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Enterprise Products Partners L.P. (EPD)

Enterprise Products Partners is one of America's largest midstream master limited partnerships (MLPs), with 50,000 miles of natural gas, natural gas liquid (NGL), crude oil, refined products, and petrochemical pipelines. The company also owns a number of storage facilities, processing plants, and import/export terminals.

Enterprise’s network of assets helps move different types of energy and fuel from one location to another for upstream exploration and production (E&P) companies. Enterprise primarily makes most of its money from fees it charges E&P customers for its services.

Like many midstream MLPs, Enterprise began mostly as a natural gas pipeline operator. However, over the past two decades it has transformed itself into a vertically-integrated giant thanks to more than $60 billion in investments and acquisitions.

Today the company has a hand in connecting nearly every major U.S. energy producing region to end users to every variety of fossil fuel. Some of the oil & gas formations it has a presence in include the Eagle Ford (east Texas), Permian basin (west Texas), Niobrara (Colorado), and the Marcellus and Utica shale gas fields (Pennsylvania and Ohio, respectively).
Source: Enterprise Products Partners Investor Presentation
Enterprise is also one of the largest exporters of crude oil (a recent occurrence in the U.S. due to a lifting of a Congressional ban on U.S. oil exports), as well as NGL and NGL-derived products.

NGL transportation and processing provides the majority of the company’s profits. Enterprise is doubling down on this area because the shale gas boom has resulted in such an abundance of NGLs (which are used to make plastics) that there is a large and fast-growing export market for refined NGL products such as Ethylene and Propylene in Asia and Europe.
Source: Enterprise Products Partners Investor Presentation

Business Analysis

The pipeline business has a number of appealing qualities. For one thing, constructing a pipeline can cost billions of dollars and take years to complete, resulting in high barriers to entry. Few companies have the capital and industry connections (e.g. oil & gas producers, regulators) to build and operate pipeline systems, which are also highly regulated. 

Only so many pipelines are needed within a particular geographic area as well, often resulting in a consolidated market. Pipelines also have few substitutes given their safety and cost-efficiency, along with geographical constraints (many oil & gas formations are in hard-to-access areas). 

Furthermore, pipelines enjoy relatively stable demand patterns since many of the products that require refined oil and gas are non-discretionary in nature. In a way, the midstream industry is similar to utilities in that it provides an essential service for U.S. oil, gas, and NGL producers, resulting in a stable and recurring cash flow stream.

In fact, Enterprise Products Partners’ claim to fame is its unbeatable track record of stable and consistent growth through all sorts of commodity, economic, and interest rate environments.

The company has been able to pay uninterrupted distributions since going public in 1998 (including more than 60 distribution increases) largely due to its business model, which is less sensitive to oil & gas prices than one might initially think. This is because Enterprise’s cash flow is protected by long-term, fixed-fee contracts (with minimum volume guarantees) and annual rate escalators (to offset inflation).

In addition, many of its contracts guarantee a minimum gross margin, which helps to further stabilize cash flows even if energy prices collapse (as long as customers can still pay). As a result, Enterprise's cash flow has managed to remain relatively steady despite wild swings in energy prices (red line below).
Source: Enterprise Products Partners Investor Presentation
Besides the attractive characteristics of the pipeline business, a major key to Enterprise’s success is its conservatism. For example, the MLP has focused on diversifying its cash flow through enormous scale (which also helps with boost margins) and a broad range of customers. 

The company has more than 200 customers, and the majority of them maintain an investment grade credit rating. Therefore, if commodity prices were to significantly weaken, Enterprise's customers are more likely to be able to continue honoring their contracts. 

Unlike other pipeline operators such as Kinder Morgan (KMI), which went debt crazy during the boom years of 2010 through 2014 (when oil was about $100 per barrel), Enterprise’s management has always been far more conservative in its approach to growth as well.

