Enterprise Products Partners: The Ultimate Deal, Buy Their 8%+ Yield And Get Any Growth For Free

Summary

• Enterprise Products Partners stands out as a premium quality midstream operator with their very impressive distribution growth history that stretches back over two decades.
• Whilst they took a hit during the downturn of 2020, they are already seeing their cash flow performance recover with their operating cash flow now tracking towards a new record.
• Management has clearly indicated that their distribution growth is set to continue but interestingly, the market is not even pricing their units for their existing distributions, let alone any growth.
• This was based upon my Monte Carlo Simulations that also showed that even most distribution growth sees their intrinsic value about 40% higher.
• This gives investors the ultimate deal with prospects to generate significant alpha whilst also receiving a very desirable income, which has seen my rating upgraded to very bullish.

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Introduction

If there is one truth when it comes to investing, it would have to be that the market and can both give and take, although thankfully in the case of Enterprise Products Partners (NYSE:EPD), it appears to be the former. This gives investors the ultimate deal whereby they can buy their high 8.26% distribution yield for a great price and also get any growth for free, thereby lining up the prospects to generate significant alpha whilst also receiving a very desirable income.

Background

Whilst many in the midstream industry talk up their focus on rewarding unitholders, few can back up those words with evidence like this premium quality industry giant. Throughout the last two decades, they have consistently increased their distributions every year, as per the commentary from management included below.

"I think we've got - this is the 23 year in a row that we've increased our cash distribution. And I - there's not another midstream company out there that I know of that can say that. So distributions are really our first go-to."

- Enterprise Products Partners Q2 2021 Conference Call.

Whilst their cash flow performance took a hit during the turmoil of 2020, at least their distribution growth was not derailed with their operating cash flow of $5.892b only down by a manageable 9.65% year-on-year from their result of $6.521b during 2019. Thankfully with operating conditions recovering during the first half of 2021, they have seen their operating cash flow follow in tandem with their result of $4.017b exceeding their equivalent result of only $3.194b during 2019 by an impressive 25.77% year-on-year. If they continue generating cash at this rate then their annual result will reach approximately $8b and thus easily exceed their current high point of $6.521b during 2019.

Image Source: Author.

Their surging operating cash flow was accompanied by capital expenditure reductions to $1.303b during the first half of 2021, versus their $1.983b during the first half of 2020 and thus saw their free cash flow surge along with their distribution coverage that now sits at a strong 140.36%. This means that one way or another, their distributions will grow in the future, as was discussed in my previous article because they can either fund higher investments or higher distributions. Whilst the former option would provide more distribution growth potential in the medium to long term, they appear to be taking the latter path with their forecast growth capital expenditure for 2022 being slashed by more than half, as the slide included below displays.

Image Source: Enterprise Products Partners Second Quarter Of 2021 Results Presentation.

Even if their operating cash flow remained static year-on-year during 2022, this would see their free cash flow surge approximately $900m higher versus 2021. When combined with their existing strong distribution coverage, this helps provide ample scope for more distribution increases, which seem to be very realistic, as per the commentary from management included below.

"I mean, we take a look at the distribution every quarter. But here the last two or three years, we've done it where we've come in and really announced the increase in January for the next year. And I think we would probably stick to that."

- Enterprise Products Partners Q2 2021 Conference Call (previously linked).

When this supportive commentary from management is combined with their equally supportive and very desirable cash flow performance, it seems a foregone conclusion that their distributions will continue growing during the foreseeable future, barring a black swan event. If interested in further details regarding their healthy financial position that sports only moderate leverage and adequate liquidity, please refer to my previously linked article because they are not of high importance to this thesis and have not materially changed since publication.

Discounted Cash Flow Valuations

Since they are a Master Limited Partnership and offer a high distribution yield, it stands to reason that their intrinsic value centers upon the income that they can provide their unitholders. This means their intrinsic value can be estimated by utilizing a discounted cash flow valuation that exchanges free cash flow for their distribution payments. If interested, all of the details regarding the inputs utilized for these valuations can be found in the relevant subsequent section.

Since selecting variables for discounted cash flow valuations can be rather difficult and open to small errors as well as manipulation, Monte Carlo Simulations have been provided to illustrate how the odds are stacked in each scenario. There is never a silver bullet for ascertaining whether the intrinsic value of an investment but generally speaking, the more positive the results are skewed, the better the probability of generating alpha. When conducting the analysis an estimated target price was found through finding the point in which whereby the results were equally split between positive and negative.

Bearish Scenario

When it comes to selecting investments, I feel that the potential downside risk is equally important to the potential upside and thus a bearish scenario has firstly been provided to assess the downside risk for investors. This scenario foresees their distribution growth grinding to a halt and remaining unchanged at their current annual rate of $1.80 per unit perpetually into the future.

Following their previously discussed strong distribution coverage that should only grow stronger along with the supportive commentary from management, it would be very surprising and disappointing to see no future distribution growth. Whilst there may be other investors who would consider a distribution reduction as the bearish scenario, I feel that this would simply be too bearish in the same way that expecting decades of continuous double-digit growth is too bullish.

Despite representing a bearish scenario, it can still be seen that only 27% of their results produced an intrinsic value below their current unit price of $21.80 with a target unit price of $25.35, which is still 16.28% higher. These very impressive results indicate that the market is not even fully pricing their units for their current distributions, let alone any future growth. This allows investors to buy their existing high yield for a great price and also get any growth for free, which lines up prospects to generate significant alpha whilst lowering the medium to long term downside risk of overpaying.

Image Source: Author.

Bullish Scenario

Following the very impressive results from the previous bearish scenario, the second scenario takes a middle-of-the-road bullish path to estimate the potential upside. This sees their distribution growth continuing at a modest 2.50% per annum for the next ten years, which sits materially lower than their historical ten-year average compounded growth rate of 4.22%. After this point, it was assumed that their distributions would remain unchanged perpetually into the future to provide a margin of safety given the long-term headwinds posed by the clean energy transition. Whilst not an issue within the short to medium-term, eventually this will require investments later in the decade to navigate given their reliance upon fossil fuels and thus could see distribution growth paused.

After moving to this more realistic bullish scenario, it can now be seen that a massive 100% of the results produced an intrinsic value above their current unit price along with a target unit price of $30.90, which sits a very impressive 41.74% higher. This indicates that even if their distribution growth only continues at a modest pace, their units are significantly undervalued with the market assigning no value to their very realistic distribution growth outlook, thereby lining up prospects to generate significant alpha.

Image Source: Author.

Valuation Inputs

The Monte Carlo Simulations utilized 121 different discounted cash flow valuations, which were based upon a wide range of cost of equity assumptions with expected market returns from 5% to 10% and risk-free rates from 0% to 5%, both of which using 0.5% increments. Each of the discounted cash flow valuations utilized a cost of equity as determined by the Capital Asset Pricing Model that utilized a 60M Beta of 0.92 (SA).

Conclusion

Thanks to the market assigning no value to their very realistic distribution growth outlook, it gives investors the opportunity to simply buy their existing high yield and get any growth for free, thereby lining up the prospects to generate significant alpha with little risk of overpaying. These deals are particularly rare for a premium quality industry giant, which makes this the ultimate deal for income-seeking investors, and thus, my rating is being upgraded to very bullish.

Notes: Unless specified otherwise, all figures in this article were taken from Enterprise Products Partners' SEC filings, all calculated figures were performed by the author.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of EPD either through stock ownership, options, or other derivatives. 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.