Enterprise Products Partners (EPD 0.82%) is offering investors a huge 8.9% distribution yield today. When yields get that high, it can be an indication that investors are worried about a business' ability to survive. Such concerns, however, don't seem appropriate here. This is what you need to know about Enterprise and its fat yield so you can get comfortable bucking the Wall Street trend and putting it on your list of potential buy candidates.
A solid core
The first thing to understand about Enterprise is that it is a midstream-focused master limited partnership (MLP). MLPs come with some tax issues, and they don't play nicely with tax-advantaged retirement accounts, so they can be a bit more complex to own than regular stocks. But if you are willing to deal with the corporate structure, Enterprise's midstream business is one of the largest and most diversified in North America. In fact, it would be virtually impossible to replicate its collection of pipelines, processing plants, storage assets, and transportation facilities.
Equally important, most of Enterprise's revenue is derived from long-term fee-based contracts. Essentially, its customers pay it for the use of its midstream assets. The prices of the oil, natural gas, and refined products that flow through its system are much less important to Enterprise than the demand for these products. To put a number on that, 87% of its gross operating margin was fee-based through the first nine months of 2020, roughly in-line with historical trends. This is the business backdrop that's helped Enterprise increase its distribution annually for more than two decades.
That actually what brings us to the big concern here. After a long period of regular quarterly increases, Enterprise has chosen not to increase the distribution over the last four quarterly payments. The obvious driver of that choice was the steep drop in energy demand driven by efforts to slow the spread of the coronavirus. These two factors combined have investors worried, leaving the unit price low and the distribution yield high. That's an opportunity for more intrepid investors that are willing to dig into the numbers a bit.
It's not that bad
To get the biggest concern out of the way upfront, Enterprise was able to cover its distribution by a robust 1.7 times in the third quarter. Coverage over the first nine months of 2020 was an impressive 1.6 times. Historically, 1.2 times was considered strong coverage in the midstream sector. In other words, there's material room for adversity here before a distribution cut seems likely.
That said, Enterprise's business appears to be holding up pretty well given the circumstances. Yes, revenue was lower by around 12% year-over-year in the third quarter. But cost containment efforts and reduced interest expenses, among other things, helped to keep distributable cash flow roughly flat year-over-year in the three-month span. The world's a rough place right now, but Enterprise is muddling through just fine.
Helping that along is the partnership's historically conservative approach. The best place to see this is actually on the partnership's balance sheet. Enterprise's financial debt to EBITDA ratio was roughly 3.7 times at the end of the third quarter. That's toward the low end of the industry, which is right where the partnership usually lands. It is, basically, a rock in a storm right now, with solid finances backing a robust distribution.
The one big issue that investors really need to think about is growth, which is likely to slow materially from here. That's because this niche of the energy sector has traditionally grown by building new assets, something that isn't likely to happen while energy demand is weak. Enterprise, like its peers, has been pulling back on the capital spending front. So for now, the dividend is likely to be the major source of return for investors. However, being an industry giant with a well-positioned balance sheet, Enterprise could pivot from building assets to acquiring them with relative ease. In other words, long-term investors might still find that there's a growth component here -- it will just be lumpier and less predictable than ground-up construction.
Worth a deep dive
Dividend investors looking at the energy sector for bargains today would do well to take a close look at Enterprise Products Partners. It is definitely dealing with headwinds, but so far its well-positioned business appears to be handling them very well. In fact, despite the problems in the energy patch, this partnership is still handily covering its nearly-9% distribution yield. If you don't want to take on the risk of oil price volatility, but still want to invest in this deeply out-of-favor sector, Enterprise could be the right fit for you.