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Enterprise Products Partners: Likely To Deliver Alpha As A Result Of An Irrational Valuation

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About: Enterprise Products Partners L.P. (EPD)
by: Kody's Dividends
Kody's Dividends
Dividend investing, dividend growth investing, long-term horizon
Summary

Since I last covered Enterprise Products Partners, the stock has produced a total return of -4% while the S&P 500 has generated 11% total returns.

This would lead a rational investor to question whether Enterprise Products Partners is simply delivering poor operating results or whether the market is overreacting, and creating a long-term buying opportunity.

Given Enterprise Products Partners' continued strong operating results, I am quite confident that the latter is more likely to be in play in this situation.

This disconnect between operating results and stock price is causing Enterprise Products Partners to trade at what I believe is a 21% discount to fair value.

Between the 7.0% yield and 4-5% annual DCF growth, units of Enterprise Products Partners are likely to exceed my annual total return requirement of 10% over the next decade, without even including the annual 2.4% valuation multiple expansion that I expect.

Image Source: I Prefer Income & I Prefer Income Filter

As an investor that places an equal emphasis on owning both dividend growth and immediate income stocks, it shouldn't come as a surprise that I am constantly looking for stocks that offer a bit of growth to go along with yield.

Because I also require my investments to deliver annual total return potential of around 10% or greater, I find it helpful to use specific criteria to narrow my universe of potential stocks for further consideration.

Using the filter illustrated above where I filter for a yield greater than 6.5%, earnings growth of greater than 3%, and dividend growth of greater than 3%, I am able to narrow down midstream/MLP stocks from 66 to just 7.

Today, I'll be providing an update on Enterprise Products Partners (EPD) since I covered the company last October. I will be using Enterprise's latest financial results to reiterate the safety of the company's distribution and the growth potential of the distribution going forward. These quarterly results will also be used to analyze the strength of Enterprise's operating fundamentals, after which I'll be reexamining the risks associated with an investment in Enterprise at this juncture. Finally, I'll be revisiting Enterprise's unit price relative to its fair value to determine the extent to which units of Enterprise are undervalued.

Steady Distribution Increases And A Distribution That Remains Well-Covered

It is often said that the safest distribution or dividend is the one that has just been raised.

While this often proves to be true and Enterprise recently raised its quarterly distribution (from $0.4425/unit to $0.4450/unit) for the 62nd consecutive quarter, I find it prudent to always examine a stock's applicable payout ratios to determine whether a stock is overextending itself with too generous of increases in its dividend or distribution that may need to be eventually taken back because of missteps by management.

Given that Enterprise generated DCF of $6.6 billion in FY 2019 and retained $2.7 billion of DCF during the year (a 24% increase in retained DCF compared to 2018) as indicated in its Q4 2019 earnings release, this equates to a DCF coverage ratio of ~1.7 based on the $1.755/unit distributions paid in FY 2019.

Enterprise's retained DCF as a percent of total DCF in FY 2019 was 40.9% (compared to 38% during the period of Q3 2018 to Q2 2019 when I last covered the company), which is once again a significant increase in Enterprise's retained DCF and suggests that Enterprise's already safe distribution is continuing to shown signs of improvement in sustainability.

In looking at distribution growth for 2020, Enterprise outlined in its Q4 2019 earnings release that the company will propose to its Board of Directors a $0.0025/unit per quarter increase in the quarterly distribution, which would represent a "2.3% increase compared to aggregate distributions declared with respect to 2019."

Over the long-term, I expect Enterprise to reward unitholders with 4-5% distribution increases as the company continues to grow in size and scale and accretive projects begin to diminish.

Improving Operating Results And An Extensive Pipeline Of Projects

Image Source: Enterprise Products Partners Fourth Quarter 2019 Earnings Support Slides Presentation

As I alluded to earlier, Enterprise reported another solid quarter.

Enterprise's cash flow from operations or CFFO increased 6% from $6.1 billion in 2018 to a record $6.5 billion in 2019.

