Enbridge Energy Partners Is Not the Next Boardwalk

At first glance,  Enbridge Energy Partners exhibits many of the same symptoms as Boardwalk Pipeline Partners before the latter firm's unexpected 81% distribution cut in February. Gas/natural gas liquids industry conditions have affected the profits of EEP's gas processing business. EEP's operating cash flows have been unable to fully pay for declared distributions for more than two years. The balance sheet is relatively leveraged at more than 4.5 times debt/EBITDA. And finally, the partnership has large growth spending needs through 2016.

Although each of these issues is a serious risk to the distribution and the business overall, we believe they are all fully manageable for three reasons. First, Enbridge Energy Partners has a strong, symbiotic relationship with its general partner, Enbridge Inc. (ENB), which serves as a financing backstop. Second, it is entrenched in a massive $4 billion growth program for 2013-17 with Enbridge Inc. that will deliver largely fee-based, contracted, visible cash flows as projects come on line over the next several years. Third, throughout 2013, EEP completed several financing initiatives--with the help of Enbridge Inc.--that shored up its balance sheet and established adequate liquidity for the medium term.

Distribution Coverage Is Short, but Cash Flow and Coverage Will Improve
Distributable cash flow has now been short of full coverage for two years, and we do not expect any distribution growth until 2015 at the earliest, and more likely 2016. Distributable cash flow in 2013 was particularly disappointing for the partnership, with distribution coverage coming in at only 0.67 times while 2012 coverage also fell short at 0.80 times. However, we believe EEP's operating cash flows have eclipsed an effective trough following 2013, as we attribute the recently weak profits to primarily cyclical and exceptional reasons. In particular, EEP contended with a one-time adverse Environmental Protection Agency ruling worth $274 million, while the gas segment contributed a very weak performance (EBITDA fell 71% year over year) due to low gas/NGL prices industrywide. The low profitability of 2013 hurt the partnership in two ways: Cash flows have been unable to cover distribution payments to existing unitholders, and weaker-than-expected EBITDA increased EEP's debt/EBITDA leverage measurement, which affected its future financing capabilities.

In EEP's liquids segment, the partnership continues to pay severe penalties and cleanup costs, including the aforementioned $274 million charge, related to its Line 6B spill in Michigan in 2010. The spill itself was catastrophic in terms of both environmental damage and penalties paid. The total bill has risen to $1.1 billion ($575 million, net of insurance recoveries) and has proved a major swing factor in EEP's earnings for several years now. However, we consider these costs truly exceptional in nature. We believe the chances of another a large-scale spill are very low, particularly because the 6B spill and ongoing penalties probably triggered a greater vigilance regarding safety and maintenance industrywide.

The partnership's natural gas business has been suffering from the persistently low gas/NGL pricing environment. The gas segment derives most of its cash flow from gathering natural gas from the wellhead and processing, treating, and fractionating natural gas/NGLs for transportation and distribution. However, with gas/NGL prices as low as they have been since early 2012, dry gas drilling declined. Throughput has fallen 11% since 2011, while EBITDA fell 60% to $200 million in 2013. Despite this, EEP continues to see need for capacity expansion, particularly with respect to the rise in liquids-rich gas drilling activity. EEP has been steadily investing in these more lucrative activities, and its Ajax processing facility in the Granite Wash and joint venture Texas Express NGL pipeline went into operation in late 2013. Another processing facility at Beckville will begin service in 2015. These capacity additions should bolster throughput and add an incremental $90 million in EBITDA while we wait for gas/NGL prices to recover to more normalized, midcycle levels.

Thus, despite these recent challenges, we believe Enbridge Energy Partners' cash flows were truly abnormally low in 2013. Barring additional special 6B charges, we expect significant profit improvement thanks to a better operating environment as well as incremental cash flows from new capacity coming on line in 2013 through 2017. Accordingly, management has guided toward operating income of about $1.1 billion in 2014, a 150% improvement over last year.

Expansion Plans Provide Clear Pathway to Distribution Growth
The Enbridge family is amid a massive CAD 41 billion growth program, and EEP is a major contributor. The growth projects generally target the expansion of Enbridge's pivotal North American system, which carries Canadian and Bakken crude south and east to the Gulf Coast and East Coast, respectively. EEP is participating through independent pipeline additions, such as the Sandpiper pipeline, which will carry Bakken crude east to connections that will enable access to East Coast refineries, as well as joint venture pipeline expansions/extensions both with Enbridge Inc. and third parties on the liquids and NGL sides.

