Description

ENTERPRISE GP

EPE

$25.54

Market Cap: $3,555MM

INVESTMENT SUMMARY

Enterprise GP is a very well positioned company that manages a vast network of mid-stream energy assets, including pipelines and storage facilities. The majority of Enterprise GP’s assets provide natural gas and NGL (natural gas liquid) related services, and the company is structured as a Master Limited Partnership (MLP). Enterprise GP is currently trading at a 7.7% distribution yield and that yield is likely to grow in the mid-teens to twenties over the next 3-5 years. This combination of high yield and high growth will likely result in a 25-30%+ IRR over that time period with minimal risk of permanent capital loss.

While MLPs, including Enterprise GP, have been under significant pressure in the market recently, their businesses are in fact thriving due to the steadily increasing demand for energy in the U.S. and the need for increased infrastructure such as pipelines and storage facilities. The across the board MLP sell-off is largely due to trading factors, such as large MLP-dedicated funds unwinding and the unwinding of total return swaps with Lehman, Morgan Stanley and others, rather than any fundamental business performance issues.  The market dislocation provides an opportunity to purchase excellent assets such as Enterprise GP at severely depressed prices.

It is important to note that Enterprise GP’s income stream is largely fee-based, providing the company with steady cash flows. Although this is an energy-related business, Enterprise GP’s cash flows do not fluctuate materially with movements in commodity prices. Rather, the company’s cash flows are based on volumes, which are predictable and natural gas and NGL volumes, unlike gasoline, continue to be in steady demand despite the current economic malaise.

Enterprise GP owns the general partner (GP) interest in three underlying limited partners (LPs): Enterprise Products Partners (EPD), TEPPCO (TPP) and Energy Transfer (ETP). (Although Enterprise GP’s ownership structure is complex, note that Enterprise GP simply collects cash flows from its ownership interests in these three companies.) The GP/LP structure is enormously advantageous to the GP if the underlying LP is growing because, as the LP’s cash flow grows, the GP is paid a higher percentage of those cash flows without putting up any additional equity. Thus, the return on capital for the GP is enormous and the cash flow growth is 2-2.5X that of the LP. Moreover, while the LP unit price is under pressure, there is no potential equity overhang for the GP because it does not need to issue any equity for growth.

This write-up focuses on the structure and business of MLPs and their GP owners, highlights the key points explaining why midstream energy MLPs are attractively valued now, and discusses why Enterprise GP is the best risk-reward within a materially undervalued space, as well as why MLP stocks have been under extreme pressure recently despite the strong performance of the businesses.  

STRUCTURE

MLPs have an advantaged tax structure because Congress wants to incentivize more investment in U.S. energy infrastructure.  There is no corporate tax, and the distribution is largely tax deferred until the owner sells the units (at which time it is counted as ordinary income). MLPs are best held by taxable institutions because non-taxable institutions, such as foundations and endowment funds, trip Unrelated Business Taxable Income (UBTI) issues.  That said, there are ways around these tax-related hurdles, such as setting up blocker corps and executing total return swaps.

MLPs are very similar to REITs in that both must pay out most of their net income.  (Note that this leaves a great deal of discretion to MLP management teams because net income is far below distributable cash flow.)  The main distinction between MLPs and REITs is the general partner (GP) structure.  A quirk of history is that energy MLPs have a graduated “splits” scheme whereby the GP is incentivized to grow distributions by receiving a higher percentage of the MLP’s distribution as that distribution grows, typically capped out at 50% of the MLP’s distribution.  For example, Energy Transfer’s split scheme requires the MLP to pay 2%, 15%, 25% and 50% of its marginal cash flows to the GP for different levels of distributions. Thus, as the MLP’s distribution grows, the GP’s share of those distributions, which is termed incentive distribution rights (IDRs), grows dramatically.  Furthermore, as the GP’s share of the MLP’s distribution increases, the GP’s share of capital spending typically remains capped at 2%. Herein lies the true power of the GP: cash flows grow rapidly with essentially no capital required at the GP level, making the GP’s return on capital extraordinarily high.  A GP’s distribution growth rate is typically 2-2.5 times greater than their related MLP’s distribution growth rate. 

