Table of Contents
Thesis and Background
Many income investors are drawn to Energy Transfer (NYSE:ET) and Enterprise Products Partners (NYSE:EPD) for good reasons. They both provide generous and stable dividends in the long term. Currently, the FWD dividend yield for ET is about 6.2% and almost 7% for EPD. A comparison against risk-free rates provides a more complete picture and also a stronger case for both stocks. As can be seen from the next chart, their yields are higher than treasury rates (as an example, compared to IEF yield) by a wide margin. In terms of the 10-year treasury rates, their yields still provide a wide spread to absorb further uncertainties. ET’s yield is about 2.6% higher than 10-year treasury rates (5.6% yield minus about 3.0% of treasury rates) and EPD is about a 3.8% higher.
The thesis of this article is that although both are attractive dividend stocks, our view is that ET is better. The remainder of this article will detail our considerations, which fall into the following three buckets.
First, ET provides safer income in the long term. Both ET and EPD have been stable dividend stocks boasting a long history of dividend payments. However, in relative terms, ET provides substantially lower payout ratios and also a thicker dividend cushion ratio. Its cash payout ratio is only about a half of EPD’s and its earnings payout ratio is about 20% lower. It also provides a thicker dividend cushion ratio of 1.93x compared to 1.46x from EPD.
Second, ET also enjoys better profitability than EPD. Many of the profitability metrics are comparable between these two leading pipeline players. However, we are more impressed by ET’s much higher gross profit margin and operation efficiency. It earns a much higher revenue per employee and also operates with a slightly higher asset turnover rate.
Finally, despite its comparable or even superior profitability, ET is valued at a dramatic discount relative to EPD. Its valuation is discounted by almost half in terms of price to earnings ratio, price to cash flow ratio, and price to book ratio. Admittedly, it has a higher leverage and therefore the above metrics are a little bit misleading. But even when its higher leverage is considered, its valuation is still about 20 to 30% lower than EPD.
Given the above considerations, our view is that ET is not only better poised to deliver a higher total return, but also its total return would be better protected given that the dividends will be a significant part of the total return in both cases.
ET offers better profitability and safer dividends
Both ET and EPD currently offer an attractive dividend yield. In terms of TTM dividend yields, ET’s yield is about 5.6%, and EPD is about 6.8%. In terms of FWD dividend yield, ET’s yield is about 6.2%, and EPD’s is almost 7%. Both stocks have been paying stable and increasing dividends in the long term because their fundamental businesses are supported by consistent profitability and our increasing energy needs.
As you can see from the following chart, their profitability is quite similar in many metrics and also comparable to the overall economy. Take the net income margin as an example. Both feature a net margin of around 8% to 11%. To put things under perspective, the average profit margin for the overall economy fluctuates around 8% and rarely goes above 10%. Of course, this is an average across all business sectors. Nonetheless, as a rule of thumb, 10% is a very healthy profit margin, and as you can see both ET and EPD earn such a healthy margin.
Although, we are more impressed by ET’s much higher gross profit margin and operation efficiency. As a pipeline business, we give more weight to these cost- and operation-related metrics. As you can see, ET earns a much higher gross margin (20%+ vs about 15%). In terms of operation efficiency, it earns a much higher revenue per employee (almost 40% higher than EPD) and also operates with a slightly higher asset turnover rate (0.67 vs 0.62).
And for dividend investors, I am sure all of us know all the typical metrics to gauge dividend safety such as payout ratio in terms of earnings, payout ratio in terms of cash flow, et al. The following chart shows ET and EPD’s payout ratio in terms of cash flow and earnings. As seen, both ET and EPD have been doing a consistent job of managing their dividend payout in the past.
Also, you can see that overall ET’s payout ratios are lower than EPD’s by a substantial amount. In terms of cash payout ratio, ET pays out 26% on average vs 59% from EPD. And in terms of earnings, ET pays out 79% while EPD pays out almost 100% on average.
Dividend cushion ratios
The above pay-out ratios we commonly quote enjoy simplicity, and we also like to go a step further for a more comprehensive assessment of dividend safety. As detailed in my earlier article here, the major limitations of the above simple payout ratios are twofold:
- The simple payout ratio ignores the current asset that a firm has on its balance sheet. Obviously, for two firms with the same earning power, the one with more cash sitting on its balance sheet should have a higher level of dividend safety.
- The simple payout ratio also ignores the upcoming financial obligations. Again, obviously, for two firms with the same earning power, the one with a lower level of obligations (pension, debt, CAPEX expenses, et al) should have a higher level of dividend safety.
The above simple payout ratios ignore all these important pieces. For a more advanced analysis of dividends stocks, we find the so-called dividend cushion ratio an effective tool. A detailed description of the concept can be found in Brian M Nelson’s book entitled Value Trap. And a brief summary is quoted below:
The Dividend Cushion measure is a ratio that sums the existing net cash (total cash less total long-term debt) a company has on hand (on its balance sheet) plus its expected future free cash flows (cash from operations less all capital expenditures) over the next five years and divides that sum by future expected cash dividends (including expected growth in them, where applicable) over the same time period. If the ratio is significantly above 1, the company generally has sufficient financial capacity to pay out its expected future dividends, by our estimates. The higher the ratio, the better, all else equal.
