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Enterprise Products Partners And Our Barbell Early Retirement Portfolios (NYSE:EPD)

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Thesis and Background

As my wife and I are reviewing our accounts to prepare for an early retirement, an idea like Enterprise Products Partners (NYSE:EPD) really sparked our interest.

First, a bit of background of our overall strategy. As detailed in our earlier article, contrary to the popular advice of building “a” retirement portfolio or “the” perfect retirement portfolio, we always hold two portfolios. And we suggest you do the same at any stage of life. Build two portfolios in a so-called barbell fashion – one for short-term survival (e.g., a visit to the ER next month) and one for long-term growth (e.g., take care of things when we are 90 years old and estate planning for kids and grandkids). Long-term and short-term risks are never the same and delineating them is the first step of diversification.

Under this general background, we are intrigued by some of the pipeline businesses such as EPD for our short-term portfolio. We just analyzed Energy Transfer (ET) yesterday and argued why it can help hedge unfolding uncertainties like the Russian geopolitical situation, Fed rate decision, and inflation. These same arguments apply to EPD too. This article carries the analysis further to examine EPD’s capital structure, profitability, and price appreciation potential. And you will see that:

  • The stock is supported by a stable capital structure
  • Its profitability enjoys competitive margins that are well above the cost of capital in the long term
  • And at the same time, a sizable capital appreciation is very likely in the near term too given the current margin of safety.

Stable and Strong Capital Structure

The following table shows the capital structure of the stock in recent years. First, let’s address the elephant in the room for many investors – debt. Its debt has increased by almost 2x in the past decade, from about $14.7B in 2012 to the current level of $28.5B. However, the issue needs to be put into perspective. First, the cost of the debt has been steadily decreasing over the past decade, thanks to the secular decline of the interest rate and EPD’s credit rating. Its borrowing rates decreased from about 5.3% in 2012 to the current 4.5%, a 15% decrease. Secondly, as can be seen, its capital structure has actually been quite stable and consistent in terms of equity/EV ratio and debt/EV ratios. The surge of debt/EV ratio in 2021 was only due to the artificially depressed stock price during the COVID pandemic.

EPD capital structure

Author and Seeking Alpha

Low Cost of Capital and High Profitability

This section evaluates its profitability by comparing its cost of capital to its return on capital.

This analysis uses the Weighted Average Cost of Capital (“WACC”) to evaluate its cost of capital. The WACC is calculated as:

WACC = portion of equity * cost of equity + portion of debt * cost of debt * (1- tax rate)

We already have all the inputs above for the WACC calculation from the capital structure evaluation. So the next chart directly shows the WACC results. Note that the cost of equity is calculated using the Capital Asset Pricing Model (“CAPM”), considering the volatility of the stock (the beta) and the risk-free return (the 10-year treasury bond yield).

As seen, the cost of equity for EPD has been quite stable around 8.6% in the past decade, in line with the typical range of 8-10% used in practice. And finally, EPD’s cost of capital has been quite stable in the range from 8.3% to 8.8%, with an average of only 8.6%.

EPD WACC

Author based on Seeking Alpha data

The next chart also compares the WACC against its return on equity (“ROE” or Return on Partner’s Capital) for EPD. As seen, its ROE has been systematically higher than WACC with a healthy margin. EPD’s ROE has been on average 10.0%, substantially and consistently higher than the average WACC of 8.6%. WACC is the hurdle rate of return, or the minimum required return, that a business needs to make to overcome the cost of the capital. And this comparison shows that the business can sustainably earn a healthy return on capital raised.

EPD ROCE

Author based on Seeking Alpha data

Valuation and Expected Return

Here, I will use the discounted dividend model (“DDM”) given EPD’s stable dividends. In the DDM model, the fair value of a business is the summation of all its future dividend payments discounted to their present value. And this analysis uses the WACC as the discount rate because WACC is the minimum required return that a business needs to make to overcome the cost of capital. Therefore, it is the minimum rate that future earnings should be discounted.

With the above understanding, the DDM calculations for EPD are shown below. These calculations considered different combinations of WACC and terminal dividend growth rate (“DGR”). Because as we have seen above, the WACC did and will fluctuate in a certain range. Many factors could cause such fluctuation such as interest rate and the capital structure of the EPD. Therefore, it makes sense to explore a range of possibilities. These calculations also considered a range of terminal dividend growth rates, ranging from 1.5% to 6.0%. These are the growth rates that a business can perpetually maintain and usually are in the mid- to lower-single digit range. To put things into perspective, EPD has been growing its dividend at a 5.0% CAGR in the past ten years and at a 4.0% CAGR in the past five years.

The color in the background shows the possibility of each combination. The darker the background color, the more probable the scenario is expected to materialize. And as can be seen, the most probable scenarios are those in the middle highlighted with red.

With the above valuation, the marking of safety and expected return can be projected. And the projections are summarized in the next chart in this section.

  • As a base case, I expect the fair value to be about $40. The base case considers an average WACC and an average growth rate. Even in this case, the current price represents a margin of safety of about 70%.
  • The bull case considers a lucky combination of a higher growth rate and a lower cost of capital. The fair value in this case will be about $50. In this case, investment at the current price features a considerable margin of safety of 113%, and the five-year annual return is estimated to be a whopping 16.3%.
  • The bear case represents an unlucky combination of a higher cost of capital and a lower growth rate. And even in this case, investment at the current price has a sizable margin of safety, about 36%. And the 5 years projected return is projected to be a decent 6.4%.

EPD projected returns

Author based on Seeking Alpha data

EPD returns

Author based on Seeking Alpha data

Risks

  • Interest rate risk. As aforementioned, EPD carries a relatively high debt load and is therefore somewhat sensitive to interest rate change. EPD’s current long-term debt is about $28B. Hence, a 1% increase in its interest rate would translate into $280M of additional interest expenses. Its net income is about $4800M in 2021. Therefore, the additional interest expenses are about 5.8% of its income, a non-negligible risk.
  • Short-term volatility. The current energy supply disruptions and geopolitical tensions in Europe, particularly in Ukraine, may disrupt the global financial markets in the short term. However, In the long term, my view is that such disruptions are irrelevant to EPD because its assets are all in the U.S. And such disruptions could even prove to be favorable for EPD in the long term just as we argued for ET. Such disruptions could cause international demand for U.S. crude oil, natural gas, and NGLs to strengthen.

Conclusion and Final Thoughts

EPD is appealing as a candidate for retirement accounts seeking current income and short-term appreciation potential, for several good reasons:

  1. Its current yield spread relative to the risk-free Treasury rate is near the widest end of the historical spectrum. Particularly, as of this writing, the yield spread is about 6%. It can help hedge unfolding uncertainties like the Russian geopolitical situation, Fed rate decision, and inflation.
  2. Its profitability enjoys competitive margins that are well above the cost of capital in the long term. Its ROE (or Return on Partner’s Capital) has been systematically higher than WACC with a healthy margin (average 10.0% ROE vs average WACC of 8.6%).
  3. And at the same time, a sizable capital appreciation is very likely in the near term too given the current margin of safety.

https://seekingalpha.com/article/4489475-enterprise-products-partners-epd-barbell-early-retirement-portfolios