In addition to benefiting from increased distributions, the GP benefits when its underlying MLP issues equity units. For each equity unit issued by the MLP, the GP receives the IDRs for that unit. So as the MLP funds its capital investment program with equity, the GP not only benefits from the higher level of distributions, it benefits from the increased number of MLP equity units outstanding.  In essence, the GP is similar to a hedge fund’s GP that can raise assets at will.

The GP structure was originally put in place with the expectation that MLPs would have slow growth and likely never enter the high splits.  However, Rich Kinder figured out the significant value created for GP owners by growing the MLP’s distributions through an aggressive acquisition and capital spending program, and he was the first to pursue such a strategy at Kinder Morgan. Other MLPs soon followed, and the total capitalization of public MLPs is now approximately $90 billion.

BUSINESS

MLPs are in a variety of businesses within the energy space.  The best assets are predictable, steady businesses such as pipelines and storage.  There are some exploration and production (E&P) GPs, but it can be argued that there is too much variability in these businesses to make them suitable for the MLP structure. Outside E&P MLPs, most of the others do not have much direct commodity price risk.

The industry can be segmented by type of commodity: natural gas, natural gas liquids (NGLs), crude oil and refined products (e.g. gasoline and aviation fuel).  Another division is between interstate pipelines, which are usually very predictable and regulated by the federal government (Federal Energy Regulatory Commission, or FERC), and intrastate pipelines, which have somewhat more variability depending on particular fields and/or refineries and are regulated by the states (e.g. the Texas Railroad Commission).  Intrastate natural gas pipelines are seen as somewhat higher risk than other types of pipelines because they depend upon the health of the field of origin, but they also provide higher returns than the more regulated, lower growth interstate pipeline assets.

In addition to direct transportation and storage, most MLPs also engage in ancillary pursuits such as gas processing (stripping liquids out of the gas) or “splitting” natural gas liquids into commodities more in demand than others (such as ethylene and propylene).

REASONS MIDSTREAM ENERGY MLPs ARE ATTRACTIVE NOW

The midstream energy MLP sector is attractive now for several reasons:

- Demand for energy infrastructure is growing, especially in the natural gas space.  Both the sources (fields) and users (increasingly electricity plants) of natural gas are changing, requiring new pipelines.  After years of underinvestment, the U.S. needs more general energy infrastructure to support consumption growth. MLPs are the best vehicle for making these needed investments because of their tax advantages.

While the midstream energy MLP sector is attractively priced now, several of the GPs in the sector are even more attractively priced. The GPs have the same business drivers as their underlying MLPs, so the growing demand for energy infrastructure, strong drilling activity, steady cash flows and little economic sensitivity are beneficial to the GPs as well. Some of the publicly traded GPs are particularly attractive because they have sold off disproportionately to their underlying MLPs, notably Enterprise GP.  At current prices, Enterprise GP has an attractive 7.7% yield along with mid-teens to twenties distribution growth.  Thus, Enterprise GP owners get a tax advantaged 7.7% yield plus get to enjoy that distribution growth, resulting in a compound annual return of 25-30%+. 

ENTERPRISE GP

Business:

Enterprise GP (EPE) owns GP and LP interests in three well-managed midstream energy companies that have high quality, steady, fee-based assets: Enterprise Products Partners LP (EPD), TEPPCO and Energy Transfer.  The ownership structure of Enterprise GP (outlined below) is quite complex, but the important point is that Enterprise GP simply collects cash flows from its ownership interests in the three companies mentioned above: EPD, TEPPCO and Energy Transfer.  The health of Enterprise GP is directly tied to the health and growth of these three companies.

Enterprise GP has always had a significant interest in EPD through IDRs and LP units, but its ownership in TEPPCO and Energy Transfer are relatively new developments.  In May 2007, Enterprise GP completed two separate transactions that involved the purchase of equity interests in the GPs and LPs of TEPPCO and Energy Transfer. Another structural change for the Enterprise family has been the creation of Duncan Energy Partners (DEP), which took place in September 2006. Duncan Energy Partners, a subsidiary of EPD, was formed to provide an additional funding option for EPD.

