investment-grade rating. Go with the best. Lock in this generous yield of 11% for the very long run. Management has a very high insider ownership, and strongly believe in their company. You should too!

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Disclosure: I am/we are long EPD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Treading Softly, Beyond Saving, PendragonY, Preferred Stock Trader, and Long Player all are supporting contributors for High Dividend Opportunities.

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