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Enterprise Products Partners: One of the Best MLPs for Income

Enterprise Products Partners (EPD) is one of North America's largest midstream master limited partnerships, with approximately 50,000 miles of natural gas, natural gas liquids (NGL), crude oil, refined products, and petrochemical pipelines. The company also owns a number of storage facilities, processing plants, and terminals.

Enterprise’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 makes most of its money from fees it charges E&P customers for its transportation and storage services.
Source: Enterprise Investor Presentation
Like many midstream MLPs, Enterprise began mostly as a natural gas pipeline operator. However, over the past two decades it has transformed itself into a vertically-integrated giant thanks to more than $60 billion of growth investments and acquisitions.

Today the company has a hand in connecting nearly every major U.S. energy-producing region to end users of numerous fossil fuels. Some of the notable oil & gas formations it has a presence in include the Eagle Ford (east Texas), Permian Basin (west Texas), Niobrara (Colorado), and the Marcellus and Utica shale gas fields (Pennsylvania and Ohio, respectively). Enterprise is also one of the largest exporters of crude oil, as well as NGL and NGL-derived products.
Source: Enterprise Investor Presentation
NGL transportation and processing provides the majority of the company’s profits (56%). Enterprise is doubling down on this area because the shale gas boom has resulted in such an abundance of NGLs that there is a large and fast-growing export market for refined NGL products such as ethylene and propylene in Asia and Europe. Crude (17% of profits), petrochemicals (15%), and natural gas (12%) account for the remainder of Enterprise's business mix.

Enterprise Products has raised its distribution (a tax-deferred form of dividend paid by MLPs) for 20 consecutive years.

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 operate pipeline systems, which are also highly regulated. 

Only so many pipelines are needed within a particular geographic area as well, often resulting in a consolidated market. Pipelines also have few substitutes given their safety and cost-efficiency, along with geographical constraints (many oil & gas formations are in hard-to-access areas). 

Furthermore, pipelines enjoy relatively stable demand patterns since many of the products that require refined oil and gas are non-discretionary in nature. In a way, the midstream industry is similar to the utility sector in that it provides an essential service for U.S. oil, gas, and NGL producers, resulting in a stable and recurring cash flow stream.

In fact, Enterprise Products Partners’ claim to fame is its track record of stable and consistent growth through all sorts of commodity, economic, and interest rate environments. 

The company has paid uninterrupted distributions since going public in 1998 (including more than 60 quarterly distribution increases) largely due to its business model, which is less sensitive to oil & gas prices than one might initially think. This is because most of 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). As a result, Enterprise's cash flow has managed to remain relatively steady despite wild swings in the price of oil (red line below).
Source: Enterprise Investor Presentation
Besides the attractive characteristics of the pipeline business, a major key to the MLP's success is management's conservatism and well-aligned incentives with unitholders. 

Enterprise is led by CEO Jim Teague, who has over 40 years of industry experience, and Chairwoman Randa Duncan Williams, daughter of the MLP's founder. The Duncan family owns EPCO, which is Enterprise's general partner and controls 32% of all Enterprise units (what MLPs call shares).
Source: Enterprise Investor Presentation
The firm's high insider ownership helps explain why management has always taken a long-term view to maximize Enterprise's distribution safety and growth potential in all economic, industry, and interest rate environments.

That includes eliminating half of the partnership's incentive distribution rights, or IDRs, in 2002, and then fully in 2011 in a stock-based transaction that avoided both taxes for unitholders as well as a distribution cut. IDRs send up to 50% of marginal cash flow to the general partner and significantly increase an MLPs cost of capital, making it harder to grow profitably (and thus slowing future distribution growth).

Enterprise's conservative management team has also led the MLP to be cautious with its use of debt, which got many of its peers into trouble during the 2014-2016 oil crash (when many MLPs had to slash their distributions).

During the boom years of 2010 to 2014, when oil prices were averaging over $100 per barrel and low interest rates drove strong investor demand for high-yield MLPs, many midstream operators chose to grow their payouts as fast as possible. As a result, they had to fund their capital-intensive growth projects with debt and new equity issuances.

