Description

Gandalf wrote-up EPD in 2019 and I think the story is worth revisiting here at a lower price after they have made it through the worst of the Covid-19 pandemic while increasing their well-covered distribution.  In a world that increasingly seems to have less attractively priced investment opportunities, an 8.4% tax-advantaged distribution that is 1.6x covered from irreplaceable assets seems attractive to me.

No one needs a reminder that energy is wildly out of favor right now.  Its weight in the S&P 500 has fallen from 12.5% a decade ago to about 2.5% today.  I don’t know about you, but I certainly don’t think energy’s value to the economy has fallen in the last 10 years.  You can’t power your Amazon servers or Tesla without energy in the background and renewables alone just can’t do the job and won’t be able to for a very long time.  You certainly can’t make all the plastic goodies we love at Wal-Mart without oil.  The midstream baby has been thrown out with the upstream bathwater.  

Gandalf’s write up gives a pretty good overview of EPD’s business, but I will give a succinct highlight of the assets here and their profit contribution.

Natural Gas Liquids (NGL) Segment - Processing Facilities (20 operated with ~11,370 MMcf/d) /Pipelines (19,891 miles)/Fractionation Facilities (9 with 1,238 MBPD)/Storage Facilities (9 facilites capacity of 178.5 MMBbls) / NG Export facilities 2 – accounts for 51% of operating income 

Crude Oil Segment – Pipelines (7 Systems 5,300 miles)/ Storage Terminals (6 terminals – 40.8 MMBbls net storage capacity)- accounts for 24% of operating income.

Natural Gas Segment – Pipelines (14 Systems 19,386 miles)/Marketing Activities - accounts for 11% of operating income

Petrochemical Segment— Primarily chemical production facilities including propylene production, butane feedstock facilities, and associated pipelines accounts for 13% of operating income.

The big take away here is that ~85% of Enterprise’s margin is fee based (not commodity price dependent).  Another 10% is differential based, and while differentials can vary from quarter to quarter, on average there is a significant differential to capture.  When the commodities go wild the differentials tend to be a source of additional income.  So, really, we are talking about 5% of the business that is subject to commodity price swings.  2020 bore this out.  Oil prices fell epically, and Enterprise’s distributable cash flow was $6.4 billion down from $6.6 billion the year before.

Are midstream companies a value trap?

If we are all going to join Will Ferrell driving GM EVs, does EPD still have a business?  

My answer to this is emphatically yes.  First, the world is moving away from fossil fuels very slowly.  I’m not alone in my views.  Even the EIA predicts petroleum and other liquids growth over the next 30 years (See: https://www.eia.gov/pressroom/presentations/AEO2021_Release_Presentation.pdf slide 9).  Exxon (https://corporate.exxonmobil.com/-/media/Global/Files/outlook-for-energy/2019-Outlook-for-Energy_v4.pdf) and the IEA (https://www.iea.org/reports/world-energy-outlook-2020) reach similar conclusions .  While gasoline use flat-lines the industrial sector continues to grow.  Even if we introduce draconian legislation in the U.S. (unlikely because it will inflict too much pain on consumers), we would probably still become a major exporter of oil and gas (like Norway) and Enterprise’s assets are well positioned to facilitate a much bigger export market with easy access to the Gulf of Mexico.  EPD exports 23% of all US crude related product exports and 44% of NGL related product exports.

Even if you assume oil as a transportation fuel is dead in the water, EPD’s business is only 25% oil related.  The rest of the business is really a natural gas business.  I don’t think even the most optimistic predictions about EVs and regulations to address climate change can significantly damage this business.  To some extent if we increase regulation and make it harder to build new pipelines, then the value of the existing ones should increase as replacement cost has gone up.

