By Samuel Smith
We believe that midstream pipeline (many of which are master limited partnerships, or "MLPs") companies are significantly undervalued right now due to an attractive combination of poor sector sentiment, improved company fundamentals, and strong industry growth tailwinds.
In addition, many MLPs have strong distributions with yields significantly above 5%. You can see our full list of 5%+ yielding dividend stocks here.
Within the sector, there are three high-yield investments in particular that look especially attractive to us today: Enbridge (ENB), Enterprise Products Partners (EPD), and Energy Transfer (ET). This article will discuss why now is a good time to consider midstream MLPs, and why these three in particular are attractive for income investors.
MLPs are now in the midst of a strong secular growth cycle and yet trade at extremely cheap valuations. The growth runway appears to have considerable room to run as well, since the world is going to need more oil and natural gas. The International Energy Agency's World Energy Outlook 2018 posits that energy demand growth will be driven by developing economies, based on announced energy policy plans and targets.
Global energy demand is expected to grow by at least 25% through 2040, thanks in large part to the strong economic momentum in Asian economies like India and continued strong global population growth. While renewable energy and energy efficiency certainly pose a long-term threat, these estimates have already been accounted in the sector's impact quite conservatively, by cutting the projected demand in half.
Another major tailwind for North American pipeline MLPs is that the US and Canada are expected to play a major role in meeting that demand as growing players in the world market of energy production and exportation. In fact, in 2018 the US became the world's largest oil producer, adding to its decade-long reign as the world's largest natural gas producer.
Additionally, for about a week last year - for the first time in over 70 years - the US became a net exporter of crude and refined products. This shows just how far the US energy production industry has come over the past couple of decades, given that at the turn of the millennium the country was "being bled dry" by its thirst for foreign oil. Given its strong growth momentum and record-level of proven reserves, the US is expected to retain its leadership in global oil and natural gas production growth for the next several decades, with some forecasts projecting that the US will account for almost three-quarters of the total increase in global oil output and 40% of the global increase in natural gas production over the next 5-6 years.
As a result, demand for new and sustained energy infrastructure (i.e., pipelines, storage, export terminals, and processing capacity) will be strong. Connecting supply with demand is going to require significant additional investments in energy infrastructure and this is where MLPs come in the picture.
Finally, the fundamentals of these companies have never been better. After steadily growing their EBITDA over the past few years, MLPs are beginning to grow their distributions again. On top of that, many of these MLPs have spent the past two years fixing their balance sheets in order to reduce dependence on unforgiving equity markets to fund growth projects. The icing on the cake is that, as already seen in the graphs above, the market has not recognized the fundamental recovery yet in the unit prices. As a result, MLPs stand at their most attractive valuations ever thanks to their significantly de-risked business models, high yields, and strong distribution growth potential.
Enbridge is an oil & gas company that operates the following segments: Liquids Pipelines, Gas Distributions, Energy Services, Gas Transmission & Midstream, and Green Power & Transmission. The company was founded in 1949 and is headquartered in Calgary, Canada.
Enbridge reported its Q4 and FY18 earnings results on February 14th. The company generated revenues of CAD$11.6 billion during the fourth quarter, which was 10.3% less than the revenues that Enbridge has generated during the previous year's quarter. Enbridge's top line, equal to US$8.7 billion, was expected to decline year-over-year due to asset sales that Enbridge made during the past year. Despite the declining revenues, the company managed to grow its profits as well as its cash flows substantially on a year-over-year basis.
This is because Enbridge's newly built assets are higher margin than its older, non-core assets that it has been selling to finance its growth projects. More importantly, distributable cash flow grew 7% year-over-year to $0.77 per share. Enbridge has stated that it sees distributable cash flows of ~CAD/share of $4.50 during 2019 and CAD/share of $5.00 during fiscal 2020, which equates to approximately US$3.38 and $3.76, respectively. On top of that, management forecasts that its growth investments will allow for distributable cash flow growth of 5%-7% beyond 2020.
Despite Enbridge recently improving its structure (by rolling up its undervalued subsidiaries), achieving self-funding status, fortifying its balance sheet, and consistently growing its cash flows and dividend at a robust pace, shares have barely budged and remain well off of all-time highs. Meanwhile, the dividend yield is hovering near new highs as management recently raised the dividend payout by 10%.