Note that our following analysis made one revision to the above method. Instead of subtracting the total long-term debt, we subtracted the total interest expenses over a past five-year period. The reason for this revision is to adjust the status of businesses such as ET and EPD. Mature businesses like these probably will never have the need to repay all of their debt at once. But it does need to have enough earnings to service its debt (i.e., cover the interest expenses). With this background, the dividend cushion ratios for ET and EPD are calculated and shown below.
The key message from this chart is that their true financial strength and dividend safety are even strong than the simple payout ratios shown above. They are actually in the strongest position in a decade.
Both had very thin or no “cushion” at all in the past, as shown by the negative cushion ratio for ET and near-zero cushion ratio for EPD. Their dividend payments had been hand-to-mouth in the past. You can argue that there is nothing wrong with this, especially for a pipeline partnership stock. However, as conservative investors, when we pick stocks for their dividends, we ourselves would like to see some dividend cushion, ideally a cushion ratio above 1. A cushion ratio above 1 approximately means the business has 1 year of cushion time if its profits hit a major speed bump.
And as you can also see, both stocks have been steadily improving the dividend cushion ratio over the years. Currently, their dividend cushion ratios have been at the highest level in a decade, and both are significantly above 1. Specifically, ET’s dividend cushion ratio turned positive in 2020 for the first time in the past decade. And based on the TTM financials, its current cushion ratio is about 1.93, which approximately means the business has enough cushion if its profits hit a major speed bump TWO years in a row.
EPD also enjoyed a similar steady improvement of its cushion ratio over the years, and its current cushion ratio is a very healthy and safe 1.46x. Although, its current cushion ratio is lower than ET’s.
Valuation and Projected Returns
As shown in the chart below, ET is valued at a dramatic discount relative to EPD despite its comparable (or even) superior profitability and safer dividends. As highlighted in the red boxes, its valuation is discounted by almost half in terms of price to earnings ratio, price to cash flow ratio, and price to book ratio. Its single-digit PE ratio is not only compressed relative to EPD, but also too low to ignore in absolute terms.
Although admittedly, ET has higher leverage, both higher than EPD and also significantly higher than the overall market (which is typically for pipeline business). ET has a long-term debt of around $45B (and its market cap is about $36B as of this writing). In contrast, EPD’s long-term debt is only around $30B (and its market cap is also much larger at around $59B as of this writing). And therefore the above valuation metrics are a little bit misleading because they are either based on profit or equity and did not consider leverage. But even when ET’s higher leverage is considered such as by the EV/EBITDA ratio highlighted in the blue box, its valuation is still at a 20 to 30% discount relative to EPD as you can see.
As detailed in my earlier article, a total return in the next 3~5 years is projected to be in the double-digit range for both stocks. We are projecting about 11% annual return for EPD and about 14% annual return for ET considering their profitability, valuation change, and organic growth rate.
So in summary, ET is projected to deliver a higher total return. Moreover, note that the current dividends would be a considerable portion of the projected total returns for both cases (a little more than ½ for EPD’s case and almost ½ for ET). Hence, ET’s total return would be better protected by the current dividends given its safer dividends and thicker dividend cushion ratio.
- In the short term, both face macroscopic risks. 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 both ET and EPD because their assets are all in the U.S. And such disruptions could even prove to be favorable for them in the long term. Such disruptions could cause international demand for U.S. crude oil, natural gas, and NGLs to strengthen.
- In the mid-term, higher borrowing cost is another risk. Both depend on debt financing substantially, and ET more so as aforementioned. ET carries a relatively high debt burden and is therefore somewhat sensitive to borrowing rate changes. Its current long-term debt is about $45B. Hence, a 1% increase in its interest rate would translate into $450M of additional interest expenses. Its net profit is projected to be about $4250M in 2022. Therefore, the additional interest expenses are about 10% of its net profit, not fatal but not negligible either.
- In the long term, climate and environmental concerns are a risk for all of them. Our concerns over climate change and the environment could impact oil and gas businesses in general. Both are often involved in legal disputes with environmental groups, protests, lawsuits, and government regulations.
Conclusion and final thoughts
Both ET and EPD are strong dividend stocks with high dividends, safety, and favorable price appreciation potential. In particular,
- Both offer attractive dividend yields. Their yields are high in absolute terms already (6%+ FWD dividend yield), and become even more appealing when considering their thick spread relative to treasury rates despite the recent rates surges.
- Although we ourselves like ET better for two main considerations. Our considerations are A) in relative terms, ET provides safer dividends in terms of lower payout ratios and thicker dividend cushion ratio, and B) ET valuation also provides a thicker margin of safety and therefore better return potentials.