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What’s the ideal investment to meet the needs and preferences of retirees? Enterprise Products Partners (NYSE:EPD) would be my first choice. To begin with, it’s a great business with great management and a 25-year record which is unsurpassed in its category. Secondly, its earnings and distributions are steady and safe. Third, it’s cheap by all measures and has important tax advantages. Most retirees are constantly on the lookout for investments like that – steady, high quality, and predictable. The perfect retiree investment can be broken down into the four elements below of which the tax advantages are pretty much unique.
- Safe, high quality and predictable.
- A solid income provider, and/or
- A capital compounder with a potential place in a legacy that can be left to heirs.
- A chance to postpone taxes and potentially avoid them altogether.
This article will explore the ways in which Enterprise Partners Products fits into these requirements. As I will turn 80 in a few months I have a good personal sense of how retirement investing differs from the kinds of investing one does in the years between thirty and sixty. The major difference is time. When you are young the future extends to a receding horizon. There’s plenty of time for a diversified growth portfolio to bounce back from down markets and build long-term success. If time is the young investor’s friend, the opposite is often true for retirees who have done most of their risky growth investing and now must engage a time horizon that looms ever closer.
When I was an investment advisor I used to spend quite a bit of time advising elderly relatives to avoid investments that had high yields which turned out to be in large part a return of one’s own capital. The first thing to point out about EPD is that its distribution is exactly that – a return of capital. It is therefore not taxed when received (but designed to be taxed years in the future in a way that I will explain below) and differs from the gimmicky investments I discouraged in the fact that it generates cash to be dispersed regularly as if it were a dividend. The term “dividend” is sometimes used with this disbursement, once even in EPD’s own publications perhaps treating it as a catch-all. “Distribution” is the correct term and those who buy EPD own “units” rather than “shares.” As for “return of capital,” it correctly refers to capital employed while “return on capital” refers to the return that capital produces, a mistake that occurred on a website that should have known the difference.
Details like the above are important for owners of Enterprise Products Partners. It’s a wonderful investment meeting all four of the above criteria. Income and compounding value may be something of an either/or, but may also be a both/and. Owning EPD requires some research and attention to detail and returns will be greatly enhanced by clever use of a few loopholes which require understanding the mechanical workings of, mainly, taxes. The tax rules require quite a bit of work for the owner or the owner’s tax preparer. Investors who are less well-informed or less willing to attend to details may attempt to wing it but put themselves at risk of making a major mistake. That being said, EPD is very much worth the trouble.
It was my own recent consideration of legacy which set me on a quest to find the ideal retiree stock. Nothing seemed to be quite what I was looking for. Then I happened to notice Enterprise Products Partners on a list, can’t recall the exact list but likely value stocks or energy stocks. Energy still contains the cheapest businesses on the market compared to the market as a whole or to their own long-term historical valuations. EPD is in the stable and conservative midstream area which gathers, processes, stores, and transports oil and gas. The high quality and predictability of EPD make it very much worth the trouble to bone up on the rules and the numbers.
An Outstanding And Durable Business
First, let me frame the results produced by Enterprise Products Partners over its 25 years as a publicly traded partnership. To start with, it has raised its distribution every year over that quarter century. The fact that it is part of the energy space makes that more of an accomplishment with energy prices moving up and down with wild abandon and next to no predictability (remember the moment in 2020 when next-month-settlement futures of oil traded below zero so that the market was paying you to take it away). None of the gyrations in oil and gas prices led to any change in the steady growth of EPD distributions, in part because at the current 56% of cash flow EPD leaves plenty of room to absorb any drop in the commodity prices. Its midstream business model inherently defends against drop in the prices of oil and NGL, its most important business. Most of its business operates on a fee basis. Prices come and go, sometimes wildly, but customers are very steady in their need to have EPD’s products processed and delivered.
The more I thought about it, the more I saw that a well-run midstream company was the way to go in the energy sector. There was a time when drillers were the preferred energy sector for many investors because of the possibility of hitting on a new oil and gas field with a chance to shoot the moon. The trouble is risk, both in finding oil and gas and in the prices at which you will be selling it. Enterprise Products Partners is a dependably plodding business, but over the long run it offers a higher probability of shooting the moon in investor returns, albeit in slow motion. The chart below shows its Total Return performance compared to the S&P 500 over its 25-year history:
What the above chart reveals is the enormous power of compounding a large cash distribution, now around a tax deferred 7%. It’s your personal choice whether to treat the 7% as income or compound it by plowing it back into more units. Just to show the importance of that steady distribution, here’s the chart of EPD and SPY based on price only:
In the second chart, the EPD still leads the S&P 500 but by a much narrower margin. The powerful spike between 2009 and 1014 represents the last glory days of energy companies when oil prices were high and Exxon Mobil (XOM) was still ranked #1 or #2 by market cap in the S&P 500. Perhaps the most interesting thing is the fact that EPD comes across as a defensive stock that picks up a little ground when the S&P 500 isn’t doing well. For investors this implies that you may do pretty well with very little risk even if you are taking the entire distribution as income. As for the tax deferral advantage, that calls for fuller treatment in a separate section.
