Enterprise Products Partners: Recession-Resistant Midstream With A 6.6% Yield
Summary
- EPD generates strong free cash flow from its fee-based supply contracts with its energy partners.
- Strong distribution history and coverage ratio imply a growing unit distribution.
- The LPG business represents a growth opportunity for EPD.
- Units of EPD are possibly about fairly valued, but the strong yield is a buy.
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Units of Enterprise Products Partners (NYSE:EPD) have seen strong price appreciation in 2022. The units have gained about 30% this year, in a weak market, and units, selling at 10x EV/EBITDA, are probably already fairly valued. However, the midstream company’s strong yield and distribution coverage make units interesting regardless. Since Enterprise Products Partners covers its distribution with cash flow, distribution growth can be expected to continue!
Enterprise Products Partners: Fossil fuels will remain key to the U.S.'s energy mix
Fossil fuels will remain crucial energy sources that meet the needs of American companies and consumers in the next three decades. Although alternative, low-carbon energy sources are set to see a doubling of their representation in the energy mix by FY 2050, petroleum products are going to remain key to America’s energy security. For that reason, fossil fuel companies like Enterprise Products Partners continue to face attractive long-term growth prospects in the industry.
EIA
Diversified business with strong reliance on fees, not market prices
Enterprise Products Partners owns and operates an extensive web of pipelines in the United States that is used for the transportation of raw materials such as natural gas liquids, natural gas, crude oil, petrochemicals and refined products. Enterprise Products Partners operates a 50,000-mile long pipeline network which connects supply basins to storage and distillation facilities.
Enterprise Products Partners
Enterprise Products Partners generates the majority of its revenues and gross operating margins from its NGL pipelines and related services. In FY 2021, 50% of EPD’s gross operating margins came from NGL pipelines while Crude Oil, Natural Gas and Petrochemical/Refined Products had gross margin shares of 20%, 14% and 16%. For Enterprise Products Partners, these contributions have not changed materially in the last five years, meaning the NGL business is set to remain the most important gross margin contributor for EPD going forward. Due to the post-pandemic recovery in energy markets in 2021, Enterprise Products Partners saw a 6% increase in its total gross operating margin in FY 2021.
Gross Operating Margins by segment in millions | FY 2017 | FY 2018 | FY 2019 | FY 2020 | FY 2021 |
NGL Pipelines & Services | $3,258.3 | $3,830.7 | $4,069.8 | $4,182.4 | $4,315.9 |
Crude Oil Pipelines & Services | $987.2 | $1,511.3 | $2,087.8 | $1,997.3 | $1,679.9 |
Natural Gas Pipelines & Services | $714.5 | $891.2 | $1,062.6 | $926.6 | $1,155.5 |
Petrochemical & Refined Products Services | $714.6 | $1,057.8 | $1,069.6 | $1,081.8 | $1,357.2 |
Adjustments | $5.8 | $34.7 | ($24.10) | ($85.70) | $53.8 |
Total gross operating margin (net) | $5,680.4 | $7,325.7 | $8,265.7 | $8,102.4 | $8,562.3 |
FY 2017 | FY 2018 | FY 2019 | FY 2020 | FY 2021 | |
NGL Pipelines & Services | 57.4% | 52.3% | 49.2% | 51.6% | 50.4% |
Crude Oil Pipelines & Services | 17.4% | 20.6% | 25.3% | 24.7% | 19.6% |
Natural Gas Pipelines & Services | 12.6% | 12.2% | 12.9% | 11.4% | 13.5% |
Petrochemical & Refined Products Services | 12.6% | 14.4% | 12.9% | 13.4% | 15.9% |
(Source: Author)
Enterprise Products Partners generates the majority of its gross operating margins from fees which are set in advance and give midstream companies planning security. Fee-based contracts exist in all of EPD’s business segments with Crude Oil having the highest fee share of 100% in FY 2021. About 82% of EPD’s FY 2021 gross operating margin was contributed by fees, a percentage that only slightly decreased to 79% in Q1’22.
Enterprise Products Partners
Enterprise Products Partners generated $2.26B in gross operating margins across its business segments in Q1’22, showing a decline of 3% year over year due to weaker performance in its natural gas business.