The scale of these plans ($4.1 billion of organic projects) has the short-term impact of reducing near-term returns on invested capital, as the growth investments raise the capital base immediately while associated cash flows sometimes will not fully come through until a year or two later, after all permitting and construction are complete. Importantly, though, these projects are all supported by long-term customer contracts, which are either take-or-pay or cost-of-service based, allowing for the recovery of capital costs and adequate economic returns. Such visible and virtually assured terms--a result of the highly regulated nature of assets, revenue, and returns--are the primary basis for our narrow Morningstar Economic Moat Rating. EEP's liquids pipeline assets in particular are interstate routes, which benefit from Federal Energy Regulatory Commission regulation of competition, construction, maintenance, and tariff rates. The regulation, which can be cumbersome and costly at times, effectively mandates a required economic return for pipeline infrastructure and thus carves out an economic moat.

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These massive growth plans are one reason Enbridge Energy Partners differs from Boardwalk Pipeline Partners. Whereas Boardwalk's legacy system and main cash flow support is battling serious secular headwinds, EEP's liquids pipelines--by virtue of their connectivity to the Enbridge family's expansive pipeline network--remain in high and growing demand. As a result, EEP's cash flows are now effectively contracted to grow. Boardwalk, on the other hand, continues to navigate a relatively uncertain future. Its project pipeline is not clear, and recent investments in storage and gathering/processing have not yet clearly paid off, due to industry headwinds. Though EEP's gas segment (now mostly held at the Midcoast Energy Partners level) will continue to struggle through 2014, it is a relatively small contributor currently (13% of operating income in 2013) and it continues to invest in fee-based, economic capacity expansions in liquids-rich gas plays. Long term, we expect profits to improve.

In 2014, we expect EEP's operating income to improve from $441 million to $1 billion, as revenue from its Eastern Access and Mainline expansions begin contributing to cash flow. By 2018, after the current growth program is largely up and running, we expect cash flows to ramp by an annual 20%, which we expect will support a distribution compound annual growth rate of 2.2% from 2014 to 2018. This is in line with EEP's distribution growth target of 2%-5% annually.

EEP Routinely Manages a Leveraged Balance Sheet
Broadly speaking, we associate distribution risk with balance sheet risk for a couple of reasons. A distribution shortfall (when distributable cash flows cannot fully cover declared distributions to unitholders) alone is not that worrisome--in many cases this can occur due to short-term operational or cyclical issues, which often can be funded with additional withdrawals on a credit facility. Thus, as these types of short-term issues subside, we'd expect cash flow and distribution coverage to recover.

When a distribution shortfall is combined with a weak balance sheet, however, this is cause for concern. This not only means the master limited partnership has fewer levers to pull on to finance the distribution (with the balance sheet already burdened), but also it is often indicative of currently high capital spending plans, which can further limit liquidity.

EEP investors are therefore rightly concerned when we consider that distribution coverage has been short since 2012, and the partnership typically runs a relatively leveraged balance sheet; it has averaged about 4.5 times debt/EBITDA since 2006. While this may appear high to corporate investors, debt/EBITDA ratios in the low to mid-4s are actually common in the MLP world, where partnership payout structures almost encourage higher leverage than may be typical for a corporation. Because MLPs often pay out 80%-100% of operating cash flows, they must routinely issue new capital to fund growth projects (and at times distributions).

EEP, like its MLP peers, has a revolving credit facility that carries a debt/EBITDA covenant of less than 5 times, so during periods of high organic growth spending, its leverage ratio can creep up to this limit. In March 2013, EEP's leverage ratio hit around 5.7 times debt/EBITDA because of heavy investments during a period of relatively low EBITDA (EEP spent $1.8 billion in growth capital while generating only $1.2 billion in operating cash flow). The growth initiatives required new capital, and with the balance sheet already burdened at more than 4.5 times debt/EBITDA, EEP issued equity through its payment-in-kind vehicle, Enbridge Energy Management , twice during the year.

The EEQ unit issuances--as well as Boardwalk's recent distribution cut--highlight how few options a leveraged firm with high spending needs actually has. Issuing new equity exacerbates the current distribution coverage shortage, while issuing new debt worsens leverage ratios. Thus, for EEP/EEQ, the new units provided quick covenant relief (as the cash proceeds were used to reduce borrowings), but it also diluted the existing unitholder base for a distribution level that was already short of full cash flow coverage. We believe that this acknowledgement of the suboptimal issuance, on top of ongoing gas segment profit concerns and high spending needs for the next couple of years, probably triggered EEP and Enbridge Inc. to evaluate at all near- and medium-term financing needs and options on the table in spring 2013. We believe EEP's balance sheet is now manageable, and we expect the partnership's debt/EBITDA ratio to remain in the mid-4s for the medium term. Moreover, we emphasize that EEP maintains a very strong financing backstop in Enbridge Inc. Their mutual interests go beyond the typical LP/GP relationship, which we believe is pivotal to understanding the leverage reduction steps taken by and between the two firms.