The company has chosen to retain far more distributable cash flow, or DCF (the equivalent of free cash flow for MLPs, and what funds the distribution), which has allowed it to fund more growth internally rather than depend more on fickle debt and equity markets.
Source: Enterprise Products Partners Investor Presentation

The company's relatively lower dependence on capital markets has resulted in less investor dilution and a greater ability to grow its payout consistently over the years. Besides relying more on internal cash flow to fund growth, Enterprise has taken several other steps to lower its cost of capital. 

Most notably, Enterprise was one of the first MLPs to buy out its sponsor's incentive distribution rights, or IDRs. IDRs grant the general partner of an MLP (which manages the assets and sells its growth projects) up to 50% of all distributions above a certain hurdle rate.

IDRs result in a much higher cost of capital for the MLP and tend to slow payout growth over the long-term since up to half of an MLP's incremental DCF goes to management. Therefore, Enterprise decided to buy out its general partner's IDRs for $8 billion in 2010 when its unit price was still depressed from the effects of the credit crisis. 

Rather than send 50% of marginal DCF to its general partner (which would raise its cost of capital and make future distribution growth more difficult), this move resulted in management owning more than 30% of the MLP. Limited partners (retail investors) ended up with 100% of DCF and faster, more secure distribution growth. 

Since Enterprise went public in 1998, management has also reinvested $1.7 billion of its own money pay back into the MLP, showing a true long-term commitment to growing alongside retail investors.

Simply put, management’s interests are now completely aligned with income-focused investors, meaning that management only makes money as long as the company's payout continues growing steadily and securely over time.

The other key to Enterprise's low cost of capital is its conservative approach to debt. Since MLPs are pass-through stocks, meaning that most of their DCF is paid out as distributions, relatively little cash flow is retained for growing the business.

In both the financial crisis and 2015 (worst oil crash in over 50 years), many MLPs ended up being cut off from both debt and equity markets because investors were unwilling to lend over-leveraged partnerships even more debt when it appeared the shale oil & gas industry might go bankrupt.

This fear also meant that unit prices were too low to raise accretive equity growth capital. Many MLPs were forced to cut their payouts substantially in order to survive and redirect DCF to funding their existing growth backlogs or paying down debt to protect credit ratings.

Enterprise has always taken a conservative approach to debt, maintaining below average leverage ratios (average debt/EBITDA near 4 vs industry average of 6.5 to 8) to ensure that it has always had access to low cost debt, even during financial crises and oil crashes. 

Going forward, management has outlined an even more conservative capital allocation plan in which it will cut the growth rate of the distribution in half through 2019 (from 4.8% to 2.4%) in order to become fully self-funded for its organic growth projects, which traditionally would have been funded with a 50/50 mix of new debt and equity.

However, by 2019 Enterprise's retained DCF will be large enough to fully replace its equity portion of that funding, resulting in an even lower risk-adjusted growth profile. As a result, not only will Enterprise's future growth potential become nearly 100% independent of fickle stock market sentiment, but its overall cost of capital, already one of the lowest in the industry, should decline even more.

When combined with the company's enormous backlog of projects coming into service over the next few years, which will result in a significant rise in cash flow, Enterprise's distribution coverage ratio and balance sheet will strengthen further.
Source: Enterprise Products Partners Investor Presentation
Not only does Enterprise plan to lower its leverage ratio, but beyond 2020 it should have far more flexibility to reward investors with faster distribution growth or even buy back units if they are highly undervalued.

However, one of the main reasons to consider owning Enterprise Products Partners is for the company's long-term growth prospects. While Enterprise began with a large focus on natural gas pipelines, management has diversified the business into faster-growing areas, such as NGLs (which now account for the majority of its business) and oil exports. 

Low cost U.S. natural gas means that natural gas liquids such as ethane, butane, and pentane are much cheaper than in Europe and Asia, fueling strong export demand.

NGLs are also important feedstocks for the petrochemical industry, which uses them to make materials such as plastics. Thanks to cheap input prices, the petrochemical industry is investing more than $100 billion into new plants and facility expansions, mostly on the Gulf Coast, which is expected to generate significantly greater production, mostly for export markets.

