Don't Miss This Buy Signal From Enterprise Product Partners
- Enterprise Product Partners announced a unit repurchase program that appears to have gone unnoticed by the market.
- Shares yield close to 8%.
- Insiders are buying the stock.
- Enterprise Product Partners is a conviction buy.
- Friendly reminder that the company issues a K-1 tax form.
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Enterprise Product Partners (NYSE:EPD) just can’t catch a break. The company continues to report record numbers, but shares nonetheless trade at a blistering yield near 8%. The pessimism surrounding volatility in the energy markets seems to have prevented investors from recognizing the significant policy shift in capital allocation taking place at EPD. The company’s apparent newfound appreciation for share repurchases may drive strong forward returns. I rate the shares a conviction buy.
Firing On All Cylinders
EPD is one of the largest fully integrated midstream companies in North America. In simple terms, the company makes money by using its 50,000 miles of pipelines to transport natural gas, natural gas liquids, crude oil, petrochemicals, and refined products.
(Source: 2019 December Presentation)
As we can see above, EPD is strategically located primarily in the Permian Basin, arguably the most important region for energy production in the United States. It pays to have top-tier strategic positioning.
For 2019, the company reported distributable cash flow ("DCF") of $6.6 billion, an 11% increase over 2018. This covered its distribution 1.7 times - one of the highest coverage ratios in the sector. EPD attributed much of its growth to its success in adding bolt-on projects to its integrated system backed by long-term contracts with creditworthy customers. When you’re located in a high demand region, it’s easy to keep adding to your pipelines at accretive rates.
DCF per unit grew from $2.74 to $3.01 for the full year. Free cash flow (calculated after growth investments) grew from $2.00 billion to $2.47 billion, and is now almost covering the $3.8 billion in distributions. While I’d like to say that this is a standout quarter, in reality, EPD has been reporting fabulous numbers for many years, if not decades. Strong numbers aren’t unusual for the best of breed. I’m excited about something else: EPD did disclose new guidance, which, in my opinion, could be a game changer.
Don’t Miss The Point: Buybacks Are Finally Coming
In comparison with other energy companies, EPD has a higher commitment to shareholder returns due to its high dividend yield. That said, the company is still reinvesting for growth. In 2019, EPD spent $4.3 billion on growth capital expenditures and $325 million on sustaining capital expenditures. It has another $7.7 billion in projects under way:
(Source: EPD 2019 Q4 Slides)
In all fairness, shareholders would do far worse than let EPD invest in growth projects, as the company’s high 11% ROA (based on DCF) indicates an exceptional track record of capital allocation. That said, the trend in Wall Street has been to reward energy companies that are placing greater emphasis on shareholder returns over growth reinvestment.
EPD guided for $3-4 billion of growth capital expenditures and $400 million of sustaining capital expenditures in 2020. It also guided for $2-3 billion of growth capital expenditures in 2021. These are both directionally lower than 2019. Management commented that “the lower CapEx in 2021 that we currently see would lead to higher free cash flow, which would provide the potential for us to consider larger buybacks.” (2019 Q4 Conference Call Transcript)
The big news was the company's announcement of a planned share repurchase program totaling 2% of cash flow from operations. EPD estimates that the total shareholder payout in 2020 would represent a 5.6% YOY increase (including the 2.2% distribution increase). Investors could be forgiven for growing impatient with EPD regarding buybacks. In early 2019, the company had announced a $2 billion buyback program, which had yours truly anticipating significant buybacks. Such hopes would prove disappointing, as EPD ended up mainly repurchasing shares “opportunistically.” This latest announcement suggests a greater commitment to share repurchases. Based on 2019 numbers, EPD might repurchase $130 million in units based on a 2% CFFO ratio. If the company maintains its $6.6 billion DCF run rate, then 2021 numbers look even more optimistic. EPD above guided for $3 billion in capital expenditures, of which $1.5 billion might be funded by internally generated cash flows based on their intention to fund capital expenditures with 50% debt. That would leave $1.2 billion in remaining free cash flow that could be deployed to share repurchases. If the market doesn’t reward EPD for a consistently growing distribution, then the company could “force” the issue by aggressively repurchasing shares. After valuations improve, EPD could instead choose to aggressively raise its distribution instead of buybacks. This is a great situation to be in for EPD unitholders.
