Introduction
Historically, dividend stocks have been a great place to be, mainly because of their ability to distribute consistently rising dividends, making them stand out in a world of companies that struggle to do the same.
Unfortunately, the past four years have been tough on dividend stocks. Using the Vanguard High Dividend Yield ETF (VYM) as a proxy for dividend stocks, we see the ETF has underperformed the S&P 500 since 2018/2019.
After the pandemic, dividend stocks made a big comeback. Unfortunately, this resulted in a new decline in the VYM/S&P 500 ratio, this time even steeper than the one we saw during the pandemic.
Dividend stocks have faced a number of headwinds:
- The market rushed into AI-related investments when ChatGPT and similar applications showed the potential of this emerging technology.
- Economic growth in certain areas, including consumer discretionaries and manufacturing, has come down substantially, making fast-growing tech stocks even more attractive.
- Due to higher rates, dividend stocks got competition, allowing investors to buy higher income with lower risk.
As we can see below, last year, the “long bond” started to yield almost 4%. Dividend stocks, in general, could not compete with that. On top of that, money market funds yielded more than 5%, allowing investors to park their money in safe spots with even higher income.
Now, this may come to an end!
Although markets often change their mind, they are now expecting two 25-basis rate cuts this year – with a 60% probability for a third cut.
This move was backed by weaker-than-expected macroeconomic numbers and record demand for federal funds contracts. I added emphasis to the quote below:
Softer-than-expected employment and inflation data for June had already been fueling expectations for rate cuts. As of Friday, December contracts whose settlement value is based on the Fed’s policy rate was about 4.71%, pricing about 62 basis points of easing — two quarter-point cuts and almost half of a third one.
[…] Contributing to the repricing was persistent demand for October federal funds futures contracts. Volume in the contract reached a record level on Thursday and has remained elevated. Several block trades in the contract have been done at prices that assume a quarter-point rate cut — if not a half-point cut — when Fed policymakers meet in September. – Bloomberg
Although many factors are at play here, I believe that a path to lower rates could trigger a significant shift of capital from high-yielding bonds to alternatives.
This move could be enormous, as Americans have put more than $6 trillion in money market funds. That’s up from less than $3 trillion before the pandemic.
According to The Wall Street Journal, this is what JPMorgan (JPM) calls the “cash trap,” as lower rates could trigger a wave of money that needs to find a new home – preferably in high-yielding alternatives.
That’s where Enterprise Products Partners (NYSE:EPD) comes in, a stock I called a “Dividend Hero” in the title of my most recent article on April 2.
In this article, I’ll update my thesis and explain why EPD is likely to be a major winner when the “cash trap” starts to unwind.
So, let’s dive into the details!
EPD Is Where Safety And Income Meet
Before the pandemic, midstream companies, in general, did not do well. Most were dealing with very expensive infrastructure projects, negative free cash flow, high capital requirements, and headwinds from two major oil price declines in 2014/2015 and 2020.
Although midstream companies are not dependent on the prices of the commodities that flow through their systems, it caused investors to fear lower domestic production due to subdued prices.
“Luckily,” none of this materialized.
- Demand for fossil fuels is at record levels and is expected to rise for many decades.
- Major midstream projects are now completed, lowering capital requirements and boosting operating cash flow.
- Midstream companies, in general, have started to shift their focus from capital projects to cash returns.
If we get a path to lower rates, I expect the market to recognize these qualities, potentially making midstream companies one of the most desirable places to put one’s money.
What’s interesting about EPD isn’t necessarily its growth potential. There are midstream companies with more aggressive growth and lower valuations.
EPD has always been the place to be for safety, income, and no-stress wealth creation.
Founded in 1998, EPD has grown its distribution for 25 consecutive years, including the Dot-com bubble, the Great Financial Crisis, the 2014/2015 commodity crash, and the pandemic.
Even better, as we can see above, the company’s distribution coverage has significantly improved in recent years.
After hiking its distribution by 1.9% on July 11, it currently pays $0.525 per unit per quarter, which translates to a yield of exactly 7.0%.
This distribution, which has a five-year CAGR of 3.2%, is protected by a capital return ratio (as a percentage of operating cash flow) in the mid-50% range. It also has a distributable cash flow coverage ratio of 1.7x, as we can see in the chart above.
It’s also protected by a healthy leverage ratio of 3.0x EBITDA, which comes with a credit rating of A and $4.5 billion in liquidity.