Combining the fact that ENB owns some of North America's highest-quality and most critical energy infrastructure assets with its enormous scale, the business enjoys a wide moat from high switching costs, strong pricing power, economies of scale, and networking effects. In addition to its moat, the business is very stable and defensive thanks to the long-term (10-30+ years depending on the asset), fixed fee, take-or-pay contracts with investment grade counter-parties (every one of its contracts is with an investment grade client) supporting the vast majority (96%) of its cash flows. Amazingly, less than 1% of cash flows are directly subject to commodity price exposure.
The resilience of the business model (which has only gotten stronger in recent years) was proven during the stunning oil price crash from late 2014 through early 2016. ENB's EBITDA and DCF/share increased each quarter, enabling the company to continue raising its dividend even as the share price cratered during that period. In fact, this stable business model has enabled shareholders to enjoy 23 consecutive years of uninterrupted dividend growth at a robust CAGR of 11%, putting it on pace to become the first Dividend Aristocrat in the midstream industry. You can see the full list of Dividend Aristocrats here.
Finally, the balance sheet is also aided by the fact that - post-roll-up - it will be fully self-funding the equity portion of its growth projects and will also enjoy one of the highest coverage ratios in the industry. This large amount of retained cash flows puts less stress on the balance sheet by enabling them to deleverage more easily over time while also having the option of pausing growth to pay down debt levels if need-be without diluting shareholders.
This retained cash will be going to good use as well: The company is in the midst of bringing its massive $22 billion growth pipeline online, the majority of which will be taking place this year. Since the required capital to fund these projects to completion has already been secured, there should be no shareholder dilution, allowing the cash flows from these projects to flow straight to investors' bottom lines.
This all points to a highly compelling value proposition for shareholders: an opportunity to access high-quality low-risk assets at a steep discount (~10.8x 2019 distributable cash flow) while locking in an attractive, well-covered, and rapidly-growing dividend yield. While the uncertain future hanging over fossil fuels and current low oil price dictate that ENB trade at an ample margin of safety, the current dividend yield combined with expected slight annual multiple expansion and strong annual growth (~6% annually over the next five years) implies an annualized total return in the low teens (~12.5%) with minimal downside risk.
Of course, there are risks that investors should be aware of. While ENB's business model is very low risk and commodity price volatility will leave cash flows relatively unaffected, there are still some clear headwinds facing the company that are keeping its share price subdued. The potential for prohibitive environmental regulations could significantly dent the profitability and even viability of new pipeline projects. This could result in a subdued growth outlook for the company.
Additionally, the fact that ENB is a Canadian company and pays its dividends in Canadian Dollars does expose non-Canadians to currency-based cash flow and distribution fluctuations.
The company is also capital and construction intensive, meaning that operation execution risk is extensive. While ENB has experienced and expert personnel in each of these roles (as evidenced by their strong record of execution), these factors can often end up being beyond the company's control and can easily turn into costly nightmares, even leading to certain projects being indefinitely delayed or even abandoned. This, in turn, could lead to billions of dollars in losses.
Finally, especially for more green-friendly Canada and an increasingly liberal-leaning U.S. demography, the increasing preference for clean renewable energy over fossil fuels will lead to a plateauing and eventually declining demand for ENB's primary infrastructure. How quickly this transition and decline in the midstream industry takes place will likely significantly impact the intrinsic value of ENB's shares.
Some even forecast the global oil demand peaking as soon as 2036, and there are reasons to believe it could be even sooner thanks to heavy investments in the electrification of the transportation industry. However, the good news is that ENB is already beginning to make significant investments in offshore renewable wind facilities and will likely continue to gradually transition its portfolio increasingly towards renewable power over the coming decade.
EPD was founded in 1968 and operates as an oil and gas storage and transportation company. Enterprise Products has a tremendous asset base which consists of nearly 50,000 miles of natural gas, natural gas liquids, crude oil, and refined products pipelines. It also has storage capacity of 265 million barrels. Enterprise Products operates four business segments:
On May 1st, EPD reported Q1 FY19 financial results. Distributable cash flow jumped 18% year-over-year to a record $1.6 billion, providing 1.7x distribution coverage. EBITDA also surged by 17% to $1.63 billion. Meanwhile, gross operating margin overcame headwinds from the temporary closure of the Houston Ship Channel to gain 35% year-over-year. These strong results were largely driven by record volumes in its crude marine terminals and continued robust growth in crude volumes from the Permian Basin (expected to reach 700k bbl/day in 2019).
EPD's greatest strength is the quality and stability of its assets. They collect fees based on materials transported and stored, operating similarly to a toll road in the sense that the company generates fees based on volumes going through its pipelines and storage terminals. As a result, Enterprise Products is only modestly affected by falling oil and gas prices.