What's more, Enterprise's DCF grew 10.6% from $6.0 billion in 2018 to a record $6.6 billion in 2019. Adjusted EBITDA advanced 12.4% from $7.2 billion in 2018 to $8.1 billion in 2019.

As indicated by CEO James Teague in Enterprise's earnings press release:

We ended the decade with record performance in 2019 with all of our business segments reporting increased results, including 28 operating and financial records. Volume growth and new assets placed in service resulted in 13 operational records including 10.4 million equivalent barrels per day of total system transportation volumes, 6.7 million barrels per day of liquid transportation volumes and 1.9 million barrels per day of marine terminal export volumes. This fee-based volume growth, contributions from new and repurposed assets, combined with higher NGL, crude oil and natural gas marketing volumes and margins led to record gross operating margin of $8.3 billion for 2019, a 13 percent increase from $7.3 billion reported for 2018. Enterprise CEO James Teague

Starting with the aforementioned volume growth, Enterprise set a number of operational records on that front.

NGL, crude oil, refined products & petrochemical pipeline volumes increased 4.5% from 6.6 million BPD in 2018 to a record 6.9 million BPD in 2019.

In addition, Marine terminal volumes were boosted by 11.8% from 1.7 million BPD in 2018 to a record 1.9 million BPD in 2019.

NGL fractionation volumes surged 16.7% from 940 MBPD in 2018 to a record 1,097 MBPD in 2019.

Fee-based natural gas processing volumes managed to increase 6% from 5.0 Bcf/day in 2018 to a record 5.3 Bcf/day in 2019.

Equity NGL production volumes advanced 10.2% from 147 MBPD in 2018 to a record 162 MBPD in 2019.

The first of two exceptions where volumes decreased was in natural gas pipeline volumes, which decreased 2.1% from 14.1 TBtu/day in 2018 to 13.8 TBtu/day in 2019.

The second exception was in Propylene plant production volumes, which decreased 12.7% from the 102 MBPD produced in 2018 to 89 MBPD produced in 2019.

Enterprise also placed $5.4 billion of capital projects into service during 2019, which helped the company to produce record volumes throughout most of its business, and overall.

One final item worthy of discussing is that Enterprise was able to deliver such impressive financial results while also managing to increase its fee-based gross operating margin or GOM by 14% to $7.1 billion in 2019, which is significant given that fee-based GOM accounted for 86% of Enterprise's revenue in 2019.

This directly insulates Enterprise from volatility in commodity prices, which ensures that the company's financial results generally hold up well in times of volatility where commodity prices are concerned (though, Enterprise still assumes indirect risk should its customers face a liquidity crisis in the midst of low commodity prices as I'll discuss later).

Image Source: Enterprise Products Partners Fourth Quarter 2019 Earnings Support Slides Presentation

As I had indicated earlier, Enterprise was able to complete $5.4 billion of projects (of which, all major projects were completed on time and on budget as indicated by CEO James Teague in the earnings conference call).

Fortunately, Enterprise also continues to allocate a substantial amount of resources to future capital projects to generate growth going forward. To that point, Enterprise invested $1.2 billion in capital projects in Q4 2019 ($1.1 billion in growth capital and $93 million in sustaining capital expenditures), and a total of $4.7 billion in 2019 ($4.3 billion in growth capital investments or $3.7 billion after subtracting contributions from joint venture partners, and $400 million in capex).

Enterprise expects to complete $3.2 billion in capital projects in 2020, with $2.5 billion of the company's 2020 in-service projects being completed in the back half of the year.

I believe these growth projects in 2020, along with the $4.6 billion that are expected to come into service in 2021-2023 will continue to drive volume growth and GOM growth over the next few years.

Finally, Enterprise expects to allocate about 2% of its likely $7.0 billion in CFFO in 2020 to unit buybacks.

Given that I agree that units of Enterprise are substantially undervalued, spending ~$140 million on opportunistic unit buybacks in 2020 is another great way to reward unitholders with excess cash flow.