The industry's average debt/adjusted EBITDA (leverage ratio) topped out at about 6.5 in 2016 (peak of the oil crash), with some MLPs sporting ratios as high as 8.0. Enterprise's leverage ratio never rose above 4.4 and sat at just 3.7 at the end of 2018. 

The firm's strong balance sheet and BBB+ credit rating (tied for the highest in the industry) helps Enterprise borrow at relatively low costs and other favorable terms. Nearly all of its debt carries fixed interest rates, and about half of the bonds it has issued over the past decade had a duration of 30 years or longer. 

Management targets a long-term leverage ratio of about 3.5 which will result in not only an even safer distribution in the future, but also greater access to affordable, long-term debt to lock in the profitability of its growth projects and minimize the risk of rising interest rates to its business model.

Thanks to its disciplined use of debt and the projects it invests in, Enterprise has managed to generate some of the industry's highest and most consistent returns on invested capital throughout all oil price environments, a testament to the stellar management team.
Source: Enterprise Investor Presentation
Going forward, Enterprise's growth efforts and distribution safety profile will be further aided by the new self-funding business model the firm announced in 2017. As you can see below, Enterprise wants to significantly grow its retained distributable cash flow (DCF), which is the cash flow leftover after paying distributions.

Management hopes this internally-generated funding source will provide half of the financing it needs for its growth projects and acquisitions, eliminating the need for at-the-market (ATM) equity offerings. The other half of the growth budget would be funded with long-term debt.
Source: Enterprise Investor Presentation
While Enterprise has never had to issue much equity to fund its growth efforts, in 2017 it announced it would slow its distribution growth to 1 cent per year (spread out over every quarter), or about 2.5%. With distributable cash flow continuing to grow at a faster pace, Enterprise's retained DCF will increase, and its distribution coverage ratio (DCF / distributions) is expected to rise to 1.5 by the end of 2019.

If everything goes as expected, Enterprise's growth plans will be 100% independent of its volatile stock price, and its cost of capital would fall even lower, likely meaning even higher returns on investment in the future.

Enterprise has a solid track record of under promising and over delivering, and management beat expectations once again. The firm actually achieved its self-funding goal one year early thanks to several large growth projects going into service in 2017 and 2018, significantly boosting DCF and Enterprise's coverage ratio. 

The MLP is in such great financial health that it also announced a new $2 billion buyback authorization which it plans to utilize if its valuation remains low and it runs out of profitable growth projects to fund. Distribution growth acceleration to a mid-single-digit pace may come in 2020 or beyond as well.

But for now, Enterprise is completely focused on growth because its short-term backlog of projects is large and growing quickly. Enterprise's backlog of growth projects increased from about $5 billion in 2017 to $6.7 billion at the end of 2018.
Source: Enterprise Investor Presentation
While Enterprise began with a large focus on natural gas pipelines, management has diversified the business into faster-growing areas, such as NGLs (which now account for the majority of its business) and oil exports. 

About 85% of the firm's growth spending is focused on NGLs and petrochemicals. That's because America's oil & gas production boom means that NGLs such as ethane, butane, and pentane are being produced at rapidly growing rates, both from gas and oil shale formations. The U.S. Energy Information Administration expects both U.S. gas and oil production to keep growing strongly for many years or even decades, and NGL production with it.

NGLs are important feedstocks for the petrochemical industry, which uses them to make materials such as plastics. Low cost U.S. natural gas means that NGLs are much cheaper than in Europe and Asia, fueling strong export demand.

As a result, the U.S. petrochemical industry is racing to expand NGL and petrochemical production as fast as possible, including $317 billion in new projects announced between 2010 and 2017, according to the American Chemistry Council.

Management says that its discussions with the petrochemical industry indicate this strong pace of new investment is likely to continue long past 2020. Enterprise is one of the best positioned MLPs to profit from the NGL boom thanks to its large and growing network of NGL transportation, storage, fractionation (separating NGLs from gas), and export infrastructure.

