Enterprise Products Partners: More Debt Means Larger Distributions (NYSE:EPD)

Enterprise Products Partners (NYSE:EPD) announced last fall that they were going to take on debt to help take advantage of some opportunities for increased earnings growth. Mr. Market hated it, pushing down the stock price by 10%. The price has recovered lately, although some other midstream stocks have appreciated too.

Since the announcement, we’ve seen complaints in comments on articles about Enterprise. Some shareholders clearly feel damaged by this change. In contrast, my view, shared by Julian Lin, is that shareholders should be thankful.

The present article provides some discussion of the history and the implications for earnings growth of the new decision. It is intended to be complementary to Julian’s.

Enterprise Summary

Enterprise produces wonderful investor presentations, with powerful big-picture information for one thing. Every investor ought to study and think about the information they provide, about far more than midstream energy. So much of what passes for commentary on energy and related topics either ignores or conflicts with essential elements of the global context.

Those presentations also provide lots of detail about their businesses. It would take a lot of space for a summary, which I will not attempt today.

Instead here are a few bullet points that capture some important elements:

• Enterprise describes itself as a fully integrated midstream energy company.
• They earn fees delivering Natural Gas Liquids or NGLs, Crude Oil, Natural Gas, Petrochemicals, and Refined Products.
• They own 20 deepwater docks.
• They operate dozens of processing plants that convert NGLs into ethylene and propylene, the raw materials required in producing many plastics.
• In growth projects, their average return on invested capital, or ROIC, for the past decade has been 12%.
• They carry the only A-level credit rating in the midstream space.

To see what they have been up to in a global sense, we will look at their cash flows. The payout ratio (defined here as the ratio of all distributions to cash from operations adjusted to remove changes in working capital, labeled ACfO below) has come down somewhat across the last decade:

The payout ratio was above 60% and sometimes near 80% through 2018 and has been below 60% since.

Risks to Investing in Enterprise

If you consider the investor presentation linked above, and even more if you pursue some of the sources it links, it becomes clear that predictions of global peak oil are nothing but fantasies by the technically incompetent. Arjun Murti also has some great related material on substack.

But still, oil and gas are cyclical sectors, like all commodities. An extended period of sufficiently depressed prices could lead to reduced volumes through the Enterprise facilities for some years. This has happened before.

This would slow growth of ACfO and likely dividends. But based on the current state of the industry you can color me skeptical on a near-term impact.

Also unlikely but possible would be for the Duncan family and associates, who own nearly 1/3 of the shares of Enterprise, to have a massive falling out. This could lead to conversion of Enterprise from an MLP to a C-Corp, with substantial negative consequences for current shareholders.

And if you want to engage in suicidal political fantasies, the politicians could act in ways that damage the industry and impact volumes, at least for a while. The consequences would in due course drive a reversal, in my view.

For several decades by now, though, the theater surrounding oil and gas has been focused on new leases and new licenses. Stopping new leases or new licenses gets great press for the politician who wants it, and can be easily reversed too. This has been the history.

Enterprise Cash Flows

We can see in the overall cash flows that this reflects three phases of their business model:

In the years from 2012 through 2017, Enterprise was running a growth model that involved substantial capital raising. The retained cash (ACfO less distributions), shown by green bars, was well below half of their capex.

Growth was funded with newly issued stock (red bars) complemented by new debt (orange bars). These two in total were comparable to the ACfO, which in turn was comparable to capex plus acquisitions.

The business model changed after 2016, with the reduction and then elimination of share issuance, followed a few years later by initiating buybacks. Improved markets led retained cash to increase. The new debt was leverage neutral.

This was a pretty decent business model, as we will detail below. But, then in 2021, Enterprise stopped taking on new debt. This had the consequence that they were paying down debt on net. Why did this happen?

Seeking Self Protection

I rely on Michael Boyd and his Investing Group for information and analysis related to energy investments. Michael ends up in the room with Enterprise management at least a couple of times a year.

Back in the late teens and 2020, the anti-fossil-fuel advocates were making a lot of progress in their unbridled opposition to any use of fossil fuels. Some of the reasons that this is a spectacularly stupid idea are found in those Enterprise investor presentations.

Even enhanced oil recovery using captured CO2, which can lead to carbon-negative oil production, was opposed. The reason given was that fossil fuels are evil.

Enterprise became concerned about losing access to debt markets. They decided that the way to protect their shareholders was to move to a 100% self-funding model. After that decision, they took on no new debt from 2021 through 2023, as you can see in the plot above.

This led to paying down debt even while growing EBITDA, pushing Debt/EBITDA below 3.0x. This in turn led to an upgraded credit rating. These are good impacts, but it also matters what this business model does to growth.

You can see how this played out for distributions in this next plot. Distributions are shown in dark blue and the numbers give the coverage ratio.

