Pipeline Pessimism Looks Overdone Enbridge, Transcanada Still Pumping Out Profits

It’s been a miserable year for shareholders of Canada’s two largest pipeline companies. As of June, Enbridge Inc. is down about 20% on the year and TransCanada Corp. is down 11%. For long-term investors seeking income, however, the downturn represents a buying opportunity.

Investors fear higher interest rates will hurt both companies, which have borrowed heavily to finance growth. As well, investors worry that more pain might be inflicted by the effects of a U.S. Federal Energy Regulatory Committee (FERC) decision to reverse tax-favoured status for master limited partnerships, often used by companies with pipeline interests in the United States.

All this pessimism means that Enbridge, at a current price of just $40, is selling for the same price it was in 2012, while TransCanada, at $54, is at a two-year low. In my opinion, the pessimism is overdone.

Thanks to environmental and political hurdles, building a new pipeline anywhere in North America has become time-consuming and difficult, creating high barriers to entry for new players in the industry. The same obstacles also protect companies that already own pipelines, such as Enbridge and TransCanada.

Similarly, government regulations involving governments in Canada and the United States, together with provincial and state governments, discourage new investment in the sector. At the same time, long-term contracts provide stable returns that help insulate the incumbent pipeline companies from volatile oil and natural gas prices.

Both Enbridge and TransCanada have a long history of paying out and increasing their dividends, and the recent slump in the share prices has increased the dividend yields. Their dividends appear safe, as well. Both Enbridge and TransCanada have healthy and growing levels of Distributable Cash Flow (DCF), a key measure of dividend sustainability. Even if DCF were to slip, the boards of both companies are more likely to reduce head count, sell off assets or freeze the dividend at current levels for a few quarters than reduce the dividend and anger the "widows and orphans" who rely on the payout.

Disclosure: My wife and I have held both Enbridge and TransCanada in our Locked-In Retirement Accounts for many years, and we both subscribe to their dividend reinvestment plans.

Enbridge Inc. (ENB/TSX)

Enbridge, based in Calgary, is the sixth largest company in Canada, with a market capitalization (number of shares times share price) of $67.9-billion. Enbridge operates a huge crude oil and natural gas transportation system in North America, with 27,388 km of what it calls “active pipe.” The company’s pipelines transport 28% of the crude oil produced in North America. Enbridge also transports, processes and stores natural gas across North America and the Gulf of Mexico. Enbridge’s natural gas distribution network includes about 3.7 million retail customers in Ontario, Quebec, New Brunswick and New York State. Its renewable energy portfolio includes 12 wind farms, four solar energy operations, and a geothermal project.

Enbridge has an 84.6% economic interest in Enbridge Income Fund, a 34.9% stake in Enbridge Energy Partners, L.P. and a 75% of Spectra Energy Partners, both based in Houston, Texas. Its workforce totals 15,400 people.

Enbridge, launched in 1949 as Interprovincial Pipe Line Company, became IPL Energy in 1994, and became Enbridge— a blend of energy and bridge — in 1998. Since shares of Enbridge and its predecessor companies began trading more than 50 years ago, its shareholders have enjoyed an average 13.5% annual return, the company says.

Enbridge’s 2017 annual report lists total debt of $92.3-billion (including $60.9-billion in long-term debt) against $162.1-billion in assets. Enbridge is working to improve its debt position. At its annual meeting on May 9, 2018, Enbridge announced it would sell its indirect subsidiary, Midcoast Operating LP natural gas unit for US$1.12-billion, and that it would also sell 49% of some of its renewable power assets to the Canada Pension Plan Investment Board (CPPIB) for $1.75-billion as part of its plan to reduce debt.

In March, Enbridge said there would be no material impact from the U.S. FERC move.

Last year, Enbridge had Earnings before Interest, Taxes, Depreciation and Amortization (EBITDA) of $10.3-billion, up 49% over the previous year, while DCF was up 51% to $5.6-billion or $3.68 per share, with the per-share DCF down 10% as more shares had been issued. Adjusted earnings were $2.98-billion or $1.96 per share, down 14% from the previous year.