When I take into consideration Enterprise's improving operating fundamentals, the nearly $8 billion in growth capital projects in progress, and the company's wise allocation of capital to unit buybacks, I believe that Enterprise could prove to be a great long-term investment at the right price.

Risks To Consider

While Enterprise is a high-quality company, that doesn't mean the company doesn't face its share of regulatory/political, operational, and economic risks.

Given that page 82 of Enterprise's most recent 10-Q makes no reference to additional risks that have developed since its most recent 10-K, I'll be revisiting a few of the key risks discussed in my previous article on Enterprise.

While 86% of Enterprise's revenue in 2019 was fee-based and that shields Enterprise from fluctuations in commodity prices to some extent, the company is still indirectly exposed to commodity risk because its customers need energy prices to remain stable in order to pay Enterprise and remain solvent in the future.

If the energy industry endures another bear market similar to the severity of the 2014-2016 energy bear market, this could force many smaller and less integrated E&P companies out of business and result in Enterprise experiencing difficulties in collecting what bankrupt E&P customers owe them.

Enterprise would also face the more immediate task of needing to find customers to replace the lost revenue as a result of bankrupt customers, which could ultimately prove to be difficult if the larger and more integrated companies like Exxon Mobil (XOM) and Chevron (CVX) don't step in to ramp up production in a down cycle and meet the demand of consumers across the country and the globe.

Fortunately, about 80% of Enterprise's customers are investment grade, which does add a level of certainty that many of Enterprise's customers could endure another energy prices decline on the scale of 2014-2016.

Another key facing Enterprise is that as a company operating primarily in the midstream energy industry, the company's fortunes largely hinge on continued demand for oil and natural gas products (page 38 of Enterprise's most recent 10-K).

Should developed economies across the globe continue to make significant strides in gradually replacing fossil fuels with cleaner alternatives, this could lead to an eventual and gradual decline in demand for oil and natural gas 10-15 years from now.

When this does eventually occur, it would lead to reduced demand for Enterprise's energy infrastructure and an abundance of energy infrastructure, leading to increased competition to retain customers (page 39 of Enterprise's most recent 10-K).

This has the potential to reduce margins for Enterprise as the company would likely be forced to lower the rates on contracts and maybe even accept less lengthy and less steady, predictable terms on its contracts going forward. Should this occur, Enterprise's financial results may be adversely impacted.

One final risk that I had discussed previously in an article on Energy Transfer back in November, was potential resistance from environmental activists, which Enterprise also makes mention of on page 43 of its most recent 10-K.

Without going into too much detail about the difficulties of getting massive pipeline projects approved, one only has to look at a project such as EQM Midstream's (EQM) Mountain Valley Pipeline to be warned of the consequences that environmental opposition can have on a midstream company.

Last October, EQM Midstream's MVP was delayed once again and EQM indicated that it expects the MVP to be complete in late 2020 at a total cost of $5.3-$5.5 billion, which is a stark contrast to the initial in-service date of late 2018 and $3.5 billion initial cost estimate in February 2018.

EQM's difficulty in getting MVP in service has greatly impacted its distribution and the growth prospects of the distribution. What was once a regularly growing distribution has now become a frozen distribution as EQM's growth prospects are mostly hampered until MVP comes online.

Though Enterprise was able to complete all of its major capital projects on time and on budget that were brought online in 2019, in a polarizing political environmental such as the current political environment, Enterprise could just as easily become a victim of the political environment and find it difficult to make progress on major projects as they get hung up in long and drawn out court battles.

Although I believe I have discussed a few of the most notable risks associated with an investment in Enterprise, I haven't discussed all of the risks facing Enterprise for the sake of conciseness. For a more complete discussion of the risks pertaining to an investment in Enterprise, I would refer interested readers to pages 38-58 of the company's most recent 10-K and the Risks To Consider section of my previous article on Enterprise.

A Best Of Breed Operating In A Deeply Despised Industry Leads To A Depressed Valuation

Based upon my analysis above, I believe that Enterprise is truly a best of breed within its industry. However, that doesn't mean that an investor can pay any price for an investment in the company and expect to do well. It is precisely for this reason that I will be using a couple of valuation metrics and a valuation model to arrive at a fair value for units of Enterprise.