The coverage ratio dropped from 2012 through 2017, during the difficult energy markets of that period. Then it jumped up after they quit issuing stock, even as the dividend growth rate slowed.

In 2021 Enterprise made the decision to self-fund all capex. This is shown in the inset in the figure, which is from February 2023. We will see below how much that reduced the growth of cash earnings.

But then this fall Enterprise decided to return to the debt markets. The previous label was then removed from the November version of that slide.

Levered Return on Equity

So here are the details on earnings growth. My estimate of the levered Return on Equity for the investment of such cash is summarized here, for each of the three phases identified above:

Enterprise reports unlevered “Return on Invested Capital” or ROIC, using their definition of non-GAAP Gross Operating Margin and Asset Cost. This averaged about 12% throughout, as shown in the row shaded gold.

But what we want is ACfO. I used their financials to estimate the ratio of Gross Operating Margin to ACfO at about 120%, as detailed in the rows shaded in blue. Using those results, the rows shaded green show the Return on Equity, or ROE. To two-digit accuracy, the unlevered ROE is 10% across the board here.

To find the levered ROE, we need to know the ratio of new debt to growth capex. These calculations took the maintenance capex to be 20% of depreciation, based on research by Michael Boyd.

The levered ROE varied nearly 3x across the three phases shown, thanks to the changes in the Debt Ratio. But the changes in growth of ACfO were much smaller, as we see next.

Growth from Cash Retained and Raised

This section will work through the growth produced by investing cash that was retained or raised during the three phases identified above. What cannot easily be extracted from the filings, and is not pursued further here, is the growth produced by non-cash investments such as M&A funded by issuing stock.

We will work our way through this graphic:

The rows shaded blue show inputs for this calculation, discussed above. The next two sections start with the total equity raised as a percentage of ACfO.

That total equity raised was partly from retained cash and partly from issuing stock. [Debt issued enters into levered returns here.] The rows in purple show each type of equity as a percentage of ACfO.

For the cash part, shown in rows shaded green, this percentage is multiplied by the Levered ROE to find the fractional increase in total ACfO. This is then diluted by the total increase in the shares of stock to find the fractional growth of per share ACfO, shown on the row with a red font.

The rows shaded gold show the contribution from shares issued. This has two parts. There is the diluted new ACfO from investing the cash raised, shown in the first row in a green font. This is found by multiplying the levered ROE times the equity raised as a fraction of ACfO, shown with a purple font.

But one must subtract the diluted ACfO lost on a per share basis by issuing new stock. This is the equity raised times the ACfO yield in the market, with the result shown in the second row in a green font.

Subtracting these gives the total, diluted, fractional increase in per share ACfO that results from issuing stock to raise equity. One can see this on the row in a red font on a gold background.

Adding the first two red rows gives the total, diluted, fractional increase in per share ACfO produced by the cash made available as discussed above. This moved from about 6% to 5% to 4% over time and across the three phases.

Overall Changes in ACfO

The contribution of the growth just discussed is important in the long run. But, in the short run, two other factors impact actual ACfO. One of them is volumes transported through the EPD systems. These change with time and impact total fees collected.

The second is commodity prices. Like most midstreams, Enterprise has some marketing operations whose profits rise and fall with commodity prices.

These factors had impacts. Overall, from 2012 to 2016, a bad period for oil and gas, ACfO grew with a 1% CAGR despite the 6% contribution from invested cash flows.

But then during the years of improving volumes from 2017 through 2020, the overall growth of ACfO/sh was at a CAGR of 10%. This was about twice the contribution from invested cash flows.

After the pandemic and the switch to full self-funding, from 2021 through 2023 the CAGR of ACfO was 6.4%. So then most of the increase came from invested cash flows.

But still, in the long run, the latter model might only support a 3% growth of the distributions. Returning to sustaining leverage by taking on more debt seems likely to push that up higher.

That is an important difference if you hope to gain on inflation.

Shareholders Deserve More Growth

I cheered when Enterprise revealed last fall that they were increasing growth capex and going back to the debt markets. They expanded their list for 2024 and later from 10 to 15 “major” projects, at an incremental cost of $1.5B. This takes them back nearly to the levels of growth capex from 2017-2020.

We assume here that the $2.0B of new debt taken on so far in 2024 is the total for the year, and that it pays off the ~$900M coming due first. That will leave $1.1B to support growth.

Running approximate numbers on this assumption, the growth of ACfO would be in the 7% ballpark. That is larger than was achieved in 2017 through 2020, reflecting the larger current ratio of retained cash to ACfO.

That new debt will take Debt/EBITDA back up a bit. But increased growth of ACfO will bring it back down quickly.

It would please me to see Enterprise find further projects to sustain growth capex at a level of say $4B. They have a very long history of great ROIC and excellent project execution.

Riding those coattails sounds good to me. But for now, I look forward to the next couple of years of improved cash earnings and increased shareholder returns.