Enbridge increased its dividend by 15% in 2017, its twenty-third consecutive year of dividend hikes. Enbridge has paid a dividend since 1954. Over the past 20 years, the company has increased its dividend at an average compound annual growth rate of 11.7% and has generated total annual returns of about 13%. The dividend should grow by 10% per year through 2020, Enbridge’s site says.

In May, Enbridge reported first-quarter 2018 Distributable Cash Flow of $2.31-billion, up dramatically from the $1.215-billion reported in the first quarter of 2017. Adjusted earnings climbed to $1.375-billion or 82c per share, up from 57c per share in the first quarter of 2017.

In Mid-May, Enbridge announced plans to acquire all the shares it does not already own of Spectra Energy Partners, Enbridge Energy Partners, Enbridge Energy Management and Enbridge Income Fund Holdings for $11.4-billion or 272 million Enbridge common shares. Enbridge said the transactions would not affect its three-year financial guidance and would help its post-2020 outlook. The acquisitions are part of Enbridge's plan to streamline and simplify its corporate structure, which analysts said was a concern for investors.

All this relatively good news has been ignored. At a current share price of $40, the annual dividend of $2.68 yields 6.7%. This appears unsustainably high, yet Enbridge’s target dividend payout is less than 65% of adjusted cash flow from operations. The company’s dividend reinvestment plan allows shareholders to reinvest their dividends in more shares at a 2% discount to the market price.

A total of 12 out of 22 analysts who follow Enbridge see it as a buy, while 10 say hold and none see it as a sell, as listed by the Wall Street Journal.

TransCanada Corp. (TRP/TSX)

TransCanada’s market capitalization is about $48-billion, making it the thirteenth largest company in Canada. The company has a 91,900 km network of natural gas pipelines, supplying about 25% of the gas used in Canada, the United States and Mexico, together with 653 billion cubic feet of storage capacity. The company’s Keystone Pipeline, opened in 2010, transports about a fifth of western Canada’s crude oil production to the U.S. Midwest and ports on the Gulf of Mexico.

TransCanada also either owns or has interests in 11 electrical power plants with a combined capacity of 6,100 megawatts. It employs 7,500.

Like Enbridge, TransCanada is based in Calgary and has a long history of providing excellent returns to shareholders, achieving an average return of 14% since 2000.

In April, TransCanada increased its annual dividend by 10.4% to $2.76, the eighteenth consecutive annual hike. The company said it expects annual dividend growth to continue between 8% and 10% through 2021.

At $54, shares of TransCanada Corp. are down about 11% on the year. The low share price means the annual dividend of $2.76 yields 5.1%. Like Enbridge, TransCanada offers a dividend reinvestment plan that allows shareholders to buy more shares at a 2% discount to market.

In 2017, TransCanada achieved record cash flow and earnings, with net income of nearly $3-billion or $3.44 per share.

In the first quarter of 2018, TransCanada reported comparable Distributable Cash Flow of $1.4-billion or $1.64 per share. Net income attributable to common shares increased by $91-million to $734-million or 83c per share. Comparable earnings for first quarter 2018 were $870-million or 98c per share compared to $69-million or 81c per share for the same period in 2017, an increase of $172-million or 17c per share.

A total of 17 out of 20 analysts who follow TransCanada see it as a buy, while three say hold and none see it as a sell, as listed by the Wall Street Journal.

CONCLUSION

There are hundreds of giant, blue-chip corporations in the United States but only a few in Canada. (In fact, there is an old joke among Americans that in Canada, a small-cap company becomes a mid-cap one when a third man jumps into the back of the pickup truck.)

Enbridge and TransCanada are among only a dozen or so Canadian companies whose market capitalizations exceed $40-billion. The limited menu of Canadian blue chips means Canadians may already own stakes in both pipeline companies, either directly or through mutual, index or pension funds. Both Enbridge and TransCanada have been a drag on portfolios this year, and while there is no guarantee their shares are not going down further, adding to positions should at least lower their average cost.

Richard Morrison, CIM, is a former editor and investment columnist at the Financial Post. richarddmorrison@yahoo.ca