Enterprise Products: Stable share price, despite massive cash flow growth (NYSE:EPD)

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Basic thesis:

I followed Enterprise Products Partners (NYSE:EPD) for ten years. During this period, the broader oil and gas industry, still volatile, experienced major convulsions that fundamentally changed it. MLPs, generally much more stable companies than their brothers in exploration and production, have generally seen less disruption in their operations, but huge upheavals in their shareholder base. This upheaval has left many MLP stocks at significantly lower valuations despite admirable cash flow growth and improved balance sheets. EPD is the flagship child of this dynamic.

EPD gets a lot of coverage on SA. Eight articles were published this month alone. I last wrote about the company in September, where I discussed the company’s dominance in NGL fractionation and export capability. I also pointed out that at the time share prices were still 25% below their pre-Covid highs and speculated that the company was a perfect target for Warren Buffett to eliminate public unitholders and hold the company privately with the Duncans. While Buffett did not intervene, the stock appreciated about 20%. Combine that with $1.38 in distributions and the units were an excellent overall return. Yet the units still remain below their pre-Covid peak.

Although I find this ridiculous, the units have failed to return to pre-Covid levels, although many E&P companies which I follow (EQT), I talked about last yearhave appreciated considerably, the unit performance over the past five years is even more remarkable.

You can see in the chart below that EPD units have barely moved since that time in 2017.

graph of EPD unit price

EPD unit price since 2017 (Bloomberg)

The unit price does not tell everything about the evaluation, of course. Unit count increased by about 2% and debt increased by about $5 billion, plus another $800 million of preferred stock, leaving company value up about 10% since May 2017. However, cash flow has increased significantly. As you can see below, operating cash flow grew from $4.5 billion to $8.5 billion between year-end 2017 and year-end 2021. Everything importantly, the company was in the midst of a major investment cycle (the figures for May 2017 and May 2022 did not differ materially from the year-end dates). These investments are paying off, resulting in much higher EBITDA and cash flow per unit, as well as lower leverage than five years ago.

bar charts of EPD metrics

EPD cash flow and balance sheet measures (EPD Presentation)

This investment also left the company with abundant growth for the future while laying the foundation for adding capacity with a high return on capital.

graphs of permian pipe capacity

Permian oil and natural gas capacity and demand (EPD Presentation)

Growing distributions in an era of inflation:

I have written extensively on inflation over the past year. I was the first to sound the alarm when many economists and pundits called it transitional. EPD has been one of my favorite coins for what I fear will be an extended period of inflation. It has simply become much more expensive to build energy infrastructure. The cost of steel, labor, land and everything related to EPD activities is higher. Not only are some of EPD’s assets irreplaceable from a strategic perspective, but they would be much more expensive to replace due to the sheer cost of construction.

Besides replacement cost, the main virtue of the EPD for many investors is a high, growing and well-hedged distribution. The company deliberately slowed its distribution growth a few years ago so that it could finance its investment cycle internally. Now that we are past this cycle, I would either look for faster growth in this distribution, or more capital deployed for unit redemptions, or both.

bar chart of EPD distributions and coverage

Distributions and Hedging of EPD Units (EPD Presentation)

Evaluation:

As seen below, this company has steadily downgraded since late 2016.

EPD Rating Table

Valuation and multiple EPDs since 2016 (Bloomberg)

Part of this decline in valuations likely stems from volatility in the energy sector. Oil and gas prices swirled violently and the industry as a whole went through a period of about ten years in which most E&P (exploration and production) and oil services companies produced returns mediocre for shareholders. Investors are now demanding cash return rather than production growth, resulting in better balance sheets, better investment discipline and better overall returns from many industry players. As a result, shares of E&P companies performed well as oil and gas prices rose.

MLPs are a bit of a different animal. Many MLP investors were individuals seeking income. Funds struggle to own an MLP structure due to associated tax issues and K-1 status. Income-seeking investors do not expect their investments to experience great price volatility. Therefore, while EPD as (CEQP) (which I just wrote) has steadily increased its business and cash flow, stocks have been volatile. I believe this volatility has driven many individual investors away. There’s also the ESG crowd, which eschews all companies related to fossil fuels. As institutional investors did not intervene, this dynamic created a fall in the valuation multiple for DPEs and other MLPs. While this dynamic is annoying for those who already own the stock, it provides an entry point for new shareholders or for current holders who wish to add to their position. The market is a short-term voting machine and a long-term balance. As highly speculative investments like many tech companies lose their froth and likely permanently damage capital, investors could return to companies like EPD that are enjoying steady, cautious growth and increasing their distributions. I expect this company to at least regain its pre-Covid high at some point, if not regain its 2017 multiple.

Conclusion:

The energy moved from a sector that was essentially left for dead to a new lease of life. The world’s energy shortages show even the most diehard environmentalists that traditional energy is still very much needed in this world. Energy security is national security. The United States is endowed with abundant energy resources, especially natural gas and NGLs. The main need is to have enough pipes to bring these resources to market. Companies like EPD play a major role in meeting this need. The company has a massive footprint in an industry that is proving to be a major economic force in the United States. Combine these characteristics with the protection it offers in an inflationary environment, a high quality balance sheet and exceptional management and I consider EPD a must.

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