Enbridge Inc. and EEP Depend on One Another for Growth
We've long touted the many benefits of having midstream titan Enbridge Inc. as a general partner: Enbridge Inc. brings a stronger credit rating (EEP's rating depends on its implicit backing), financial support through various debt and equity issuances throughout EEP's history, inclusion in an indispensable North American pipeline network, and access to this network's ample growth opportunities. As a result, it and EEP are dependent on one another for current business and future growth. We believe this intangible in particular--in having fully aligned long-term operational strategies--justifies our conviction that EEP's distribution is sustainable. We believe Enbridge Inc. has a great, vested interest in assuring EEP's distribution--not only because it receives a substantial payout from its ownership of LP and GP interests, but also because it relies on EEP's MLP structure and financing options to grow. We believe Enbridge Inc. simply cannot allow EEP to risk any distribution cut, as this would impair EEP's capital access and hence damage growth prospects for the entire Enbridge family.

Enbridge Inc. and Enbridge Energy Partners have such highly integrated assets that they cannot operate without one another. The pipeline networks are fed into each other, and hence they rely upon each other's connections and throughput. Volumes from one end of the Enbridge system in Canada necessarily pass through EEP's pipes to get all the way down to the Gulf Coast. Because of this interconnectedness, we view Enbridge Inc.'s growth projects as those of Enbridge Energy Partners' and vice versa, as each initiative effectively increases throughput on the systems of each other.

When viewed through this lens, we believe it makes sense to consider all Enbridge-related MLPs as effectively financing vehicles for the expansion plans of Enbridge Inc. at large. We believe all new projects are planned and allocated in a very centralized fashion from the Enbridge system viewpoint, specifically with the intent of maximizing the strong capital access of Enbridge's MLP vehicles. This translates into capitalizing on the main advantages of the MLP structure.

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Specifically, MLPs are able to routinely roll existing debt, add incremental leverage up to a generous 5 times debt/EBITDA covenant limit, and regularly tap new equity capital through follow-on or at-the-market issuances for growth capital spending. Enbridge Inc., as a normal corporation, does not wield these options directly, as corporate investors are generally less tolerant of high leverage and routine equity issuances. Without EEP/EEQ/MEP's ability to serially refinance debt and issue new equity, Enbridge Inc. would have to take on the full burden of many of its currently jointly financed projects with subsidiaries. This level of debt held at any one level--required to finance a growth program of CAD 41 billion--would likely cripple a corporation with a market cap of CAD 41 billion. Hence, we believe that Enbridge will always be willing to take on additional incremental financing costs for subsidiary/joint projects on an as-needed basis, as these costs are minuscule compared with the potential burden of losing EEP/EEQ/MEP's MLP capital access.

Additionally, reduced capital needs at the parent/corporate level preserves financial flexibility for the entire Enbridge family. Enbridge Inc.'s strong investment-grade balance sheet allows it to step in with financing relief when needed. Joint projects often even entail some built-in call/put options, which allow for Enbridge and its partner to increase or decrease the size of their respective investment commitments during project development. The benefits of this optionality were seen in early 2013, when EEP's operating cash flows couldn't support spending plans. EEP worked with Enbridge Inc. to develop several financing transactions to solve for, effectively, all medium-term balance sheet and growth spending needs.

Finally, we emphasize that this interdependence and the mutual growth interests between EEP and ENB are very different from the relationship between Boardwalk and its general partner, Loews (L). Loews is similarly a deep-pocketed general partner, which has historically provided liquidity for its MLP through both debt and equity capital. It does not, however, have any operational dependence on Boardwalk, and hence its investment stake is passive. Boardwalk's access to capital or growth projects does not affect the operations of Loews, and they maintain separate growth ambitions and separate management teams. We continue to believe Loews will provide support for Boardwalk's long-term strategy, but their relationship clearly differs from the strong operational ties and shared interests and managers of EEP and ENB.

Enbridge Inc.'s Recent Financial Support of EEP Shows Symbiotic Interests
In 2013, Enbridge Partners ran into covenant concerns early in the year, as growth capital and debt levels climbed and EBITDA fell below normal levels. Enbridge Inc. quickly stepped in with several forms of financial support for EEP.

