Introduction
After seeing their massive distribution yields, it should come as no surprise that the Master Limited Partnership giants, Energy Transfer (NYSE:ET) and Enterprise Products Partners (NYSE:EPD) are favorites of income investors. Due to their operations being very similar, not only are they very comparable, but investors also gain little diversification benefit from holding units in both of them at the same time. This analysis looks at their relative valuations and, most importantly, which one gives an investor a lower risk of losing money in the long-term.
Background
If the future growth potential of each partnership were exactly the same, then the choice would be very simple as Energy Transfer offers a significantly higher distribution yield of 14.30% versus 8.81% for Enterprise Products Partners. Even though they are very similar from an operational viewpoint, their finances are not quite as similar and thus there is a higher probability of the former reducing their distributions.
Although this may not be an ideal situation for the unitholders of Energy Transfer, it still does not necessarily mean that the difference between their respective distribution yields is justified, as the graph included below displays. By extension, it also does not automatically mean that their units have a higher probability of producing negative, long-term returns.
Arguably the single most important financial aspect for these two partnerships is their leverage due to their often discussed reliance on debt to fund either growth projects or distributions, depending on differing points of view. When looking at their respective leverage, it can be seen in the graph included below that Energy Transfer is moderately more leveraged than Enterprise Products Partners, although the difference has been narrowing during recent years.
Image Source: Author
Since both partnerships seem to have their leverage improving or trending sideways, it indicates that their distributions are fundamentally sustainable during normal operating conditions. Throughout the past six months, both of them have taken steps to reduce their reliance on capital markets for funding, which further supports their sustainability even throughout these recent uncertain operating conditions. At the end of the day, I believe that both partnerships have the fundamental ability to support their distributions going forward and that any possible reductions would only prove temporary. Given that this topic has been frequently analyzed over the past year, it seems rather redundant to provide any more coverage since the purpose of this analysis is to compare their valuations.
Discounted Cash Flow Valuations
Since both of these partnerships are primary candidates for income investors, the intrinsic values were estimated by using a discounted cash flow valuation that simply replaces their free cash flow with their distribution payments. A moderate upper- and lower-end scenario was envisioned for both partnerships along with two more in-between scenarios, each of which was then run through a Monte Carlo Simulation using a wide range of 121 different cost of equity assumptions, as per the Capital Asset Pricing Model. These include expected market returns from 5% to 10% and risk-free rates from 0% to 5%, both of which using 0.5% increments. A 60M Beta of 1.27 (SA) was utilized for Energy Transfer and 0.99 (SA) for Enterprise Products Partners, with the higher Beta indicating higher systematic risk.
The four scenarios for each of the two partnerships are listed below and it can be noticed that each of the equivalent scenarios for Enterprise Products Partners are more bullish. This was done to reflect the lower risks stemming from their aforementioned lower leverage, as it provides them greater scope to support their unitholder returns no matter the operational conditions.
Energy Transfer
- Zero Perpetual Growth
- Halved For Five Years, Then Reinstated With Zero Perpetual Growth
- 25% Reduction, Then Zero Perpetual Growth
- 33% Reduction, Then Zero Perpetual Growth
Enterprise Products Partners
- 2.50% Growth For 20 Years, Then Zero Perpetual Growth
- Zero Perpetual Growth
- 10% Reduction, Then Zero Perpetual Growth
- 25% Reduction, Then Zero Perpetual Growth
The idea behind this approach was to estimate which of the two partnerships appears to have their potential returns more skewed towards the positive and thus presents the least downside risk in the long-term. The graph included below displays that Energy Transfer has their results significantly more skewed in a positive direction, with an impressive 81% of the results producing positive returns versus a still decent 68% for Enterprise Products Partners. These results indicate that there is a materially lower probability of an investor losing money with Energy Transfer units versus those of Enterprise Products Partners in the long-term, as the current valuation of the former is considerably more attractive. This is further enhanced by their average negative returns also being lower.
Image Source: Author
Discounted Cash Flow Valuations - Neutral Risk
Since they are very similar partnerships, the exact same previous analysis was conducted with only one difference, their level of systematic risk as measured by their 60M Betas, were kept equal by using their average. Since Energy Transfer has a higher Beta, this boosted their results and dragged down those of Enterprise Products Partners, which further skewed the results in a favorable direction for the former. This indicates that if an investor deems both partnerships to have broadly the same level of risk, Energy Transfer has massively less downside risk to their current valuation in the long-term, with only 9% of the results producing negative returns versus a sizeable 43% for Enterprise Products Partners.
Whilst it is debatable whether an investor should base any investment decision around a risk-neutral approach, if there was ever a situation where this was warranted, it would be when comparing these two partnerships. Due to having very similar operational aspects, their associated risks are also very similar and thus barring a specific black swan event, it could be argued that in the long-term their returns would be quite similar.
Image Source: Author
Additional Rule Of Thumb Considerations
Even though I find exploring different quantitative valuations important and quite interesting, I still believe that it can be helpful to review simple rule of thumb considerations. These are all based around their respective distributions since that has been the focus of this analysis and also continues to use the premise that Energy Transfer is more likely to reduce their distribution than Enterprise Products Partners.
The first and most simple consideration is that even if Energy Transfer reduces their distribution, due to the current large difference between their current yields, they would have to halve it before it was noticeably below that of Enterprise Products Partners. Realistically it does not seem all that likely that the former would reduce their distribution by such a significant extent whilst the latter was able to continue performing well.
This then circles around to the second consideration, even if this did eventuate and Energy Transfer took five years before reinstating their current distribution, after only two more years their total distributions would approximately equal that of Enterprise Products Partners, even if they continued growing them by 2.50% every year. This indicates that even if this actually eventuated, in the medium- to long-term, the investors who brought Energy Transfer would still see equal or more cash returned.
Conclusion
After reviewing these results it seems that investors are paying too high of a premium for the units of Enterprise Products Partners. Even though they offer better prospects for future distributions, this still indicates that it comes at the expense of a significantly higher probability of seeing negative returns in the long-term. Following this analysis, I believe that it is appropriate to maintain my very bullish rating on Energy Transfer. Meanwhile, I believe that a bullish rating is appropriate for Enterprise Products Partners, as they still seem to be a desirable income source, albeit to a lesser extent than the former.
Notes: Unless specified otherwise, all figures in this article were taken from Energy Transfer SEC filings and Enterprise Products Partners SEC filings, all calculated figures were performed by the author.