Image Source: I Prefer Income

The first valuation metric that I will be using to determine the fair value of units of Enterprise is the yield to historical yield.

Enterprise's current forward yield of 6.98% is almost 22% above its historical yield of 5.73%.

Given that Enterprise's operating fundamentals appear to be as strong as they have ever been, I believe a reversion to a yield of 5.75% and a fair value of $30.96/unit is a realistic assumption.

This would imply that units of Enterprise are trading at a 17.6% discount to fair value and offer 21.4% upside from the current price of $25.50 a unit (as of February 9, 2020).

The next valuation metric that I'll be utilizing to arrive at a fair value for units of Enterprise is the historical price to EBITDA.

As illustrated by the image above, Enterprise's price to EBITDA is significantly below its historical price to EBITDA.

Assuming a reversion in Enterprise's price to EBITDA to its historical price to EBITDA and a fair value of $33.71 a unit, Enterprise is priced at a 24.4% discount to fair value and offers 32.2% of capital appreciation from the current price.

Image Source: Investopedia

The valuation model that I will be using to assign a fair value to units of Enterprise is the dividend discount model or DDM.

The first input into the DDM is the expected dividend/distribution per share/unit, which is another term for a stock's annualized distribution per unit. In the case of Enterprise, that amount is currently $1.78.

The next input into the DDM is the cost of capital equity, which is the rate of return that an investor requires on their investments. Although this can vary quite a bit from one investor to another, I require a 10% rate of return on my investments because I believe this amply rewards me for the time and effort that I dedicate to researching and monitoring investments.

The final input into the DDM is the long-term distribution growth rate or long-term DGR.

While the first two inputs into the DDM are relatively simple for an investor to plug into the DDM, the long-term DGR is arguably the most difficult input.

This is because in order to accurately assign a fair value to a stock, one must take into consideration numerous variables, such as a stock's payout ratio (and whether the payout ratio is likely to expand, contract, or remain the same over the long-term), long-term earnings growth rate, industry fundamentals, and the strength of the stock's balance sheet.

When I consider Enterprise's manageable payout ratio, its stable operating fundamentals, and strong balance sheet, I believe my previous long-term DGR assumption of 4.5% remains intact.

Upon plugging the inputs above into the DDM, I compute a fair value of $32.36 a unit.

This indicates that units of Enterprise are trading at a 21.2% discount to fair value and offer 26.9% upside from the current price.

When I average the three fair values together, I arrive at a fair value of $32.34 a unit, which means that units of Enterprise are priced at a 21.2% discount to fair value and offer 26.8% of capital appreciation from the current price.

Summary: Thank The Irrational Market For A High Yield And Attractive Total Return Opportunity

Enterprise has produced 62 consecutive quarterly distribution increases and I believe this is just the beginning of Enterprise's quarterly distribution increase streak.

Enterprise delivered strong operating results in 2019, with DCF growing 10.6% compared to 2018. And for those that believe Enterprise isn't capable of delivering similarly strong results in the future, one only has to take a further look at Enterprise's pipeline of projects to come to the realization that Enterprise is positioned to continue delivering growth in every important metric in the years ahead.

Investors that are looking for a great buying opportunity in a best of breed company within a despised industry should further consider Enterprise because it is trading at a 21% discount to fair value according to valuation metrics sourced from I Prefer Income and the dividend discount model or DDM.

Between the 7.0% yield and 4-5% annual DCF growth, units of Enterprise Products Partners are likely to exceed my annual total return requirement of 10% over the next decade, without even including the annual 2.4% valuation multiple expansion that I expect.

It is for the aforementioned reasons that Enterprise comprises 3.3% of my portfolio in terms of weighting and contributes to 5.3% of my portfolio's annual forward dividend/distribution income.

Disclosure: I am/we are long EPD, CVX, EQM, XOM, 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.