In fact, when looking at the data below, EPD scores extremely high when compared based on credit ratings, leverage (balance sheet health), distribution/dividend yield, payout ratio, and return on equity.
What matters is that while EPD is not a fast-growing company, it has the perfect asset base and investment plans to capitalize on what should be a long period of rising demand for energy infrastructure.
As we can see above, even in the IEA WEO 2023 report, coal is the only commodity expected to decline through 2050. EPD has no exposure to coal.
The Expanding Empire
Enterprise Products Partners is so large that it’s almost a proxy for energy volumes in the United States – both domestic and export.
The company owns more than 50 thousand miles of pipelines, more than 300 million barrels of storage, 20 deepwater docks, 42 natural gas processing trains, and other assets – most of its assets are located in the South, servicing the mighty Permian Basin and the export-focused Gulf Coast.
Given the rising demand and supply of fossil fuels and value-added products, EPD is in a great spot to generate rising unitholder value.
For example, in the first quarter, the company reported $2.5 billion in gross income, a 7% year-over-year increase.
This growth was driven by new assets placed into service and a significant 17% increase in net marine terminal volumes.
Moreover, strong demand for U.S. energy and higher sales volumes in the Octane Enhancement business further contributed to this performance.
In order to prepare for higher demand in the future, the company started operations of its Leonidas and Mentone 3 plants in the Permian Basin, each with the capacity to process more than 300 million cubic feet of natural gas per day and extract over 40 thousand barrels of natural gas liquids (“NGL”) on a daily basis.
Even better, with three additional 300 million cubic feet per day plants under construction in the Delaware Basin and one in the Midland Basin (both are part of the Permian), EPD is in a great spot to significantly increase its processing capabilities.
According to the company, the completion of these projects will bring the total number of Permian processing plants to 19, capable of producing 675 thousand barrels of NGLs per day.
Furthermore, as I already briefly mentioned, EPD is an export giant benefitting from America’s increasing importance in global energy exports. As we can see below, waterborne exports of LPG in the U.S. have risen from 2 million barrels per day to more than 4.5 million barrels per day over the span of just ten years.
Enterprise Products Partners exports roughly 70 million barrels of liquids per month. The company has initiatives to increase this number to 100 million barrels per month, excluding potential contributions from its SPOT project.
Valuation
Valuation-wise, EPD remains highly attractive. Trading at a blended P/OCF (operating cash flow) ratio of just 8.2x, it trades a few points below its long-term normalized P/OCF ratio of 10.5x.
Moreover, using the FactSet data in the chart below, analysts expect 3-10% annual per-unit OCF growth through 2026, paving the way for a fair price of $41, using a 10x OCF multiple – that’s 37% above the current price.
As such, I believe EPD remains a super attractive company that has a lot of room to run, especially if rates come down, causing a wave of money to look for a new home in high-quality, high-yield investments.
The only reason why neither I nor any family members EPD is because it’s hard to invest in MLPs as non-Americans.
Takeaway
Dividend stocks have been in a tough space over the past few years, underperforming the S&P 500 due to a range of economic headwinds and rising competition from high-yield bonds and money market funds.
However, with the potential for rate cuts on the horizon, there could be a significant shift in capital back into high-yield alternatives.
Enterprise Products Partners, with its massive asset base, consistent distribution growth, and strong financial health, is poised to be a major beneficiary.
The company offers a compelling combination of safety and income, making it a prime candidate for investors looking to capitalize on the anticipated “cash trap” unwinding.
Pros & Cons
Pros:
- Reliable Income: EPD has a fantastic track record of 25 consecutive years of distribution growth, offering a current yield of 7.0%.
- Financial Health: With a strong credit rating and a leverage ratio of 3.0x EBITDA, EPD has a fantastic balance sheet.
- Strategic Assets: EPD’s infrastructure and strategic position in the energy sector allow it to capitalize on the rising demand for fossil fuels.
- Attractive Valuation: Trading below its historical P/OCF ratio, EPD offers significant upside potential – especially if rates come down.
Cons:
- Limited Growth: Some midstream companies may offer more aggressive growth.
- Sector Risks: Midstream companies can be indirectly affected by fluctuations in oil and gas prices, potentially impacting investor sentiment.
- MLP Structure: Investing in Master Limited Partnerships like EPD can be complex for non-American investors due to tax implications.
- Interest Rate Sensitivity: If rates don’t come down as expected, the competition from high-yield bonds and money market funds could persist.
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