The third chart (below) compares EPD, the energy select sector SPDR (XLE), and the S&P 500 over the past three months. The energy sector as a whole has rallied strongly since the middle of January pulling ahead by a nose over the S&P 500 in the last few days while Enterprise Products Partners has outperformed both. Analysts have been divided both on and off this site as to whether the rally of energy companies since March 2020 has run its course. I’ll continue to be an agnostic because anything can happen in the short term but one could make the argument that the energy rally since oil prices went negative in 2020 followed many years during which the sector was cut to one third of its former value within the S&P 500. If carbon energy is a survivor, which I believe it is likely to be for a couple of decades, that leaves plenty of space for a continuing rally.
Growth And Operational Excellence
Even a cursory glance at the basic numbers over the long term makes it clear that EPD’s revenues, earnings, and cash flow all trend in the right direction. It is also clear that the forward progress is lumpy, with periods of several years when there is little or no growth followed by a year or two of huge jumps. The last such jump was in 2022 when revenues and net income both increased about 20% from 2021 after four years when both had bounced around with no net progress. The reason is that major jumps in revenue, income, and cash flow come from acquisitions like Navitas in 2022 or large projects coming online. It’s the nature of the business and EPD partners need to get used to it. A large storage facility does not emerge in small increments but comes online in full. This table from slides accompanying the Earnings Call Presentation on February 1 shows projects expected to come online during the next two years with the important bar charts of expected Growth Capital Spending in 2024 and 2025. The $3.75B and $3.08B compare to $3.2B in 2023.
EPD
The roughly $3 billion expenditure of Growth Capital is the second largest use of free capital after the $4.3 billion in distributions to unit holders. It should over the long run produce mid-single-digit increases in DCF and distributions in both good and bad years for oil and gas prices. That’s an important point that the market doesn’t quite seem to grasp. It’s the facilities and pipelines under operation that drive the results of EPD to a far greater extent than commodity prices. The ups and downs of the oil and gas market going back to the years before and after 2014 and including the crash of March 2020 all have little impact on operating results and distributions from EPD although its unit prices bounced around as if they did.
By all standards of measurement EPD is dirt cheap. It sells at less than 11 times earnings and 8 times cash flow while paying out a distribution that yields 7%. The current price at which units are traded is still far lower than it was in 2014 and the recovery from 2020 looks cautious and incomplete. That’s a major reason for accumulating shares now while the price is irrationally biased to the downside.
A few numbers tell the story of a very disciplined management whose own stake in the partnership assures that they have skin in the game. Over recent years the leverage ratio has been reduced from 4.1 to 3.4, with capital expenditures funded by operations rather than increased debt. S&P Global rewards its conservative balance sheet with an A- rating, the highest rating in the midstream space. Distributions seem likely to grow by at least 3% annually. The chart below gives a detailed picture of uses of cash flow, the most important being the $4.3 billion to equity holders and $3.2 billion to investing activities, leaving a 94% adjusted FCF payout ratio (the required amount being 90% for MLPs):
EPD (EPD)
The long-term picture is of a continuing and increasing stream of distributions to unit holders achieved without increasing net debt and with a number of projects that will come online sequentially but lumpily.
Some Things To Know About Distributions and Taxes
It has probably sunk in by now from the stock charts above that EPD soundly beat both the S&P 500 and the Energy ETF over the 25 years of EPD’s history as a publicly traded partnership. If you want to own energy at all, this is the most stable and profitable way to own it. The single huge advantage of the MLP structure is that distributions are not taxed twice like corporate dividends which are first taxed as income within the company and then taxed a second time when paid out as dividends. One thing to be aware of is that there is a current trend in which MLPs flip to the conventional corporate structure. It’s hard to see any need for EPD to do this, but a change would take away much of what makes EPD so attractive. EPD is 32% owned by the managing partners and you may rest assured that they use all of the strategies in this and the following section and will fight very hard to avoid giving up any of them.
EPD’s distributions are essentially tax deferred return of capital although most MLP distributions include up to 10-20% derived from taxable income. You get to keep the bulk of the distribution and use it as you wish. Many retirees may prefer to accept it as a nice pop of income. Others like myself would prefer to reinvest in EPD and allow it to compound. That reinvestment choice doubles the number of units owned in roughly seven years if unit prices and the growth of distributions remain where they are today. What that does for long term return is shown in the first chart above. You may also choose to spend part and reinvest part as you like.
So what happens to deferred taxes on the distributions? What are they deferred to? The short answer is that when you sell, the aggregate amount of past deferrals is deducted from your cost basis so that you pay for the cumulative distributions over the period you owned the unit by the increased capital gains tax you will ultimately owe regardless of the market price you receive. If the cost basis is eventually reduced to less than zero the amount below zero will be tacked on each year and taxed as income at your personal rate. There are, however, two possible approaches to prevent this from happening.