Currently, Enterprise GP is the owner of the GP and 3% of LP units of EPD, the GP and 5% of the LP units of TEPPCO (TPP) and 17% of Energy Transfer’s publicly traded GP, Energy Transfer Equity (ETE).  This year, Enterprise GP’s cash flow breakdown will be approximately 55% from EPD, 23% from Energy Transfer GP and 22% from TEPPCO.

Enterprise Products Partners LP. The primary business of Enterprise GP is to manage the operations of EPD, which is a North American midstream energy company engaged in the development of pipelines, processing, marketing and storage facilities. The company's midstream energy asset network links producers of natural gas, NGLs and crude oil from supply basins in the U.S., Canada and the Gulf of Mexico with domestic consumers and international markets.

EPD operates in four segments: NGL Pipelines & Services (including natural gas processing plants and related NGL marketing activities, NGL fractionation plants, and NGL pipelines and storage), Onshore Natural Gas Pipelines & Services (including natural gas pipelines, storage facilities and marketing), Offshore Pipelines & Services (including natural gas pipelines, oil pipelines and platform services), and Petrochemical Services (including Propylene fractionation facilities, Butane isomerization facilities and Octane enhancement facilities). EPD’s gross operating margin breakdown is as follows:

Thus, the majority of EPD’s cash flows are generated by its natural gas and NGL pipelines, storage, processing and marketing assets. Over 90% of EPD’s gross operating margin is generated from diversified fee-based assets.

EPD has several competitive advantages including its lower cost of capital, due to 25% high splits as compared to the industry norm of 50%, and an integrated and large network of assets. Once a midstream operator has an established position in a given market, this position increases the likelihood and return potential of future bolt-on projects. Given EPD’s large networks of pipelines in the U.S., the company will likely be able to spend in excess of $1.5BN of growth capital over the next 3-5 years, annually. Planned capital spending that has been announced so far includes projects in the Rockies and the Barnett Shale, two of the U.S.’s most active natural gas plays. EPD’s ability to raise this capital is bolstered by its low cost of capital as well as its numerous funding options including raising hybrids and equity at the LP level, equity at DEP, and drop-downs to DEP. 

EPD has an excellent competitive position in its core businesses: natural gas and NGL pipelines, storage, processing and marketing. The company has strategically located assets serving the most prolific supply basins, including the Rockies and the Gulf Coast, and the largest consuming regions of natural gas and NGLs in the U.S.  EPD’s large geographic footprint touches approximately 92% of natural gas production and 88% of reserves in lower 48 states. Moreover, the company’s facilities handle over 10 billion cubic feet a day (Bcf/d) of natural gas, or approximately 20% of U.S. natural gas production, making Enterprise’s assets an integral part of the U.S. energy value chain.  While the breadth of Enterprise’s network is a substantial competitive advantage in-and-of itself, two of the company’s assets deserve specific mention.

Enterprise’s assets in the Rockies’ Piceance Basin are tied to large, long-life natural gas reserves, and the cost to get the gas out of these wells is relatively low compared to other supply sources in the U.S.  There has been a large commitment by the majors to increase exploration and production in the Piceance; for example, Exxon has announced that it will begin drilling 200 new wells this year to tap the estimated 35 Tcf of gas reserves in the Piceance, and this is Exxon’s only land-based drilling operation planned in North America. Enterprise’s processing, treating and gathering assets in the basin as well as its NGL pipeline in the region are wonderfully positioned assets that will likely generate stable, growing cash flows over time.

Enterprise’s Mont Belvieu facilities are the U.S. NGL hub. Many of Enterprise’s NGL pipelines feed product into the fractionation and storage facilities in Mont Belvieu for separation and ultimate consumption by petrochemical customers and motor gasoline producers. The Mont Belvieu facilities split NGLs into commodities (such as ethylene and propylene). Because of the size and market presence of Mont Belvieu, Enterprise can split NGLs into commodities that are more in demand than others. This optionality is very valuable and allows Mont Belvieu to be highly profitable in a number of difference commodity price environments.

While Enterprise’s assets in the Piceance Basin and Mont Belvieu are two of its best-positioned assets, the company overall has very well-positioned assets and its vast network is essentially impossible to replicate.

