Enterprise Products Partners (NYSE:EPD) operates in the deeply out-of-favor North American energy sector. That helps explain why the units are down roughly 40% so far in 2020, with the distribution yield spiking above 10%.
The big question for dividend investors is whether this is an opportunity to get in on the cheap, or a sign that Enterprise Products Partners is in for big trouble. Here are some key factors to consider before you pull the trigger on this high-yield stock.
1. Stuck in the middle
Enterprise Products Partners is a master limited partnership that operates in the midstream sector of the North American energy market. This is a vital piece of information to understand. It owns the pipelines, storage, transportation, and processing assets that help move oil and natural gas around. Roughly 85% of its gross margin is fee-based, with customers paying for the use of its portfolio of assets. It is not an exploration and production (E&P) company, where oil and natural gas prices dictate top- and bottom-line performance.
In other words, demand for energy is more important than the price of energy here. That helps to insulate Enterprise Products Partners from the normal ups and downs in energy prices. However, the current industry downturn is different. It has been driven by a massive collapse in demand because of global efforts to slow the spread of COVID-19.
That has had an impact on Enterprise, but not to the same degree as E&Ps. For example, Enterprise's second-quarter EBITDA fell by around 6% year-over-year, with distributable cash flow dropping roughly 8%. That's not great, but wildly better than the numbers E&P companies have put up. The business is meant to be boring, and it is performing exactly as expected.
2. The future is uncertain
That said, E&Ps have been cutting capital spending in a big way because oil prices remain painfully low, albeit above the worst levels of the year. This impacts Enterprise in a couple of ways. First, with less drilling, there's less demand for midstream capacity. That's showing up right now in Enterprise's results.
Second, with demand for midstream assets low, there's little need for new infrastructure. So Enterprise's own growth, which is driven by building and buying midstream assets, has diminished. In other words, things will remain tough until the current supply/demand imbalance is worked out and energy prices start a sustained recovery.
However, there's a longer-term issue here, as well. The world is in the middle of a shift toward cleaner energy sources, including things like solar and wind power. That suggests that the future of oil isn't quite as bright as it once was. It's hard to deny this, but major energy transitions take time. Oil, for example, took 100 years to unseat coal. So it's likely that there's plenty of time for Enterprise before its midstream business is obsolete. Still, investors stepping in here are clearly betting that oil isn't going away anytime soon, and that the current demand drop will eventually reverse.
Assuming you are OK with owning a reliable business that is facing a (likely) temporary industry downturn, there's still one more important fact to consider: Can Enterprise Products Partners survive the current headwinds? The answer is a resounding yes.
For starters, Enterprise has long operated in a conservative manner. Perhaps that shows up most notably on the balance sheet, where the partnership's leverage is, and historically has been, near the low end of its peer group. To put a number on that, Enterprise's financial debt to EBITDA ratio is a reasonable 3.7 times, which is well below those of similarly sized peers like Enbridge, Kinder Morgan, and TC Energy, which have financial debt to EBITDA ratios of roughly 7, 6, and 4.5 times, respectively.
Secondly, even with the difficult market conditions, Enterprise Products Partners was able to cover its distribution by 1.6 times in the second quarter. That leaves a lot of room for adversity before the distribution is at risk of being cut. So the fat 10% yield appears well-supported. And the partnership has an over-two-decade-long history of annual distribution increases under its belt. Management has clearly shown a strong commitment to returning value to unitholders via consistent distributions.
This too shall pass
Looking at the core of Enterprise Product Partners' business, the current headwinds it faces, and its conservative financial position, it's hard to get too worried here. Yes, the energy sector needs to muddle through the current downturn before investors start to see Enterprise in a different light and send its shares higher again. But history suggests that supply and demand will eventually balance out. If you can take the long-term view, Enterprise and its 10% yield look extremely enticing.