Clever Strategies, Bad Errors, And Loopholes
To come up with smart strategies a serious EPD investor should at least glance at every entry on the internet searching using a topic something like “taxation of MLPs like Enterprise Products Partners.” To begin with, read all available publications by EPD itself (there aren’t many and they are short). Then look up MLPs in Investopedia and read the short but helpful pieces by Motley Fool. Once you establish a basic understanding of the major points take a little time to read the detailed pieces by Baird and Tortoise which touch upon minor points.
Some of the more interesting details are engaged by questions and answers in Bogleheads (after the legendary John Bogle) which contains some of the smartest and most well informed individuals alongside some of the most unthinking and ill-informed who are helpful because their unhappy stories tell you what not to do. For example, never, ever, whatever you do, put MLP units into a tax advantaged account. Doing so will produce major brain damage and probably cost you money including paying for equally ill-considered actions by your broker. Worst of all, putting tax deferred distributions into a tax advantaged account is redundant. And a small point: if you are a foreigner think twice before buying an American MLP.
Remember the above mention of the bad outcome when your cost basis drops to zero and below? Just to remind, you start having to pay the IRS tax on this wonderful tax deferred investment at your personal income tax rate. If you are an investor whose major goal is not income but compounding your capital there’s a trick. You simply put your returns on automatic reinvestment or enroll in the EPD DRIP program. The distribution drops your cost basis but the reinvestment pulls it nearly right back up. Its effect is to greatly extend the period before your cost basis approaches zero. If you are an income investor you keep watching the accumulated basis decline on your K-1 and consider selling or making an additional investment if you are about to cut it close to zero. You read that sentence right. Either sell and get out before you start being taxed at your personal income tax rate or add enough to your position to avoid falling under zero for cost basis.
There’s another, even better, loophole if you are old like me. You simply don’t sell. Instead you die. Current evidence suggests the world will continue as will people you care about. If the original owner dies and the units are passed on to heirs, the heirs will enjoy a “step-up in basis” to market price at the date of the owner’s death. The same is true of all assets under current law and will be particularly helpful with stocks which have multiplied by 6-or-7 times and thus consist mainly of long term embedded capital gains (most positions in my portfolio). The only difference between stock holdings and EPD (or other MLPs) is that with MLPs you can die peacefully without ever having paid taxes on distributions.
The biggest issue addressed by Bogleheads was the necessity to file state and local taxes in states where you are not a resident. Some had never filed and boasted of getting away with it although I suspect they got away with it because the sums didn’t reach any state thresholds for filing. I don’t think that will work for me. EPD has operations in many states fanning out from its Texas headquarters. Fortunately Texas has no income tax, and neither do Alaska, Wyoming, Nevada, Tennessee, or South Dakota. Unfortunately Arkansas, Oklahoma, and Louisiana, among others, do. In most cases the tax bill is likely to be small although the nuisance will be significant. EPD will inform you as to the states in which you may need to file. Several Bogleheads said they had no trouble doing this on Turbo Tax. The good news is that you only have to do the detailed work once and in subsequent years can just fill in the blanks referring to the previous year for help. I have a pricey tax accountant but plan to do the grunt-work myself and present it for him to integrate into my family taxes. After researching the tax stuff for this article I suspect I know more about it than my tax preparer.
The little tricks in this section are important. You might look at them as an opportunity to inform yourself in a largely neglected area of the market. The beauty of EPD is that while you are likely to think of it as just another stock with a few quirks it is really best described as a distinct asset class with its own advantages and disadvantages, thus a great diversifier. Take the opportunity to learn about it thoroughly. Don’t let a little detail work prevent you from buying an investment that is very solid and likely to provide income and/or compound your money. Be sure to ask questions in the comments section and make me aware of any clever strategies or actions to avoid which you know about.
Conclusion: The Risk Versus The Reward
Energy Products Partners is the rare jewel in a stable, slow growth industry which provides a path to very good returns with the relatively simple mechanism of reinvesting distributions. It’s quite possible to manufacture a moderate level growth stock if you choose. Add to the current 7% yield the more or less assured operating growth of 3% or more and long term return has a likelihood of being very good. One other virtue of EPD is that its operating results are not closely correlated to any other parts of the economy including the energy sector. If the volatility and cyclicality of the rest of the energy sector bothers you try EPD instead.
The major risks stem from political leaders who might well attempt to pass laws unfriendly to the structure of MLPs. One motive is simply grabbing revenue from a small number of investors who don’t have much political clout. Never mind the likely several decades for which EPD businesses with their overwhelming focus on gas are the likely transitional energy source to provide a bridge to clean energy. If in firm control green energy enthusiasts are likely to follow a scorched earth policy on all energy companies until another crisis comes along to prove them short sighted.
Among carbon energy companies as a whole EPD seems less risky than most as long as policy is not controlled by extremists, especially as its biggest business by far is NGL – that necessary bridge from the present to any future in which green energy will be enough for the economy. Harassment from green energy advocates is not impossible but EPD does not look like a prime target compared to companies which actually drill for oil and gas.
As an income source and/or a vehicle for estate planning Enterprise Products Partner has few rivals. Its disciplined management should maintain both growth and shareholder return at its current level. It is selling at a price that is dirt cheap on the current numbers and by comparison to its prices going into the pandemic. It’s a Strong Buy.