Enterprise Products Partners
Business catalyst: LPG exports
Enterprise Products Partners has an opportunity to grow revenues and distributable cash flow through its LPG export business. The U.S. has become a serious player in the LPG export business with a 47% global market share in FY 2021. Enterprise Products Partners is one of the largest exporters of LPG: the company’s NGL exports averaged 658 MBpd last year, giving EPD a more than 30% share of all U.S. LPG exports. Going forward, growing demand for LPG, which is driven chiefly by the residential sector, creates an opportunity for EPD to grow its export business.
Enterprise Products Partners
Strong free cash flow and returns
The energy assets of EPD and the reliance on fee-based supply contracts translate to strong operating and free cash flow. In FY 2021, EPD’s free cash flow soared 136% year over year to $6.3B due to surging energy demand and strong operating performance in NGL, natural gas and petrochemicals/refined products.
$m | FY 2017 | FY 2018 | FY 2019 | FY 2020 | FY 2021 |
Adjusted EBITDA (non-GAAP) | $5,615.30 | $7,222.90 | $8,117.30 | $8,057.00 | $8,381.00 |
Interest expense | ($984.60) | ($1,096.70) | ($1,243.00) | ($1,287.40) | ($1,283.00) |
Net effect of changes in operating accounts, other (net) | $35.60 | $0.10 | ($353.80) | ($879.00) | $1,415.00 |
Net cash flows provided by operating activities (GAAP) | $4,666.30 | $6,126.30 | $6,520.50 | $5,891.50 | $8,513.00 |
Cash used in investing activities | ($3,286.10) | ($4,281.60) | ($4,575.50) | ($3,120.70) | ($2,135.00) |
Correction for noncontrolling interests | ($48.80) | $156.50 | $526.60 | ($100.40) | ($82.00) |
Free Cash Flow (non-GAAP) | $1,331.40 | $2,001.20 | $2,471.60 | $2,670.40 | $6,296.00 |
(Source: Author)
Recession-resistant capital returns
I believe EPD represents deep value during a recession, in large part because the midstream company gets paid for the transport of raw materials and depends more on fees than market prices. The dependence on fee-based supply contracts generates recession-resistant cash flows which implies that EPD could increase its distribution during the next recession.
In the last twelve months, the midstream business returned 80 percent of its adjusted free cash flow to shareholders, a total of $4.2B. Out of these $4.2B, $4.0B were paid as distributions and $200M were spent on unit buybacks. I expect EPD to continue to spend $200M annually on unit buybacks, but increase its total distribution payments. Going forward, I expect EPD to raise its distribution payments to $4.2-4.3B annually as the company has good coverage and it will want to keep raising its distribution.
Likely fairly valued
The midstream company generated $8.4B in LTM adjusted EBITDA and I estimate that EPD will generate between $8.5B to $8.6B in adjusted EBITDA in FY 2022, unless the market sees a major drop-off in energy demand.
Enterprise Products Partners has an EV/EBITDA ratio, on an adjusted basis, of 10.1x. Kinder Morgan (KMI) currently trades at an EV/EBITDA ratio of 10.6x while Energy Transfer (ET) has an EV/EBITDA ratio of 7.4x. I consider Enterprise Products Partners and Kinder Morgan to be trading at their fair values while Energy Transfer has revaluation potential!
Strong distribution growth
Enterprise Products Partners pays $1.86 per-unit annualized which calculates to a current unit yield of 6.6%. The distribution coverage ratio in Q1’22 was 1.8x, meaning the distribution is very, very safe. Additionally, Enterprise Products Partners has increased its distribution for 23 consecutive years at an average annual rate of 7%. Considering the payment history and the high degree of distribution coverage, Enterprise Products Partners will likely continue to raise its unit distribution in the future.
Risks with EPD
As the biggest risk for Enterprise Products Partners, I would name the U.S. government. The U.S. regulatory environment has changed materially in recent years which means fossil fuel producers and the companies that transport raw materials may face unfavorable legislation that could stifle their potential for expansion as well as their free cash flow prospects. A broad-based decline in the demand for energy products such as natural gas or NGL would likely result in units of Enterprise Products Partners revaluing lower.
Final thoughts
While I consider Energy Products Partners’ units to be about fairly valued after a 30% increase in pricing, the midstream company’s unit yield of 6.6% is attractive nevertheless, especially in a market that has become more unstable and volatile. LPG exports provide a growth opportunity for EPD and recession-resistant cash flows make the midstream company attractive for investors that are worried about a recession. Due to EPD's solid distribution coverage, I expect the firm to continue to raise its distribution!
This article was written by
Disclosure: I/we have a beneficial long position in the shares of EPD, KMI, ET 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.