- Recent Barron's article has me wondering, "What would make me sell my MLP?"
- EPD trades at lowest yield and highest multiple to DCF in the face of slowing distribution growth and rising cost of capital.
- Growth story around U.S. energy independence, natural gas and pipelines, likely may not live up to lofty expectations.
I bought my first shares of the old GP units of Enterprise Products Partners in 2005 and have been steadfastly reinvesting my distributions since. Enterprise is my kind of company. It owns essential infrastructure that supports critical public services. It is far and away my largest investment. So what would make me sell my shares? Short answer: valuation. Long answer: change in business fundamentals.
Pipelines are a very reliable business. Often described as a toll road operator, they rent the use of their pipelines to oil and gas companies that need to move their product, and get paid by volume shipped. There's a lot more to it than that, like storage and hedging strategies, but that sums it up nicely for the layman's purposes. Recently, business has been good, as the U.S. has seen a large build-out in energy infrastructure, and that is expected to keep growing.
Since Richard Kinder established the first MLP, there have been cries of accounting shenanigans. A recent Barrons article recaps the most common complaints. In a previous thought exercise that I shared on SeekingAlpha, I too joined in this chorus. The bulk of the complaint centers on how MLPs differentiate between maintenance capital and expansion capital.
Pipeline MLPs are typically valued based on distributable cash flow, which is calculated as net income plus depreciation, minus maintenance expenditures. Since MLPs exclude expansion capital from the equation, they are accused of overstating their distributable cash flows. For example, in 2013, Enterprise had $3.8 billion in cash flow (net income plus non-cash depreciation) and it spent $3.4 billion in capex. Then it issued $1.8 billion in stock for expansion. So it requires debt to run the business. This issue isn't that important, as many businesses operate with debt, and people make too big a deal out of what is really a technical accounting issue.
What is an issue for investors is the growth rate of distributable cash flows. Enterprise has raised its dividend by 1 penny per share per quarter for some time now, and I expect this to continue. Based on that loose assumption, we can posit that Enterprise will pay a distribution of $2.86 per share in 2014, then $3.02 in 2015 and $3.18 in 2016, and so on. This gives us a forward growth rate of about 6% for the current year, 5.5% next year, 5.3% the year after, and continually slowing henceforth.
MLPs are first and foremost income products, at least for most investors. Let's look at the forward yield based on my loose assumption of distributions. With a stock price of $75, you're looking at a forward yield of 4% for the year 2015. With a stock price of $80, you don't achieve a yield on cost of 4% until 2016.
MLPs in general, and Enterprise is no exception, require access to capital markets to fund growth, as demonstrated by the whole maintenance versus expansion capex debate. So for a financial instrument that ultimately requires access to capital markets to fund its distribution growth, in what is certain to be a rising rate environment eventually, you are yielding no better than 4%. This is coupled with slowing distribution growth, ongoing share dilution and a shrinking spread against the "risk free" 10 year T-bill. By virtue of comparison, you could have purchased a stock with a higher yield and almost twice the expected dividend growth rate. Philip Morris (NYSE:PM) is the first one that springs to mind. Tried and true utility investments like Southern (NYSE:SO) can match that 5% growth rate with a higher initial yield.
According to Morgan Stanley, the average historical valuation for MLPs is 13 times distributable cash flow, with a standard deviation of plus or minus two. Enterprise Products has a current price to distributable cash flow of x17.8. That means that Enterprise is trading at its highest multiple to distributable cash flow at a time when its growth rate is expected to slow down.
Enterprise assumes an operating lifespan of 25 years for equipment, so each year those investment are depreciated by 1/25th. What happens if a pipe's useful life is shorter than 25 years? One research economist suggests that shale gas plays in the Eagle Ford have an expected lifespan of only 16 years, much less than the depreciation schedule of the pipeline being used to transport that gas. So potentially, some of these pipes will sit unused before their productive lives come to an end.
Unconventional gas wells have much steeper decline rates than conventional wells, with some wells only lasting 7 to 9 years. Pipelines are built to accommodate operations at full capacity, but those rates are sustainable for an even briefer time. That means that pipeline volumes will run considerably below capacity for the vast majority of that asset's expected useful life, and that revenues will drop off sharply as production rates decline after the first few years.
The widely-used analogy of pipelines being like toll roads (I used it myself in the 2nd paragraph) is applicable only up to a point. Growth in U.S. energy production is occurring unevenly, which puts older pipelines in areas where production is flat or declining at a disadvantage. In other words, MLPs are no different than the integrated energy companies that they serve. They need to fund new projects in order to offset declines in old assets, just like the oil majors need to replace reserves. To achieve growth, they have to out build that rate of decline. As the company grows, at some point the law of large numbers must come into effect.
What about that growth story? Remember President Obama's quote about a 100 year supply of natural gas and the inevitable march toward U.S. energy independence? Certainly pipeline companies have an extraordinarily long runway of growth ahead of them before any of my petty concerns would come into play.
Anyone bullish on U.S. energy independence, natural gas, and the build-out of pipelines that goes with it, ought to read this article. The Monterey shale formation just had its reserves downsized by 95%. This was supposed to be the largest reserve of shale gas in the country. If this story plays out across the country, there may be far less growth left in this industry than we were originally sold. I've already seen this movie, the one starring Eike Batista in Brazil, and I don't care to watch the American remake. We already know what happens to broken growth stocks.
Let's take a step back from all this hyperbole. I know I'm being dramatic. The U.S. gas boom isn't going to implode overnight, the interest rate isn't going to go up substantially this summer, and MLPs are still competing to build pipes out to new gas fields. MLPs could still continue to outpace the market for a few more years. I don't know, I'm simply thinking through the problem.
So back to the original question. What would make me sell my shares? Valuation and a change in business fundamentals. First, Enterprise's valuation is hitting new highs, just as the growth rate is starting to show its age. Secondly, these real asset investments aren't as long-lived as we were told, with many of the natural gas fields having productive lives less than half of comparable traditional oil fields. Third, there is reason to suspect that the runway for growth just isn't going to be as long as we are being told. Lastly, no one seems the least concerned.
Compared to when I started building my position in 2005, valuations have become meaningfully more lofty and growth prospects no longer as rosy. I don't think that I've ever seen a negative article about Enterprise on SeekingAlpha, or anywhere else. As the great Nebraskan says, "You pay a very high price in the stock market for a cheery consensus." At $75 a share and a forward yield under 4%, I'm shopping for other investment opportunities. At $80, the combination of high valuation and diminished growth justify moving capital elsewhere.
Well, assuming you can still find somewhere to move it to.
Disclosure: I am 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.