Source: Enbridge Energy Partners.
It's not surprising that Wall Street hates pretty much all energy stocks right now. However, the worst oil crash in 50 years has hammered some midstream MLPs worse than others. Take, for example, Enbridge Energy Partners (NYSE: EEP), which is down 57% over the past year.
Since the best time to invest is often when Wall Street is running red with the losses of panicked investors, is now the time to buy this high-yield, beaten-down MLP? Or does the sky-high yield signal a warning to potential investors that a massive payout cut is imminent? Let's look at the three most important factors that will determine whether Enbridge Energy Partners' distribution survives and will make the difference between a great long-term deep value investment or a classic value trap.
Just how undervalued is Enbridge?
| Forward Yield | 5-Year Average Yield | Price/Operating Cash Flow | 19-Year Average Price/Operating Cash Flow |
|---|---|---|---|
| 13.7% | 7% | 5.6 | 10.7 |
Sources: Yahoo! Finance, Fastgraphs.
Enbridge Energy Partners is trading at about half its historical valuation. However, a yield this high just as likely signals an MLP in deep distress or one that the market has badly misunderstood its business model.
Payout profile initially seems OK, but ...
Over the first three quarters of 2015, Enbridge Energy Partners generated $742 million in distributable cash flow (DCF) and paid out $620 million in distributions.This gives the appearance that the current payout is sustainable and that management's 2%-5% long-term payout growth guidance seems realistic.
In addition, Enbridge Energy Partners and its general partner, Enbridge Inc. (NYSE: ENB), have a total potential growth backlog of $38 billion that could theoretically drive solid growth over many years. So obviously, Enbridge Energy Partners is mispriced and a stupendous long-term income opportunity, right? Not so fast. Because there are two big risks that investors need to consider.
Business model isn't as great as it seems
Source: Enbridge Energy Partners investor presentation.
The midstream MLP business model is predicated on long-term, mostly fee-based contracts that result in a predictable and recurring stream of cash from which to pay investors. However, as numerous midstream MLPs have shown during the oil crash, "fee-based" contracts only ensure cash flow if they're written with minimum volume or revenue clauses.
Enbridge's growing emphasis on cost-of-service contracts are by far the best component of its contract mix, since such contracts ensure both a return of, and a return on capital invested.
However, given how exposed Enbridge Energy Partners is to high-cost Canadian tar sands, it's possible that if oil prices stay low for the next year or two Enbridge could see fee-based volumes on its pipelines drop significantly and take its cash flow with it. However, the biggest potential risk for Enbridge Energy Partners' investors is that it may have to slash its payout even if its payout remains sustainable.
Ugly balance sheet is the key to understanding the market's pessimism
| Metric | Enbridge Energy Partners |
|---|---|
| Debt/EBITDA (leverage) ratio | 5.2 |
| Operating income/interest (interest coverage ratio) | 2.9 |
| WACC | 8.8% |
| ROIC | 7.7% |
Sources: Morningstar, GuruFocus.
Up to now, Enbridge has been able to sell expensive units and borrow relatively cheaply to fund most of its growth. However, with its unit price now so low, its access to equity markets is pretty much gone. And with a balanced sheet that's so highly leveraged, its borrowing costs are only likely to go up.
Indeed, Enbridge Energy Partners just announced it was refinancing some of its debt and funding some capital spending via a new $1.6 billion bond offering with respective interest rates of 4.4%, 5.9%, and 7.4% on its new five-, 10-, and 30-year bonds. Rising debt costs will only increase the MLP's weighted average cost of capital (WACC), which is already higher than its return on invested capital (ROIC).
This means that Enbridge is likely to find it harder to invest in future projects profitably and may very well make the painful but wise long-term decision to slash its distribution to pay down its debt and fund more of its capital spending internally.
Bottom line
Oil prices are notoriously unpredictable, and it's certainly possible that a quick, strong recovery in crude sends Enbridge Energy Partners' unit price soaring and reopens its access to equity markets.
However, should oil prices remain low or fall even lower over the next year or two, then it's very possible that Enbridge won't be able to access enough cheap capital to profitably build out its enormous backlog of projects, especially given its highly leveraged balance sheet. In that case, management may be forced to make the same painful decision that Kinder Morgan had to make -- slash the payout to reallocate cash flow to paying down debt and investing in future cash flow growth.