Ownership Culture at EPD

While I can’t add a lot to the simple description of the assets, I can give you some color about the company that Gandalf didn’t.  This company was founded by Dan Duncan in 1968.  The guy started with a couple trucks and $10,000.  He built big network of pipelines and took it public in 1998.  He died 2010 (https://www.nytimes.com/2010/03/31/business/31duncan.html) ironically the one year that the estate tax didn’t exist so his empire passed to his family tax free (you can’t claim he wasn’t lucky).  The company took the opportunity to merge the GP into the LP and get rid of the incentive distribution rights way before the rest of the industry started to do this.  The family has kept their money in the business.  They own 32% of the company and at times have continued to purchase more shares.  Randa Duncan Williams (daughter of Dan Duncan) is chairman of the board (she worked for the company in the mid-1990s so she really knows the business).  When Mr. Duncan exited the business, management promoted from within.  The current co-CEOs Jim Teague and Randall Fowler have been with the company since the late 1990s and they have continued to manage the company prudently since Mr. Duncan passed.  Because it is an MLP, shareholders’ ability to influence the company is more limited than usual.  But, with a whole lot of skin in the game, and a management with years of experience, I feel confident that we are in good hands. The insiders have consistently made open market acquisitions of the stock including a quite a bit in March.  

MLPs in General

MLPs are widely out of favor right now.  For many years, the name of the game was to finance growth with debt and capture big pay days for the owners (GPs) through Incentive distribution rights that I would say were a lot like a hedge fund performance fee (only even easier to get).  This time has passed.  Many MLPs have jettisoned the IDRs and are now in debt pay down mode.  MLPs have a number of downsides, including less control for shareholders than a usual company (at EPD you have to get 60% of LPs to agree to remove the GP and there is a 20% voting limit for any holder besides the Duncans so good luck with that).  They are annoying in that they are viewed as a pass-thru entity and generate K-1s for their holders.  Almost all of them are in the oil & gas space so they have that working against them.  However, they do have some advantages as well.  One big advantage is that they can pass on depreciation and amortization to their holders to offset some of the distributions they pay.  Now this works against your basis so eventually when you sell (if you sell) you pay the tax, but a lot of it is deferred significantly.  A more detailed look at how the taxes work can be found here: https://tortoiseecofin.com/media/2581/the-abcs-of-mlps_053018.pdf  Many MLPs have converted to C-corps (see Kinder Morgan), but for EPD and the Duncans a conversion would generate a lot of tax, so I don’t expect them to convert unless the tax law is changed to somehow disadvantage MLPs versus C-corps.  Pipelines are a big industry with good lobbyists, so I am not counting on a change anytime soon.

Balance Sheet

One trick with MLPs is because they grew on debt financing, they all have a lot of debt.  EPD is no exception with net debt of about $29 billion.  However, debt on stable or growing cashflows is perfectly appropriate and that absolutely seems to be the case here.  In fact, I view EPD very similarly to how Ben Graham viewed utilities in Securities Analysis.  This is essential infrastructure with primarily contracted cash flow.  So, debt seems appropriate to me.  EPD’s net debt to EBIITDA is 3.5x which doesn’t seem at all unreasonable especially given how stable cash flow ended up being through this downturn.  The debt is termed out with an average 20-year maturity, is 99% fixed interest rate, and the average interest rate is 4.4% and probably going lower as they gradually roll into today’s delightful interest rates.  The bottom-line is unlike most of the MLP sector EPD has never gorged on debt.  They’ve always used it but the didn’t abuse it like perhaps others like Energy Transfer did.  If EPD’s debt is risky someone forgot to tell the bond market because its 10-year debt yields a whopping 1.7%.  Its 30-year debt is at a whopping 3.4% yield.

Conclusion

In a market that isn’t exactly serving up big safe and liquid 8.4% yields, I’d say that is what you get with EPD.  I trust this management team to respond to market conditions and grow the business prudently where they can.  In the meantime, I expect them to pay you 8.4% tax deferred and rising.  I can think of worse things to do with my money.  Most pension plans would kill for a stable 8% return right now.  Maybe they should acquire some pipelines.

Catalyst

EPD analyst days on 02/22 (ESG day) and 02/23 (regular analyst day)

Collecting your distributions

Tailwinds as the company refinances debt at today’s low yields

Energy coming back into favor (even a little)