PAGP - Better Buy After Q4 Earnings: Enterprise Products Or Plains?

Summary

• Plains All American Pipeline and Enterprise Products Partners are two high-yield investment-grade midstream businesses.
• PAA/PAGP is far cheaper, but EPD has a vastly superior track record.
• We compare them side by side and offer our take on which is a better buy after reporting Q4 results and issuing 2023 guidance.

Both Plains All American Pipeline, L.P. ( PAGP , PAA ) and Enterprise Products Partners, L.P. ( EPD ) are high-yield investment grade midstream businesses. PAA/PAGP is far cheaper, but Enterprise has a vastly superior track record:

In this article, we will compare them side by side and offer our take on which one is a better buy right now.

Plains Vs. Enterprise: Q4 Takeaway

Plains completed a very strong 2022 for the company in which it beat its February adjusted EBITDA guidance by $310 million (a whopping 14.1% beat), generated $1.61 billion in free cash flow (18.4% of current market cap), significantly reduced its leverage ratio to 3.7x (below the long-term target range of 3.75x-4.25x), and announced a return to significant distribution growth, starting off with a $0.20 per unit increase along with $74 million worth of unit repurchases. Management attributed its outperformance to market based opportunities captured by its assets throughout the year, higher commodity price benefits, and increased tariffs volumes primarily in the Permian systems.

Looking ahead, management is guiding for flattish adjusted EBITDA year-over-year as increased tariffs due to inflation-linked escalators are being largely offset by fewer market based opportunities and asset sales. The company is also guiding for flattish free cash flow generation, though free cash flow net of asset sales will actually likely go up significantly this year.

The company intends to use its free cash flow to pay distributions, self-fund capital expenditures, and to pay down debt as it matures to further accelerate deleveraging.

Enterprise, meanwhile, also generated very strong Q4 results , with EBITDA growing 11.1% year-over-year. Management expects 2023 EBITDA will likely be flattish from 2022 levels as well, though it may increase slightly given that it will not face the same asset sale headwinds that Plains will be facing.

The partnership's leverage ratio is now under 3.0x, which reflects its continued EBITDA growth and debt reduction. Management continues to expect to use its free cash flow to self-fund growth investments and opportunistic acquisitions, keep leverage low, and fund its distributions and opportunistic unit buybacks.

Plains Vs. Enterprise: Business Model

Plains has been pruning non-core assets in recent years and plowing the proceeds primarily into debt reduction as well as some opportunistic unit repurchases. It expects to continue selling about $270 million of its assets in 2023 as part of this effort.

Its core assets are very high quality, particularly in the Permian Basin, where its crude and refined products midstream businesses generate about 80% of its adjusted EBITDA. This network is very strategically positioned and is likely to drive strong long-term performance for the business as long as the Permian Basin remains an attractive production basin. It complements its crown jewel Permian assets with some NGL assets in Western Canada.

Enterprise's portfolio is world-class and well-run, generating a consistent cash flow stream year-after-year, which has enabled it to grow its distribution per unit for 24 consecutive years. It owns a well-diversified midstream network that reaches every major shale basin and ethylene cracker in the United States. It also owns exported facilities that are strategically located on the Gulf Coast along with a high quality petrochemical business.

Plains and Enterprise generate cash flows that are largely commodity price resistant and mostly benefit from lengthy, fixed-fee, take-or-pay terms.

Plains Vs. Enterprise: Balance Sheet

Enterprise's balance sheet - already probably the strongest in the midstream sector with a BBB+ credit rating - continues to get stronger and stronger with each passing quarter as it grows EBITDA and reduces debt. It ended 2022 with a net debt to EBITDA ratio of Q3 to 2.9x, giving them enormous breathing room relative to their previous leverage target range of 3.25x - 3.75x. Moving forward, management decided to signal their intent to continue pursuing an increasingly conservative financial posture by setting a new leverage target of 2.75x - 3.25x. They explained their reasoning for this reduction in their leverage target on their Q4 earnings call :

To support our financial goals to responsibly grow the partnership and provide our limited partners with a growing and resilient stream of cash distributions over the long term, we believe we have entered into a new era in which it is wise to have a stronger balance sheet than historical norms in the energy industry. We are seeing our customers in the E&P, refining and petrochemical sectors do likewise. As a result, we are lowering our target leverage ratio from 3.5 times to 3.0 times, plus or minus a quarter of a turn. That is a range from 2.75 times to 3.25 times. And as we've noted earlier, our leverage for 2022 we ended at 2.9 times. So we're in good shape with regard to this new target.