While recent volatility in oil and gas prices and distribution cuts among some of its peers has kept a tight lid on Enterprise Products' share price, the company's underlying cash flows and value creation have remained solid since it has minimal exposure to commodity prices. This aspect of its business model has fueled EPD's impressive record of 58 consecutive quarters of distribution growth, making it a highly attractive income growth stock. The company's long-term strong performance has been fueled by its unlevered return on invested capital of 12%, a very attractive figure for this industry.
EPD's recent strong growth performance is set to continue thanks to the energy production and export boom in North America and the fact that EPD is a large supply aggregator with access to domestic and international markets. EPD is ideally positioned to capitalize on this energy export boom thanks to the very strong position it has built in natural gas liquids shipping channel, fractionation, storage, and pipeline assets as well as its connection to every ethylene cracker on the Gulf Coast.
These factors provide it with tremendous opportunities for growth as evidenced by its $38 billion of organic growth projects and $26 billion of major acquisitions completed since its IPO and the $5.1 billion of growth capital projects currently under construction which are expected to come online over the next 2 years. EPD sees additional growth coming from producer-driven projects, additional gas processing plants as well as natural gas, natural gas liquids, and crude oil pipeline capacity, expanding seaway crude oil pipeline capacity, expanding LPG export capacity and the Aegis ethane pipeline, and additional marine terminal capacity and offshore crude oil ports.
Another reason we really like EPD is that, though it is an MLP, it pays out no GP IDRs and its distribution is very secure with a 1.6x distribution coverage in 2018. This large amount of retained cash enables it to self-fund the equity portion of its growth projects while also opportunistically repurchasing units at attractive valuations. As a result, EPD is able to take advantage of market volatility to enhance DCF/unit growth rather than be dependent on market conditions to fund its growth. Therefore, investors should expect these growth projects to be fully accretive to DCF/unit without fear of needing to issue units at dilutive prices in order to fund the projects. We expect EPD to grow EBITDA/unit by 4% annually over the next half decade.
In addition to boasting a top-tier asset base and an attractive self-funded growth outlook, EPD's dividend yield is very attractive at ~6.2%, making it a high-yield stock. You can view our guide list of current high-yield opportunities here. This high yield is also very resilient as evidenced by the fact that it has grown for 20 years in a row at a CAGR of 8%. As a result, with another 5 years of growth, it will follow closely behind ENB as a member of the highly respected Dividend Aristocrats.
Given our positive growth outlook for the company, EPD will very likely get there. As an illustration of the power of long-term dividend growth: investors who bought EPD units 20 years ago at its IPO are now receiving distributions at a yield on the original cost approaching 50%! Furthermore, total distributions received now stand at six times the original IPO cost of units.
The company has consistently raised its distribution by a small amount every quarter for the past 14.5 years, giving us confidence - in light of their significant growth projects underway and the positive long-term tailwinds - that management will continue to prioritize raising the distribution. As a result, we expect distributions to grow roughly in line with DCF growth over the next half decade (~4% per year). Though the low payout ratio could support faster distribution growth, management's commitment to maintaining a low leverage ratio and self-funding growth projects will preclude them from doing so.
Furthermore, management just announced a $2 billion buyback authorization. This sends two very strong messages for dividend growth investors. First, it means that EPD has plenty of surplus cash flow beyond what is needed to fund growth projects and the distribution. This signals that the distribution is very safe. Secondly, it also means that distribution growth will be easier moving forward since the lower the unit count, the fewer units there are to dilute the total distribution being paid out by the company. As a result, management will be able to afford to pay out a higher distribution per unit.
Backing both its growth and distribution is EPD's strong balance sheet. Virtually all of its debt is fixed rate, making it interest expense very easy to forecast, especially given that its average maturity now stands at nearly 20 years. Its weighted average interest rate is only 4.7% and the leverage ratio has fallen tremendously over the past 2 years, from 4.4x in 2016 to a mere 3.5x at the end of 2018. As an illustration of how highly investors view EPD, nearly 50% of its debt was issued at 30 years or more. As a result of its highly respectable balance sheet, EPD easily warrants its sector-leading Baa1/BBB+ credit rating.
Similar to ENB and the main reason why we rank it as one of our top midstream buys is that EPD's current valuation remains attractive, especially given its growth prospects and business quality. Enterprise value stands at around 15 times trailing 12-month cash from operations, which is a fair price for the growth potential and strength of the business model.