First, in May 2013, EEP issued $1.2 billion in preferred units to Enbridge Inc., which provided immediate covenant relief and alleviated investor fears about a common unit issuance. The unit price rose 10% on the day of the announcement as a result. The special direct issue featured unique terms that defer cash distribution on the units (which offer a 7.5% yield) for two years, so that EEP may preserve cash to pay for other growth projects or limited partner distributions in the meantime. After the fifth anniversary of the issuance, EEP has the right to redeem the preferred units. In our valuation, we maintain Enbridge Inc.'s preferred stake, though we believe that by 2018, with growing cash flows and improved distribution coverage, EEP's unit price will appreciate well beyond our current fair value estimate. At that point, the partnership should be in a solid financial position to issue new units to redeem the relatively expensive $1.2 billion in preferreds.

The private transaction was tailored to EEP's unique situation: It provided cash up front without overwhelming leverage metrics or diluting common unitholders, who were already contending with no near-term distribution growth. This additional layer of equity investment in EEP (adding preferred units on top of Enbridge Inc.'s limited partner and general partner ownership) further aligns the two entities' growth and development goals.

Second, in June 2013, EEP exercised a put option to reduce its 40% stake in the Lakehead expansion (which includes both Eastern Access and Mainline Expansion projects) to 25%, while retaining the option to re-up this stake until one year after these projects begin operations. The put freed up about $720 million in investment commitments. When the partnership requires cash--as it will for the next several years of heavy growth spending--EEP is allowed to cut its investment stake. Once these projects (and others) are operational and when the partnership has greater financial flexibility, EEP retains the option to increase its claim on the projects' cash flows. Enbridge Inc. is essentially allowing Enbridge Partners to participate in the growth program as much as it can manage.

Third, Enbridge Inc. agreed to purchase as much as $350 million in accounts receivables of certain EEP subsidiaries on a monthly basis through 2016. This agreement will enhance liquidity and save in new funding costs of about $10 million annually. We consider the receivables transfer relatively low risk, as the sales will include only investment-grade receivables and will be sold net of a discount for the risk of noncollection.

Fourth, EEP's balance sheet is significantly improved following the initial public offering of EEP's gas segment through Midcoast Energy Partners in November 2013. Though this transaction was done directly at the EEP level (and hence has no direct ties to Enbridge Inc.), we believe the IPO strategy was probably designed at the parent level, with the intention of generating cash to both shore up EEP's balance sheet and pave a path for future growth. The formation of MEP provides the balance sheet capacity of another MLP in the Enbridge family, and it sets up an asset monetization plan for EEP through future dropdowns to MEP. The company expects the first MEP dropdown to take place in mid-2014, which should support debt/EBITDA in the low to mid-4s.

While we believe EEP's balance sheet is sufficient for now, further cyclical or execution risks exist that may endanger its financial health once again. However, we believe Enbridge Inc. still maintains several alternative financing options if needed, including a forfeiture or deferral of incentive distributions, a hybrid debt/equity issuance like preferred or convertible debt/equity, or an increase/decrease in equity stakes in joint venture projects. To deliver on these financing alternatives, however, we again highlight the value and need to preserve Enbridge Inc.'s strong balance sheet and investment-grade credit rating.

Enbridge's Yield Is Stable and Attractive
As a result of EEP's existing asset positioning, secured growth plans, and the invaluable financial/operational backing of its general partner, we believe its annual distribution of $2.17 per unit is not only sustainable, but also well positioned to ultimately grow 2%–5% annually. While there are plenty of near-term headwinds in ongoing weak gas/NGL prices, relatively high leverage, and large ongoing spending needs, EEP and Enbridge Inc. have contracted long-term, stable cash flows, which will ensure adequate funding, recovering profitability, and a resumption of normal distribution growth. We caution, though, that distribution coverage is currently short and will probably remain so through 2016. The board may increase distributions before the partnership achieves full distribution coverage in 2015 or 2016, but we believe investors will have to wait at least a year before we see any material distribution growth. However, once most of the current growth program is in service by 2016, we expect EEP to ramp distributions rapidly in 2016 through 2018 to compensate for the long wait.

In the meantime, we believe the units themselves are modestly undervalued, trading at about $30, or 0.9 times our fair value estimate of $32, and offering a very robust 7.4% yield. Though the high yield certainly reflects some of the near-term risks we've discussed, we firmly believe the distribution is sustainable with contracted cash flows forthcoming and a very strong financing backstop in Enbridge Inc. The current yield therefore serves to reward patient investors as they await a long-anticipated payout from secured growth plans and distribution improvement.