Meanwhile, Plains' BBB- credit rating could be upgraded to BBB in the not-too-distant future thanks to management's significant progress in paying down debt and reducing their leverage ratio to 3.7x by year-end. This year, they plan to pay down at least $600 million in debt while maintaining roughly constant adjusted EBITDA, thereby reducing their leverage ratio from 3.7x to 3.5x by the end of 2023. The company is also looking at eventually opportunistically retiring some or all of its preferred equity since it is now becoming more costly to them with recent increases in the distribution rates on those preferreds due to higher interest rates.

When asked about its expectation for the long-term leverage ratio given that they are already below the low end of their long-term target, management said:

we intend to migrate further below the low end and kind of operate there. And I think what our view is we'll assess [whether we want to lower our target leverage range]. We do believe that probably broader energy industry leverage probably needs to be lower than it's been historically. But we'll take a little time and assess that in the future, but for now, just kind of look at it and pass along the math that we just intend to kind of operate below the low end.

The bottom line here is that both businesses are in excellent financial shape and are at little risk of financial distress for the foreseeable future. In fact, both appear to be communicating that they expect to get even stronger financially in the future.

Plains Vs. Enterprise: Dividend Outlook

Plains management announced back with its Q3 report that it expects to grow its payout significantly in the coming years:

Management currently intends to recommend to the Board of Directors of PAA GP Holdings LLC ("the Plains Board") an annualized increase of $0.20 to PAA's and PAGP's fourth-quarter 2022 distribution payable in February 2023 (one quarter earlier than our standard beginning-of-the-year annual budgeting process), which would increase the annualized rate from $0.87 to $1.07 per common unit and Class A share. Beyond 2023, as part of its standard annual review process, management anticipates targeting annualized common distribution increases of approximately $0.15 per unit each year until reaching a targeted Common Unit Distribution Coverage Ratio of approximately 160%

This makes Plains a highly attractive income growth stock, especially when considering that it currently offers an 8.3% forward yield.

Meanwhile, Enterprise recently made a pretty clear indication on its Q4 call that it plans on accelerating the distribution pace relative to where it was in 2021 and earlier, building off of last year's distribution growth rate:

I think over the last, call it the last 18 months, we've shown -- we've sort of completed that pivot to go from an externally funded model to an internally funded model. And we had slowed distribution growth there for about three years or so. And over the last, call it 18 months, we've taken that distribution growth back up to about 5% area. So we have increased the pace of distributions. And then the buybacks, we continue to do that opportunistically. So we feel like we're in good shape to execute on opportunities that come to us in 2023, 2024. So we feel like we're sort of checking the box of returning capital and all of the above and also maintaining lower leverage at the same time.

While Enterprise's distribution growth rate moving forward is likely to lag Plains' in the coming years, it still offers a very compelling combination of mid-single digit distribution growth and a 7.7% current distribution yield.

Plains Vs. Enterprise: Catalysts And Risks

PAA/PAGP is a riskier midstream business than Enterprise simply due to the fact that it is more concentrated in terms of both size and commodity concentration. Furthermore - as already discussed - its balance sheet is not as strong as Enterprise's and therefore has a lower credit rating.

We can therefore conclude that PAA/PAGP's long-term fortune will largely hinge on demand for oil from the Permian Basin, which is where it has concentrated its assets.

Meanwhile, Enterprise serves as a more broadly diversified investment in the midstream sector. As a result, Enterprise has significantly less downside catalysts than PAA/PAGP, but also does not have as strong of a potential upside catalyst as PAA/PAGP does.

Plains Vs. Enterprise: Valuation

Based on the data below, we see that PAA is significantly cheaper relative to EPD on both a comparative and historical basis:

Even PAGP - the economic K1-free equivalent of PAA - is considerably cheaper than Enterprise, as it currently trades at just a 4.3% premium to PAA.

Investor Takeaway

Both Plains and Enterprise are very attractive investments at the moment in our view, with strong balance sheets and well-covered and attractive payouts.

That said, Enterprise's balance sheet is second to none in the industry and its portfolio of assets is truly world-class. If you are simply looking for a safe high yield that will grow in line with inflation moving forward, Enterprise is a slam dunk buy.

That said, Plains offers investors significantly greater payout growth potential on top of its slightly better current yield as well. As a result, if you are looking for a higher return, higher risk option, Plains is very attractive as well. For investors looking to avoid the K-1 tax form, PAGP is a very attractive pick, whereas PAA is a better value for those investors who do not mind the K-1 tax form.

Given the makeup of our midstream portfolio at High Yield Investor, we think that PAA is a great fit for our Core Portfolio alongside three other picks, while EPD is a great fit for our Retirement Portfolio alongside two other midstream picks.

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