However, thanks to its vertically integrated status, Enterprise also has other growth opportunities including being one of America's leading energy exporters. At the end of 2018 Enterprise had 5 million barrels per day of export capacity which it plans to grow that by 60% in the coming years, largely by building a new offshore oil export terminal which is expected to be complete in 2021. 
Source: Enterprise Investor Presentation
U.S. oil and NGL exports are expected to continue growing strongly thanks to ongoing improvements in fracking technology, which is keeping domestic energy production extremely cost competitive on a global basis. The U.S. shale boom, both in terms of gas and oil production, has exceeded expectations for the last 15 years, helping explain why the long-term growth outlook for the midstream industry remains appealing.

In fact, according to the International Energy Agency, rising U.S. energy production will require $700 billion to $900 billion in additional infrastructure investment by 2040. Even for an MLP of Enterprise's size, there still appears to be plenty of growth to be had in the years ahead.

Overall, Enterprise Products Partners appears to be one of the lower-risk choices for high-yield investors looking to profit from America's energy boom. That's thanks to one of the strongest balance sheets in the industry, access to low-cost capital, a low-risk self-funding business model, and arguably the best management team in the industry. 

Key Risks
While Enterprise Products Partners may represent one of the fundamentally safest midstream MLPs, there are still some 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. The MLP’s ability to continue finding profitable projects to invest in requires a global energy price environment that remains supportive of domestic oil & gas production growth. 

The long-term energy forecasts that make up a good deal of the bullish midstream MLP investment thesis are based on hard-to-predict interactions between global oil & gas supply and demand, which can be volatile. It's possible that the bullish growth expectations MLP investors have today might not materialize.

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 and remain depressed for a prolonged period of time, the need for pipelines could theoretically decline and dent the economics of Enterprise's growth projects.

What's more, whether or not its cash flow is sensitive to commodity prices, Enterprise's stock price is often correlated to crude prices which can be extremely volatile at times (including a 45% crash between October and December 2018). In other words, while Enterprise is effectively an energy utility, it's stock performance is nowhere near as stable as actual regulated utilities.

And speaking of performance risk, it should be pointed out that management's 2017 decision to cut the firm's payout growth rate in half has persisted into 2019, despite the MLP achieving its self-funding goals early. 

While EPD seems likely to eventually accelerate its distribution growth again, it's possible that management will choose to focus on buybacks instead. That's because the multi-year MLP bear market kicked off by the first oil crash (back in 2014) has meant that faster distribution growth has not been rewarded by investors. As a result, the industry has shifted to its conservative focus on stronger balance sheets, higher (and safer) coverage ratios, and self-funded organic growth. 

Anyone owning Enterprise needs to be potentially prepared for low single-digit payout growth to continue for several more years, which is just slightly faster than inflation.

Finally, investors should note that Enterprise, as an MLP, issues K-1 tax forms instead of 1099s. Owning the stock results in somewhat greater tax complexity, including potential headaches when held in tax-deferred accounts such as IRAs or 401(k)s.

Closing Thoughts on Enterprise Products Partners
Midstream MLPs have had a rough five years as energy prices crashed twice, raising concerns about the industry's long-term growth potential and the safety of many distributions as capital costs rose sharply. 

However, Enterprise Products Partners appears to be one of the most conservative businesses an income investor can own in this space. With a long history of distribution growth, a healthy and steadily improving balance sheet, a low cost of capital, improving distribution safety, and tailwinds from U.S. shale production growth, Enterprise represents an intriguing high-yield investment opportunity.

The MLP reaching its self-funding goal a year early has also made its already safe distribution even safer, and now Enterprise will have over $2 billion per year in retained cash flow to fund its growing list of profitable growth projects. 

While it's uncertain when (or if) Enterprise will choose to return to its previous payout growth rates of 4% to 6% per year, at the very least this business appears to remain a dependable source of safe and steadily rising income.

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