Over the last few years, record low interest rates have made Master Limited Partnerships, or MLPs, one of the hottest high-yield equity classes on Wall Street.
While it’s true that this sector has its own risk factors that investors need to be aware of, certain midstream MLPs (those that operate gathering, processing, storage, and transportation infrastructure such as pipelines) can make compelling long-term, high-yield dividend growth investments.
Let’s take a look at one of the largest midstream MLPs, Enterprise Products Partners (EPD), to see if this high-yield energy stock is one of the few “sleep well at night” or SWAN names in its industry and a potential fit for our Conservative Retirees dividend portfolio.
More importantly, find out if Enterprise’s combination of world class conservative management, strong balance sheet, and solid long-term growth prospects make this a solid core holding for most diversified income portfolios, especially at today’s price.
Enterprise Products Partners is North America’s third largest midstream operator, with nearly 50,000 miles of natural gas, oil, natural gas liquid (NGL), and refined product pipelines. Enterprise also owns a number of storage facilities, processing assets, and terminals.
The company’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.
As you can see from the map below, it is tied into America’s largest and most prolific shale oil & gas formations, including 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
Natural gas liquids transportation and processing provides the majority of the MLP’s gross margins, which Enterprise is doubling down on because the shale gas boom has resulted in such an abundance of NGLs (which are used to make plastics) that there is a massive and fast growing export market for refined NGL products such as Ethylene and Propylene in Asia and Europe.
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 operator pipeline systems. Only so many pipelines are needed within a particular geographic area as well, resulting in a consolidated market.
Pipelines have few substitutes given their safety and cost-efficiency, along with geographical constraints. They also enjoy relatively stable demand patterns since most of the products that require refined oil and gas are non-discretionary in nature.
Enterprise Products Partners’ claim to fame is its unbeatable track record of stable and consistent growth through all manner of commodity/economic/interest rate environments.
That’s thanks 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).
The key to Enterprise’s success mainly has to do with its industry-leading, conservative management team.
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’s top 200 customers accounted for 95.7% of Enterprise’s 2015 revenue and 75.3% of these customers maintain an investment grade credit rating. Only 3.1% of the company’s revenue is from non-rated or sub-investment grade independent companies.
In addition, 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 growth approach.
It has chosen to retain far more distributable cash flow (over $6.2 billion since 2004), or DCF (the equivalent of free cash flow for MLPs, and what funds the distribution), which has allowed it to fund much more growth internally rather than depending on external debt and equity markets.
That in turn has meant less investor dilution and an easier time in growing its payout consistently, including its 58th consecutive quarterly increase of 5.2% year-over-year despite the worst oil crash in over 50 years. In other words, Enterprise Products Partners is effectively the dividend aristocrat of the MLP industry.
Part of the reason for this is also management’s extremely unit holder friendly, long-term focus. For example, in 2010 when its unit price was still depressed from the effects of the credit crisis, the MLP bought out its general partner’s incentive distribution rights, or IDRs, for $8 billion.
This brilliant move meant that rather than send 50% of marginal DCF to its management team (which would raise its cost of capital, and make future distribution growth more difficult), management instead ended up owning 33% of the MLP, and limited partners (retail investors) ended up with 100% of DCF and faster, more secure, and more consistent distribution growth.
Or to put it another way, management’s interests are now completely aligned with income focused investors, meaning that management only makes money as long as the payout continues growing steadily, and securely over time.
While Enterprise Products Partners may represent one of the seemingly lower risk 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. This means that, although the short-term price of Enterprise’s units, which generally trade along with oil prices, doesn’t affect its cash flow, the MLP’s ability to continue finding profitable projects to invest in and thus grow its DCF does require an eventual recovery in oil & gas prices.
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, the need for pipelines could theoretically decline