Meanwhile, the overall midstream industry is enjoying excellent production volume growth thanks to advancements in technology, which have structurally lowered energy extraction costs in the U.S. As a result, U.S. oil and natural gas production is expected to continue rising in the years ahead, fueling continued growth in NGLs. 

Enterprise is one of the best positioned MLPs to profit from the NGL boom thanks to its massive and growing network of NGL transportation, storage, fractionation (separating NGLs from gas), and export infrastructure.

According to the International Energy Agency, rising U.S. energy production will require $700 to $900 billion in additional infrastructure investment by 2040. Therefore, even for an MLP of Enterprise's size, there is still plenty of growth to be had in the years ahead.

Key Risks

While Enterprise Products Partners may represent one of the safer midstream MLPs, there are still two main risks that investors need to be aware of.

First, the long-term growth story for Enterprise is tied to that of the U.S. shale industry. The MLP’s ability to continue finding profitable projects to invest in requires a global energy price environment that remains supportive of domestic oil & gas production growth.

Since pipelines have high fixed costs, their profitability is sensitive to the amount of fees they charge and how much product volume they are able to move. If energy production were to fall and remain depressed for a prolonged period of time, the need for pipelines could theoretically decline and dent the economics of Enterprise's growth projects.

In such a scenario, E&P customers might also be unable to honor the fees outlined in their contracts with Enterprise Products Partners and other midstream MLPs. The long-term growth rate of MLPs has come into question in recent years for some of these reasons.

Ironically enough, the problem for the U.S. energy industry is that the 2015 oil crash has forced it to become much more efficient, optimizing fracking techniques such as multiple wells per drill pad, longer horizontal laterals, multiple fracking stages, and greater use of frac sand. 

This has greatly lowered the breakeven price for various shale formations, helping producers continue increasing energy output even at low oil and gas price levels to generate additional cash flow. However, this could cap the long-term price of oil and natural gas, hurting the health of this debt-laden industry and limiting the ultimate growth potential of midstream MLPs. 

While that’s not necessarily a bad thing for Enterprise in the short to medium-term, since its assets would see growing demand, it might make it harder for oil & gas producers to find sufficient funding in coming years since banks are less likely to lend money at attractive rates if oil prices remain depressed.

Enterprise seems better positioned to handle this risk thanks to its focus on investment-grade rated customers who are more likely to be able to pay their contracts, but it’s still something to pay attention to.

Rising interest rates are another risk factor to consider. Fortunately Enterprise’s massive scale and industry-leading BBB+ credit rating mean that it isn’t likely to be priced out of the debt markets in the coming years. 

After all, the MLP has been steadily growing for more than a decade, and management has successfully navigated interest rates as high as 7%. Furthermore, almost all of Enterprise Products Partners’ debt has fixed rates.

Still, it's worth mentioning that as an MLP, Enterprise Products Partners pays out the vast majority of its cash flow as distributions and thus must periodically turn to debt and equity markets to raise growth capital.

If interest rates rise steadily over the next few years, then the massive amounts of yield-starved capital that fueled the MLP boom of the last few years could end up shrinking substantially. The end result for many operators could be higher costs of capital, as well as higher dilution, which makes future payout growth harder to achieve.

As previously discussed, Enterprise Products Partners is taking steps to fund much more of its growth internally, so rising interest rates shouldn't be a major concern for the company.

Finally, investors should note that Enterprise, as an MLP, issues K-1 tax forms instead of 1099s. Owning the stock results in greater tax complexity, including potential headaches when held in tax-deferred accounts such as IRAs or 401Ks.

Closing Thoughts on Enterprise Products Partners

Midstream MLPs have had a rough few years as energy prices steadily declined, raising concerns about the industry's long-term growth potential and the safety of many distributions as capital costs rose sharply. 

However, Enterprise Products Partners appears to be one of the most conservative businesses and income investor can own in this space. With a long history of distribution growth, a healthy balance sheet, a low cost of capital, improving distribution safety, and tailwinds from U.S. shale production growth, Enterprise represents an intriguing high-yield investment opportunity.

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