A strong indicator of value creation is the alignment of management with investors. EPD passes this test with flying colors as nearly a third (32%) of all EPD units are owned by management. With a distribution yield of ~6.2% and projected per-unit EBITDA growth of ~4% per year, this gives us expected total returns of 10.2% according to the Gordon Growth Model. However, accounting for expected ~4% annual multiple expansion (since the distribution yield is far too high given the business' historical averages, not to mention quality and growth prospects), we see total returns of around 14.2% per year over the next half decade.
EPD's risks are very similar to ENB's other than the fact that its assets are somewhat different with a different geographic focus (as already discussed). As a result, individual sector and geographic impacts may affect the two companies differently. Furthermore, EPD is U.S.-based, so it will be more impacted by American politics and policies than ENB will be. Additionally, EPD is an MLP whereas ENB is structured as a corporation. Therefore, MLP index volatility will likely impact EPD more than ENB.
The investment we find most attractive in the midstream space today is Energy Transfer. On October 19th, 2018 Energy Transfer Equity, LP (previously ETE) and Energy Transfer Partners, LP (previously ETP) announced the completion of a merger with ETE buying ETP. As part of the merger, ETE changed its name to "Energy Transfer LP" and the common units began trading under the "ET" symbol.
The combined firm owns and operates one of the largest and most diversified portfolios of energy assets in the United States with operations that include natural gas transportation and storage along with crude oil, natural gas liquids and refined product transportation and storage totaling 83,000 miles of pipelines. Energy Transfer also owns the Lake Charles LNG Company, as well as a stakes in publicly traded Sunoco LP (SUN) and USA Compression Partners (USAC).
ET reported Q1 FY19 results on May 8th. The company reported record $2.8 billion of adjusted EBITDA and $1.66 billion of distributable cash flow to partners, backed by impressive performance across all business segments. NGLs, refined products, and crude segments capitalized on high production and wide price spreads while gas pipelines continued to benefit from rising gas demand.
Management's near-term focus is continuing to deleverage while also self-funding the company's aggressive $5 billion growth CapEx plan. Results in the remainder of the year should benefit from the fact that the Lake Charles-to-St. James portion of Bayou Bridge pipeline started up on April 1.
The main reason we like ET so much right now is because it is dirt cheap, giving it a very attractive total return potential. Its EV/2019 EBITDA is the cheapest amongst its blue-chip peers:
At ~7.8x expected 2019 DCF, investors are earning ~12.8% returns on invested equity (i.e., the share price). Looking at the company's growth pipeline, it appears that it has no plans of slowing anytime soon, especially considering that it is self-funding its growth as well:
Finally, it's very safe and growing distribution of 8.2% is very attractive as well. Putting all three of these aspects together, we get 14.7% expected annual total returns over the next half decade (3.5% from expected annual margin expansion, 8.2% from the dividend, and 3% from annual DCF/unit growth).
Aside from its cheap valuation, we like ET because, while it lacks the impressive asset bases and BBB+ balance sheets of EPD and ENB, it still generates pretty stable cash flows and is backed by an investment grade credit rating while making efforts to strengthen it further. Nearly 90% of the MLP's cash flow is under long-term, commodity-resistant contracts. This proved vital during past steep oil price declines where the company's cash flows continued to flow steadily.
Furthermore, most of its contracts are volume-committed, helping to shield it from declining usage during a recession. ET also boasts geographic diversity across the country as well as economic diversification across the U.S. energy value chain (included a fully-integrated platform spanning the entire midstream value chain). In fact, ET's geographic diversification is among the best in the midstream sector as one of only three operators servicing all 15 major US oil & gas producing regions of the country.
Again, there are risks to consider. Not all of ET's assets are long-term stable cash flowers as a significant portion of its cash flows stem from businesses that may prove to be commodity sensitive over the long-term. Beyond that, ET's risks are very similar to EPD's other than the fact that its assets are somewhat different with a different geographic focus (as already discussed). As a result, individual sector and geographic impacts may affect the two companies differently.
There is growing evidence that the midstream sector's best days are yet to come, while company valuations remain pessimistic. While we are bullish on the overall sector, investors should emphasize building a portfolio with companies that have the best business models, balance sheets, and management teams to be able to sustain and grow attractive dividends over time. This is a proven way to achieve attractive returns over the long run. We believe that ENB, EPD, and ET offer the best total return potential among quality dividend growth stocks in the midstream MLP sector.
This article was written by
Disclosure: I am/we are long ET. 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.