Pristine Balance Sheet
EPD has share repurchase optionality due to its conservatively managed balance sheet. The company estimates its debt-to-EBITDA to be at 3.25 times or 3.5 times on a normalized basis - right square at the midpoint of its guidance range.
(Source: 2019 December Presentation)
With a BBB+ investment grade credit rating, EPD should have continued access to large sums of low-cost debt for years to come. More importantly, the company has a significant cushion to allow leverage ratios to rise in the event of any near-term volatility in the energy markets. While there are indeed cheaper midstream players in the market, I focus on names with pristine balance sheets to reduce my risk.
Deeply Discounted Valuation
Usually, high-quality companies don’t come cheap. Because EPD is in the hated energy sector, shares trade cheaply relative to their quality. It has guided for $1.805 in distributions this year. At recent prices, shares trade at a 7.5% yield. This looks too cheap in light of the company's investment grade balance sheet, significant reinvestment opportunity and high free cash flow generation.
My 12-month fair value target is $36, representing a 5% yield. I anticipate EPD to move towards this valuation on the catalysts of share repurchases and more aggressive distribution increases. In the absence of these catalysts, I do not foresee material multiple expansion, though the high 7.5% yield makes waiting worthwhile.
The volatility in energy demand as spurred by the ongoing trade war and coronavirus may lead to volatility in EPD’s results. While its customers should bear the brunt of the bottom line impact, EPD may still be negatively impacted if its customers decide to go bankrupt to get out of their long-term volume-based contracts. Investors should be prepared for short-term volatility. That said, EPD’s competitive positioning, well-covered distribution and pristine balance sheet make me confident that the company should be able to weather any short-term storm in stride.
The long-term trajectory of energy demand may not be in line with the optimistic projections provided by energy companies. Such bias can lead many energy companies to continue “throwing good money after bad” as they invest in growth projects that only pay off in the presence of high commodity prices. EPD’s high current yield and its communication of lower forward capital expenditures indicate that this is a holding which can perform strongly even if energy prices do not rebound to former highs. The same cannot be said about many other energy companies. Still, should energy prices continue to decline further, then even EPD may be negatively impacted.
EPD might not make good on its intention to repurchase stock. It has not been a serious buyer of its own stock in the past, and historically, energy companies have strongly preferred to reinvest cash flows into growth projects instead of buying back stock. Investors should carefully monitor EPD’s financial results in the next couple quarters to see if management follows through on their commitment to the buy back.
- Last thing - a friendly reminder that EPD issues a K-1 tax form. Those that do not wish to spend extra time at tax season are well-advised of this nuance regarding master limited partnerships.
Massive Insider Buying
I think EPD is very cheap. I’m not alone - insiders seem to agree with me. Consider that since December 2019, non-executive chairman Randa Duncan Williams has purchased 640,000 shares on the open market for over $16 million. CEO Teague has bought 19,700 shares for $500,380 this year. Director Brasseux bought 5,000 shares for $150,000 in August 2019. Insider buying can be a reliable indicator of share price undervaluation when there are several insiders making the purchases and the purchase sizes are significant. Insiders have made it clear: EPD is deeply undervalued.
EPD continues to benefit from its strong positioning in the Permian Basin, as evidenced by its growing cash flows. The company looks set to reward unitholders with fast-growing distributions - though it’s started this process with a unit repurchase program. EPD is seeing strong insider buying. Insiders think the stock is cheap - they’re buying the stock. The company thinks the stock is cheap - it has given a commitment to buy back the stock. I rate the shares a conviction buy.
(TipRanks: Buy EPD)
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This article was written by
Julian Lin is a top ranked financial analyst. Julian Lin runs Best Of Breed Growth Stocks, a research service uncovering high conviction ideas in the winners of tomorrow.
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Analyst’s 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.
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