The midstream energy space isn't exactly exciting, which is one of the big reasons why dividend-focused investors love it. That and the generally high yields, of course. Enterprise Products Partners (NYSE:EPD), a bellwether in the industry, is a favorite precisely because it is reliable, pays a fat distribution, and has a long history of rewarding investors with regular distribution increases. That said, there have been some changes going on at Enterprise that could have a big impact on the next few years. Here's what you need to know.
A great history
Enterprise has increased its distribution for 22 consecutive years. Within that streak is a run of over 60 consecutive quarterly distribution increases. The average annual increase over the past decade was roughly 5%, a couple of percentage points above the historical growth rate of inflation. That means that the buying power of Enterprise's distribution has been growing over time. Today, the master limited partnership's distribution yield is a generous 6.8%. That's over three times the dividend yield you would get from an S&P 500 index fund today.
There's a couple of key takeaways here. First, you don't get to 22 years of distribution increases by accident. Enterprise has a long history of operating conservatively and managing the ups and downs of the industry in which it operates. A key factor in that is the company's focus on fee-based assets, which make up roughly 85% of its gross operating margin. That means that demand for its services is far more important than the ups and downs of volatile energy prices. It has also been a good allocator of capital, having invested $42 billion on organic growth projects and $26 billion on acquisitions since it came public in 1998. Based on the impressive string of distribution hikes, that was money well spent.
Today, Enterprise is one of the largest and most diversified midstream players in North America. Although the partnership's size (it rings in with a $57 billion market cap) means that it needs big investments to move the needle on the top and bottom lines, its scale and reach would be difficult, if not impossible, to replicate. And it can take on projects and acquisitions that smaller peers couldn't even consider.
Now, add in the midstream giant's long history of conservative financial management. The best way to see that is to look at its balance sheet. Enterprise's debt to EBITDA is a modest 3.4 times, placing it at the low end of the industry leverage wise (which is right where it normally resides). All together, there's a huge amount to like here and no particular reason to expect any of these trends to change over the next five years. But that's not the full story.
Getting better all the time
A couple of years ago, Enterprise decided that it wanted to self-fund more of its own growth. As a partnership it historically passed most of its income on to unitholders via distributions. That meant that it had to tap the capital markets for growth funding. But every time it sells a new unit it dilutes current investors and debt wasn't the most desirable thing, given management's general aversion to leverage. So the top brass made a tough call, slow down distribution growth for a couple of years to free up cash flow.
That extra cash is being used to pay for capital investments. Enterprise currently has roughly $9 billion worth of growth projects in the works. The change here is most visible by looking at the midstream giant's distribution coverage, which had been as "low" as 1.2 times before this directional shift (that's actually considered good for a pipeline company) but was roughly 1.7 times through the first nine months of 2019 (which is exceptionally strong).
Enterprise is still working through this transition. So near-term distribution growth is likely to be in the low single digits for another year or so. But after that point, it is likely to pick back up to the mid-single digits. That's one change to look out for over the next five years. But, along with that, it should be a business that doesn't need to rely as heavily on the capital markets for growth funding. Thus, Enterprise will at some point in the next couple of years be an even better-positioned midstream player than it has historically been.
This brings up the possibility of an even bigger change. Once Enterprise is through this transition, it will have to decide if being a limited partnership still makes sense. Some of its biggest peers, notably Kinder Morgan, ONEOK, and Enbridge, chose to roll up limited partnerships they controlled and operate completely as traditional corporations. Some institutional investors are barred from owning partnerships, so making the switch would expand the pool of investors that could buy Enterprise. That, in turn, could potentially increase investor appetite for this midstream giant.
Converting from an LP to a regular company isn't a small transition and comes with notable tax consequences for investors. But once Enterprise has repositioned its business so that it can self-fund 50% of its own capital spending plans, it will be in a better position to make such a move. The robust distribution coverage it is building, meanwhile, would help protect the distribution from being lowered during such a shift. Investors would look very favorably on Enterprise if it converted to a corporation without a disbursement cut.
More of the same or something big?
The next five years, operationally speaking, are probably going to be boring here. Enterprise's conservative approach isn't likely to change and even the most conservative investors would be OK to step aboard this midstream name. However, the partnership's move to self-fund more of its growth opens up the possibility for what would be a very big shift -- going from a limited partnership to a traditional corporation. More importantly, the distribution cushion it is building suggests that such a move wouldn't come with a distribution cut, which investors would obviously hate to see.
Thus, there are two big trends here for the next five years. The first is that Enterprise will likely continue to perform as a business, reliably producing a stream of growing income. But investors should be prepared to see a giant change in the company's corporate structure. That may or may not take place, but it looks like the partnership could be gearing up to make just such a change in the next few years.