Hot Inflation? Enterprise Products Stock Can Help (NYSE:EPD)

March CPI inflation data

March’s CPI data just came out, and according to the data,

The Consumer Price Index climbed 0.4% in March, the same increase as in February, and exceeding the 0.3% rise that economists expected. That indicates that the hot readings in January and February may be more than a “bump” on the path to inflation heading toward the Federal Reserve’s 2% goal.

Digging a bit deeper, it is not difficult to find out that the rise was largely due to cost increases in shelter and gasoline. Combined, these two items contributed more than half of the monthly CPI increase. In particular, the energy index jumped 1.1%.

Against this background, I will argue that Enterprise Products Partners L.P. Common Units (NYSE:EPD) is an attractive idea all around. In the remainder of this article, I will detail three of the key aspects: A) its dividends that can help you hedge inflation; B) the fair (or even discounted) valuation; and C) the catalysts to help it grow at the same time.

EPD’s dividends

As a master limited partnership, or MLP, a good part of Enterprise Products Partners profit is distributed as dividends. EPD is yielding 6.87% currently, as seen in the chart below. The yield is far higher than current inflation (even the highest projection) by a large margin. Note that it is also above its own historical average of 6.63%, signaling some degree of undervaluation (more on this later).

Enterprise Products Partners has an impressive record of consecutive growing its dividends. In January 2024, it raised its quarterly unit payout to $0.515. The increase represented a YOY and sequential increase of 5.1% and 3%, respectively. Some investors may feel that the growth rates are not impressive. But they outpace inflation in the long term by a good amount. Its dividend growth was about 4.0% over the recent 3 years and also the past decade, as seen in the second chart below.

What’s more important is the consistency. As a dividend champion, EPD has been growing its dividends consistently for the past 25 years. Enterprise has one of the best and most resilient operations in the midstream sector in my view. As a notable example, during COVID-19, most firms in the group were forced to reduce their distributions sharply. Also, many of these entities’ annual payouts have still not returned to pre-pandemic levels. Enterprise not only didn’t cut its distribution, but managed to increase it every year.

Valuation

As aforementioned, its dividend yield indicates either fair valuation or some discount. In terms of P/E, EPD currently trades at 10.8x FWD EPS, which is very reasonable in both absolute and relative terms. Although as a midstream stock, it uses leverage more heavily. As such, I think a leverage-adjusted cash-based metric is more appropriate here.

The chart next shows EPD’s EV/EBIT ratio and price-to-CFO ratio compared to their historical averages. As seen, these metrics send the same signal. In terms of the EV/EBIT, EPD’s current ratio is 13.34x, compared to its historical average EV/EBIT ratio of 17.64x in the past 10 years. The ratio is also toward the lower end of the historical spectrum in the past 10 years. In terms of P/CFO, EPD’s current ratio is 8.46x, again lower than its historical average of 10.5x.

Despite the low valuation multiples, I see ample catalysts to fuel its profit growth.

Growth catalysts

The top catalyst in my mind is inflation. As mentioned earlier, energy cost is a main contributor to our current inflation problem, with shelter being the other one. And between energy and shelter, I view energy as the more fundamental drive that could cause positive feedback – positive in the sense that the feedback tends to drive inflation even higher. Our other needs (i.e., the production of food, transportation of goods, construction of shelter, etc.) eventually rely on the use of energy. One man’s problem is often another man’s opportunity. In this case, EPD is the other man (together with other energy stocks like Exxon Mobil Corporation (XOM), as detailed in my other article).

The second catalyst in my mind is the growth potential of its natural gas and liquefied natural gas (“LNG”). The next chart below shows the price of U.S. export of LNG, seasonally adjusted, over a 10-year period. The current price is $6.89 per thousand cubic feet. As seen, the current price is toward the lower end of the historical price range, and I anticipate an increase in LNG pricing. Meanwhile, EPD has large construction programs ongoing to expand its LNG capacity. As seen from the second chart below, EPD reduced CAPEX spending in 2021 and 2022, but it returned to a much more aggressive level starting in 2023.

To wit, the CAPEX spending slowed to a low of ~$1.6 billion in 2021, and it now sits at a multi-year peak of $3.2 billion in the trailing twelve months. As the U.S. becomes the world’s most important exporter of LNG, I am very optimistic that EPD could benefit from both a more favorable pricing environment and also expanded volume.

Risks and final thoughts

In terms of risks, I won’t spend too much time on the risks common to the midstream sector, such as commodity price volatility, regulation risks, environmental concerns, etc. Instead, I will focus on some of the risks that are more peculiar.

As aforementioned, the midstream sector relies more heavily on debt financing than the general economy. EPD is a more conservative and safer operator in this space. As seen in the next chart below, its current interest coverage is about 5.6x, far above the sector average and its own historical average. However, its current interest coverage ratio is comparatively lower than that of the overall economy (about 6.1x) and its long-term average is even more so. At the same time, midstream companies require significant upfront investment to build and maintain pipelines and storage facilities (and EPD is no exception, as just mentioned).

The combination of leverage and large CAPEX could limit EPD’s financial flexibility and stretch its balance sheet. A more remote risk – but with consequential impact – involves EPD’s heavy dependence on specific pipelines. A large portion of EPD’s revenue comes from a few key pipelines. If there are disruptions to these pipelines (due to catastrophic events like weather, earthquakes, terrorists attack, etc.), it could significantly impact EPD’s profits.

All told, my conclusion is that EPD presents a compelling buy opportunity, especially for income-oriented investors under current conditions. It is a very well-rounded investment combining growth potential, discounted valuation, and generous yet consistent dividends. EPD boasts a robust midstream infrastructure with a strong track record of delivering consistent distribution growth. The current yield and its historical growth rates beat inflation by a wide margin. Moreover, I see plenty of catalysts to support its profit and dividend growth in the years to come. Finally, it is also trading at attractive valuations, either on par or below its historical averages, judging by its yield and EV/EBIT ratios.