Enbridge Energy Partners: Deep Value Dividend Opportunity or High-Yield Trap to Avoid?

Source: Enbridge Energy Partners

It's not surprising that Wall Street hates pretty much all energy stocks right now. However, the worst oil crash in 50 years has resulted in some midstream MLPs getting hammered worse than others. Take for example Enbridge Energy Partners (EEP) which is down 57% over the last year.

Since the best time to invest is often when Wall Street is running red with the losses of panicked investors, is now the time to buy this high-yield, beaten down MLP? Or does the sky-high yield signal a warning to potential investors that a massive payout cut is imminent?

Let's take a look at the three most important factors that will determine whether or not Enbridge Energy Partners' distribution survives and will likely make the difference between this MLP proving to be a great long-term deep value investment or a classic high-yield trap.

Just how undervalued is Enbridge?

Sources: Yahoo Finance, Fastgraphs

As you can see Enbridge Energy Partners is trading at about half its historical valuation. However, before you run out and load up on these seemingly cheap units, remember that a yield this high either signals an MLP in deep distress, or that the market has badly misunderstood its business model and mispriced it.

To determine which of these scenarios is true let's look at the other two parts of the MLP's payout profile, its distribution sustainability and long-term growth potential.

Payout profile initially seems ok BUT...
Over the first three quarters of 2015 Enbridge Energy Partners generated $742 million in distributable cash flow or DCF, and paid out $620 million in distributions.

With a distribution coverage ratio or DCR of 1.2 it seems that not only is the current payout sustainable, but also that management's 2%-5% long-term payout growth guidance is realistic.

In addition Enbridge Energy Partners and its general partner, Enbridge Inc. (ENB 0.87%), have a total potential growth backlog of $38 billion that could theoretically drive solid growth over many years. That includes over $10 billion in potential drop downs from Enbridge Inc. and $5.2 billion in planned organic growth projects in 2016 and 2017.

So obviously Enbridge Energy Partners is mispriced and a stupendous long-term income opportunity, right? Not so fast. Because there are two big risks that investors need to consider before they invest their hard earned money into this MLP.

Business model isn't as great as it seems

Source: Enbridge Energy Partners investor presentation.

The midstream MLP business model is predicated on long-term mostly fee-based contracts that result in a predictable and recurring stream of cash from which to pay the generous yield. However, as numerous midstream MLPs have shown during the oil crash, "fee-based" contracts only ensure cash flow if they are written with minimum volume or revenue clauses.

Enbridge's growing emphasis on cost-of-service contracts are by far the best component of its contract mix since such contracts ensure both a return of, and a return on capital invested.

However, given how exposed Enbridge Energy Partners is to high-cost Canadian Tar Sands -- which is only fetching $14 per barrel at the moment -- its very possible that if oil prices stay low for the next year or two Enbridge could see volumes on its pipelines drop significantly and its DCR could decline to unsustainable levels. 

However the biggest potential risk for Enbridge Energy Partners' investors is that the MLP may have to slash its payout despite its currently adequate DCR.

Ugly balance sheet is the key to understanding market's pessimism

Sources: Morningstar, Gurufocus

Up to now Enbridge has been able to borrow relatively cheaply to fund most of its growth. However, with its unit price now so low its access to equity markets is pretty much gone. And with a balanced sheet that is so highly leveraged its borrowing costs are only likely to go up, especially in a rising interest rate environment.

Indeed Enbridge Energy Partners just announced it was refinancing some of its debt (as well as funding some of its capital spending costs) via a new $1.6 bond offering with respective interest rates of 4.4%, 5.9%, and 7.4% on its new 5, 10, and 30 year bonds. Rising debt costs will only increase the MLP's weighted average cost of capital or WACC, which is already higher than its return on invested capital or ROIC.

This means that, if Enbridge is likely to find it harder to invest in future projects profitably and may very well make the painful but wise (in terms of long-term investor returns) of slashing its distribution in order to pay down its debt and fund more of its capital spending internally through excess DCF.

Bottom line:
Oil prices are notoriously unpredictable and its certainly possible (though unlikely) that a strong recovery in crude sends Enbridge Energy Partners' unit price soaring and reopens its access to equity markets.

However, should oil prices remain low or fall even lower over the next year or two than it's very possible that Enbridge won't be able to access enough cheap capital to profitably build out its enormous backlog of projects, especially given its highly leveraged balance sheet. In that case management may be forced to make the same painful decision that Kinder Morgan had to make; slash the payout to reallocate DCF to paying down debt and investing in future cash flow growth.