TEPPCO. TEPPCO is one of the largest pipeline common carriers of refined products and liquefied petroleum gases (LPGs) in the U.S.  The company operates in three segments: transportation, marketing and storage of refined products, LPGs and petrochemicals (Downstream Segment); gathering, transportation, marketing and storage of crude oil and distribution of lubrication oils and specialty chemicals (Upstream Segment); and gathering of natural gas, fractionation of NGLs and transportation of NGLs (Midstream Segment).  The company’s asset infrastructure provides vital gathering, storage and transportation services from key supply regions to market areas in the Gulf Coast, Midwest and Northeast U.S.  Also, TEPPCO recently acquired a marine transportation business in February 2008 from Cenac Towing. TEPPCO’s cash flows are primarily fee-based and are generated from a diverse source of assets – both by type and geography. The company’s EBITDA breakdown by product is 38% natural gas, NGLs and petrochemical; 37% refined products and LPGs; and 25% crude oil.

Part of Enterprise GP’s rationale in purchasing TEPPCO’s GP was that it has a good asset base that had not been optimally managed over recent years. Notably, TEPPCO LP’s distributions have grown at a meager 1.4% over the last 3 years. With Enterprise’s team now working with TEPPCO’s team, growth should increase, creating value for Enterprise GP unitholders. In 2008 TEPPCO plans to spend ~$1 billion of growth capital, which is more than it has spent in the last 3 years combined.  Similar to EPD, TEPPCO has 25% high splits, which lowers its cost of capital and enhances its growth prospects.

Energy Transfer. Energy Transfer is primarily engaged in the natural gas midstream transportation and storage business.  The company’s transportation and storage businesses own and operate approximately 7,500 miles of natural gas transportation pipelines, three natural gas storage facilities and six natural gas treating facilities.  The company is also a retail marketer of propane.

The company has well-positioned natural gas facilities in Texas, Louisiana, New Mexico and the Rockies. The company’s natural gas assets have a significant market presence and large network that provides marketing flexibility through its access to numerous markets and customers. The company’s propane business consists of a geographically diverse retail network in areas experiencing higher-than-average population growth. Energy Transfer plans to spend a significant amount of capital on organic growth projects over the coming years in active natural gas basins such as the Barnett and the Rockies. In 2008, Energy Transfer plans to spend approximately $1.8 billion of growth capex, up from $1 billion in 2007.  While this level of capital expenditure may not continue in the future, the company will likely grow cash flows significantly as these projects come on-line, greatly benefiting the GP. 

It is important to note that unlike with TEPPCO, the Enterprise management team does not have an active role in Energy Transfer’s operations.  In the past, the management teams of each of its operating segments have been successful in identifying and consummating strategic acquisitions that enhance its businesses. The Energy Transfer management team has substantial equity ownership and is motivated through performance-based incentive compensation programs.

Management:

Enterprise’s senior managers are excellent operators and capital allocators. The team is led by Enterprise’s founder and Chairman, Dan Duncan. Dan founded Enterprise in 1969 with a single trailer truck and $10,000. Over the last 40 years, he has amassed an incredible fortune. Today, Dan’s ownership in Enterprise GP and EPD equate to approximately $7 billion. Although Dan is 75 years old and no longer the acting CEO, he is very active in the day-to-day operations of Enterprise. He continues to put in 70+ hour weeks and has humorously said he plans “to keep doing this until they carry me out in a box.”

The team under Dan is very strong. Mike Creel, President and CEO, has over 27 years of experience in the energy industry.  Before becoming CEO in August 2007, Mike served as CFO for Enterprise LP since 2000. Given Enterprise’s breadth, size and growth of assets, services and geographic locations, a lesser CEO and management team could run into numerous operational issues. While Enterprise is not immune to occasional operational mishaps, which are inevitable in the pipeline business, Mike and his team’s response to such issues has been immediate and comprehensive.  

Randy Fowler is CFO and has been with the company since 1999. Randy has more than 25 years of finance and accounting experience in the energy industry, having worked for NorAm Energy Corp., ArkLa Exploration Company and Butler-Johnson, Inc.

Bill Ordemann is COO and has been with the company since 1999. Prior to Enterprise, Bill was a Vice President of Shell Midstream Enterprises from January 1997 to February 1998, and Vice President of Tejas Natural Gas Liquids from February 1998 to September 1999.

