- Enbridge operates the world’s longest pipeline.
- It has billions in projects on the table confirming a 10-12% dividend growth rate through 2024.
- ENB is clearly undervalued
My Investing Thesis
Honestly, I’m not a big fan of the energy sector. In general, commodities are volatile and companies in these industries often post disastrous results during downturns. Do I need to remind anybody how Husky Energy (HSE.TO) lost 43% over the past 5 years (as at November 24th 2017) and cut its dividend to a big fat ZERO in 2016? Or maybe we should talk about another oil darling named Cenovus Energy (CVE.TO) which lost 63% of its value and cut its dividend from $0.27 to $0.16 and then $0.05 over the past three years?
However, I’m ready to make an exception when we talk about Enbridge (ENB.TO). First things first, ENB isn’t an integrated oil company like HSE and CVE. Enbridge transport oil and natural gas across North America. In other words, it makes a cut on each litre of oil transported in their pipeline. After the merger with Spectra, ENB became an oil sand and natural gas behemoth with over $165 billion in infrastructure assets. As its cash flow is predictable, management expects to drive a 10-12% dividend annual growth through 2024. Between January and November 2017, the stock lost almost 20% and now pays over 5% yield. This makes it a great opportunity on the stock market.
Business Model Explained to a 12 Years Old
What is nice about pipelines is that they are like a toll roads. The only difference is that you have no choice to take that road and pay the toll if you want to travel. The best part is that most Enbridge clients enter in 20-25 years transportation contracts. Therefore, no matter what happens, there are always people paying the toll. The cash flow is easy to predict in the future which leads to steady dividend growth.
Enbridge operates the longest pipeline in North America. The company recently merged with Spectra in order to create an energy infrastructure company. About 2/3 of ENB earnings is generated through oil sand (liquid pipelines) distribution while the other 1/3 is coming from natural gas transmission.
ENB enjoys its position of strength with its Mainline system and regional oil sands pipelines. This network occupies about 70% of Canada’s pipeline capacities. IN other words; if you want to transport energy in Canada, you will have to deal with Enbridge at one point in time.
Pipelines aren’t directly affected by commodities price fluctuation. However, long term perspectives will be affected as Enbridge’s clients may delay some projects if the oil price isn’t high enough. In the meantime, as pipeline constructions are highly regulated and it is a capital intensive business, no competitors will hurt ENB’s business model during economic downturns.
ENB earnings trend isn’t as strong as its revenues. However, you can’t treat earnings growth as you would with a consumer staple company. As ENB business model is capital intensive, amortization and maintenance expenses affect earnings. A better measures of Enbridge success would be a focus on its cash flow from operations or available cash flow from operations (ACFFO):
Source: ENB Q3 2017
As you can see, Enbridge shows a much better picture using those metrics. Enbridge now benefits from a better diversification through natural gas distribution and renewable energy generation. The company has currently $26 billion worth of projects on the table and another $48 billion in development. Among those projects, there is the Line 3 replacement. The company expects the completion of this project in mid-2019. There are still regulatory processes to be completed, but the Line 3 could become a real growth driver for the years to come. In fact, ENB shows an impressive list of growth projects for the upcoming years:
Source: ENB Q3 2017
As the stock price rose by 250% between the end of 2007 and mid-2015, ENB dividend yield took a serious drop. Since then, the opposite phenomenon is happening. The market got tired of ENB and reduced its growth perspectives based on weaker demand for oil sands. Since management never stopped increasing its dividend for this period, the yield went from low 2% to 5% in the past three years.
What makes the analysis of such companies difficult is that you can’t use the payout ratio or the cash payout ratio to determine the sustainability of the dividend. How can you explain that management expects a 10%+ dividend annualized growth rate through the next 7 years while the payout ratio is at 75% and the company shows a negative cash payout ratio?
However, management explains its dividend policy by using the ACFFO which is not a metric I can get using Ycharts or others financial data website.
Source: ENB Q3 2017
You can get an idea of the required adjustments to get to the ACFFO:
Source: ENB Q3 2017
You can trust management when it tells you it can keep up with their dividend growth rate policy. After all, Enbridge is one of the rare Canadian companies showing such a long dividend growth history. Enbridge has been paying dividend for over 64 years and currently shows a 22 years streak with a consecutive dividend raise. After increasing its dividend by 15% in 2017, management aims at a 10-12% growth rate:
Source: ENB website
Enbridge definitely meets my 7 dividend growth investing principles.
You can imagine that no stocks lose 20% of their value within 12 months without a good reason, heh? Enbridge isn’t not a perfect company and there are some downsides potential too. For one, Enbridge may have become an energy transportation behemoth… but it also carries a mammoth sized debt.
I told you pipelines were capital intensive, then you have the result of a strong growth through new projects and mergers. In the event of an economic downturn, ENB would be stuck with an important debt to support. As regulations around new pipelines increase, new projects may be difficult to raise in a profitable manner.
Now that the company has committed to an aggressive dividend growth strategy, you can imagine that cash flow is being used right, left and center. Between current pipeline maintenance, debt repayments and dividend distribution, the company may fall short for capital to be invested on additional projects.
When a stock drops in value, it doesn’t automatically mean it’s a buy. In fact, many falling knives never come back to life (Nortel and BlackBerry anyone?). However, ENB is currently making profit and its valuation doesn’t look that bad:
At a PE of 24, Enbridge isn’t trading at a high multiple compared its past 10 years. Now digging deeper, I’m using a double stage dividend discount model. I used an 8% growth rate for the first 10 years (which is a lot lower than the 10-12% announced by management). I then reduced the growth rate at 5% to remain conservative in my calculation. Since ENB may face headwinds in the future, I used a 10% discount rate.
|Input Descriptions for 15-Cell Matrix||INPUTS|
|Enter Recent Annual Dividend Payment:||$2.44|
|Enter Expected Dividend Growth Rate Years 1-10:||8.00%|
|Enter Expected Terminal Dividend Growth Rate:||5.00%|
|Enter Discount Rate:||10.00%|
|Discount Rate (Horizontal)|
|Margin of Safety||9.00%||10.00%||11.00%|
Please read the Dividend Discount Model limitations to fully understand my calculations.
As you can see, even with conservative numbers, ENB is strongly undervalued right now. I might be wrong, but I think it’s among the best opportunity on the stock market right now.
In the light of my analysis, I’m willing to take my money and invest in Enbridge. I think ENB business model will continue to bring predictable cash flow and management will respect its commitment to a double-digit dividend growth rate for the upcoming 7 years. Using the DDM, Enbridge clearly offer a great entry point below $50.
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Disclaimer: I am long ENB in my Dividend Stocks Rock portfolios.