Jim Teague is Chief Commercial Officer who heads Enterprise’s NGLs and natural gas processing and marketing businesses. Jim has been with the company since 1999. From 1998 to 1999 he served as President of Tejas Natural Gas Liquids, then an affiliate of Shell, and from 1997 to 1998 he was President of Marketing and Trading for Mapco. From 1972 to 1996, he held a variety of positions with Dow Chemical, including Vice President, Feedstocks.

Dan, Mike and the team are focused on creating value at the Enterprise GP and LP level. 

Valuation:

Given the mid-to-high single digit distribution growth profile of EPD, TEPPCO LP and Energy Transfer LP, Enterprise GP will likely grow its distribution in the mid-teens to twenties over the next 3-5 years. Coupling this growth trajectory with the steady, diverse and predictable nature of Enterprise’s assets, it is a compelling risk/reward at current prices. Enterprise GP is currently trading at a 7.7% 2008E yield, and an investment at current prices will likely result in a 25-30%+ IRR.

RISKS / REASONS MIDSTREAM ENERGY MLP STOCKS HAVE BEEN UNDER PRESSURE

The MLP sector began to trade off in the second half of 2007 for a few reasons. One, technical factors have weighed on the sector. The MLP sector got embroiled in the quantitative hedge fund imbroglios of the summer of 2007, putting a great deal of selling pressure in an area of small trading volumes. Many MLPs executed private placements of securities that became freely tradable and led to price declines.  Second, MLPs trade relative to credit spreads, so as credit spreads have widened out, MLP yields have increased.  While the yield differential between MLPs and other high yielding securities is one factor that should be considered in MLP pricing, it should not be the primary driver. That said, it is noteworthy that the MLP spread to 10yr treasuries is at a historic high of approximately 560 basis points. 

Over the last few weeks, MLP unit prices have been under significant pressure. There are several factors pressuring the space, including fears around access to credit, increased construction costs, declining refined products volumes, value-dilutive equity issuances, and technical selling issues.

Pointing to a reason why the natural gas focused MLP units, such as Enterprise GP, have been so weak is challenging because their underlying businesses are performing very well. With the deterioration of the debt markets, some investors are worried about these companies' access to credit, although, for the most part, these companies have continued to access the debt markets at attractive rates. Right now the debt markets are closed, but that of course is not an MLP specific issue. Others point to increased construction costs (high steel costs and labor is in tight supply); yet these costs have stabilized and management teams are continuing to find value accretive organic projects and adding to their project backlogs.

Importantly, natural gas companies are benefiting from the attractive processing spread due to the favorable gas-to-crude ratio. As the natural gas / crude ratio falls (as it has been recently), the processing margin becomes even more favorable. Additionally, with natural gas prices where they are today at $7-8 per MMBTU, drilling activity is booming and the need for more natural gas and NGL infrastructure is increasing.

Given the need for additional natural gas infrastructure, Enterprise continues to identify new expansion opportunities. Enterprise GP’s underlying LPs (Enterprise Products, TEPPCO and Energy Transfer) continue to pursue expansion projects. Enterprise Products and TEPPCO recently announced a $1.8BN Texas offshore crude port, storage and transportation system, and Energy Transfer just raised its 2008 cash flow guidance in July due to continued demand for pipeline capacity in the Barnett.

Another factor impacting MLP prices is that the drop in equity prices is driving a vicious cycle: selling is leading to more selling. First, many MLPs are growing and need to access the equity markets to pursue that growth (since they pay out most of their cash flow in distributions to shareholders). With equity prices where they are today, many MLPs are trading at prices where it is actually value destructive to pursue growth (and hence issue equity). EPD, TPP and ETP have all crossed this threshold in the past week, making the equity markets closed for the time being. Second, there is a technical factor that is feeding on itself and driving stock prices lower: MLP-dedicated funds are unwinding. Since the MLP sector is an area of small trading volumes, these troubled, large MLP-dedicated funds are having a real impact on prices.

Most recently, there has been an across the board liquidation of the MLP total return swaps that were executed over the past several years.  Investors are unwinding their trades with counterparties, such as Lehman, Morgan Stanley, UBS, Citigroup and RBC, forcing the banks to sell the MLP positions they hold.  In particular, many investors who have swaps with Lehman are closing out those trades quickly.