Inter Pipeline (OTC:IPPLF) is a Canadian company with four major business segments: oil sands transport, conventional oil pipelines, natural gas liquids extraction, and bulk liquid storage. They handle over 1.8 million barrels of energy products daily. Their long-term business strategy is to acquire and develop long-life high-quality energy infrastructure assets to generate stable and predictable cash flows. Inter Pipeline trades on the TSE as IPL and OTC in the US as IPPLF with half a million and 13000 shares traded daily on each exchange respectively. Unlike many other small Canadian stocks capable of delivering alpha, the US OTC issue has sufficient liquidity for investors and interested parties do not need to find a broker capable of purchasing shares on the TSE.
Financial year 2012 continued Inter Pipeline's (for this article referred to as IPL) history of being one of the top performing companies in Canada's public equity markets, providing a 32% total return to shareholders including a dividend hovering around 5%. Over the past five years, IPL has returned over 200% to shareholders, without including dividends. They also continued their strong tradition of dividend growth with a 5.7% raise in financial 2012. Over the past ten years, the market cap has grown ten times from 700 million to over 7 billion. The chart shows their past and projected dividend payment. (Source: Annual Report 2012)
Beyond the strong performance of their four major wide-moat business segments, (which will be discussed in the following sections) IPL is a company at a turning point. Before September this year, Inter Pipeline was structured as a limited partnership and unitholders had to be Canadian residents. This year they bought out the general partner and converted to a corporation as they are predicting free cash flows so high that general partner incentive payments would have increased. In fitting with their commitment to shareholders, they deemed these payments to be too expensive and bought out the GP to return more to shareholders. This conversion to a corporation means their shares are now available for international investors, which anticipated to increase demand and share price. Since September, shares are up almost 10%.
Beyond this, IPL is so confident in their business model that they have embarked on their largest capital project in the company's history, a 2.2 billion integrated development plan on their Cold Lake and Polaris pipeline systems which will add 1.2 million barrels per day of increased capacity with the addition of 840 km of pipe and 7 new pumping stations. This is under a proposed long-term arrangement with Cenovus Energy (CVE) and ConocoPhillips (COP) with a ship-or-pay contract, insulated from commodity prices or throughput risk as a result of minimum annual toll revenues.
The Cold Lake, Corridor, and Polaris Pipeline systems are part of IPL's oil sands transport business segment. IPL is responsible for the gathering of around 40% of Canadian oil sands production with a combined maximum capacity of 4.5 million b/d. The Canadian oil sands have been estimated by the International Energy Agency to have maximum recoverable reserves of 178 billion barrels, making Canada's proven reserves second in the world after Saudi Arabia. These pipelines are located within pipeline-friendly Alberta. IPL's customers include Shell (RDS.A), Chevron (CVX), Exxon Mobil (XOM), Cenovus Energy, Esso (OTC:ESSSF), ConocoPhillips, British Petroleum (BP), Husky Energy (OTCQB:HUSKF), and Suncor (SU) and are on contracts with terms 20 years or more with no commodity price exposure or volume throughput risks as a result of long-term cost of service contracts. In 2012, the oil sands transport business provided 25.3% of IPL's revenue, up from 24.7% in 2011. As of October 2013, the oil sands transportation segment was providing 39% of EBITDA.
Beyond IPL's capital-intensive project as mentioned above, the oil sands pipeline system has other growth opportunities such as growth of diluent demand on the Polaris system as the company controls the only diluents transportation system to the Athabasca Oil Sands region. In late 2012, IPL entered an agreement to provide Suncor with 10,000 b/d of diluents transportation. This contract will generate an estimated EBITDA of 10 million yearly during the five-year term. The entire oil sands transportation business is expected to generate 60% of consolidated 2015 EBITDA based on long-term cost of service agreements.
Inter Pipeline also has significant exposure to the conventional pipeline business; in 2012 19.5% of revenue came from this segment, up from 15.4% in 2011. As of October 2013, the conventional oil pipelines segment was providing 25% of EBITDA. These 3,700 km of gathering and transmission pipelines transported 15% of Western Canadian conventional crude oil volumes in 2012. Growth opportunities for this segment include new drilling technology reviving mature fields already on the system.
In 2012, the largest revenue source was natural gas liquid (NGL) extraction, providing 42.2% of revenue, down from 50.8% the previous year. Despite this, NGL extraction only contributed 22% of EBITDA as of October 2013. IPL is the largest producer of ethane in Canada with a capacity of 6.3 bcf/d from its three Alberta plants and processes 40% of natural gas exported from Alberta. It is located on the TransCanada (TRP) Alberta system for easy transportation to customers including Plains Midstream Canada, DOW, and Nova Chemicals. Arguably, this business segment has the most commodity price risk, and indeed the 2013 YTD EBITDA was 14% commodity based, however it is projected that by 2015 only 10% of EBITDA will be commodity based, with corresponding growth in stable and recurring cost of service and fee based revenue sources.
Finally, making up 13.1% of revenue in financial 2012, up from 9.1% in 2011, is the bulk liquid storage business segment. This segment made up 14% of EBITDA as of October 2013. Operating on a fee-based revenue structure, this segment has 19 million barrels of storage capacity and 12 multi-product terminals making it the fourth largest independent tank storage business in Europe. This gives exposure to both the Pound Sterling and the Euro as operations are spread across Ireland, the UK, Germany and Denmark, making IPL a partial play on European recovery, as well as representing a hedge against US dollar devaluation. 2012 did show a drop in capacity utilization, however this was due to the acquisition of Inter Terminals in January for 459.1 million, more than doubling IPL's bulk liquid storage capacity in Western Europe, leading to a 49% increase in revenue in this segment. It is interesting to note that wholly-owned subsidiary Simon Storage's Immingham terminals are integrated with the local Phillips 66 (PSX) Humber refinery and Total's (TOT) Lindsey refinery.
IPL's core strategy of growing through acquisition and organic development of long-life energy infrastructure assets has led to very strong financials. Over the past five years, gross profit has increased to 57% in 2012 from 35% in 2008, far higher than those of Enbridge (ENB) and comparable to those of TransCanada Corporation. The SGA expenses for IPL are lower than those for TRP or ENB, where only 12% of gross was spent by IPL compared to ~20% for TRP and ~40% for ENB. Comparing the net profit of these three companies shows the advantage of IPL; in 2012 net profit margins for IPL were over 25%, increasing from 20% in 2008. These are far higher than ENB's 2012 margins of 2.8% and slightly higher than those of TRP's ~20%. Furthermore, as of 2012 IPL would be able to pay off all long-term debt within 5.7 years using net earnings. Comparing this to TRP which requires 12-15 years to pay off all long-term debt, or ENB which requires 28 years to pay off all long-term debt, the competitive advantage of IPL is easily seen. The past 4 years have also shown increases in shareholder return on equity, increasing from 12% in 2009 to 19% in 2012.
We have several important take away messages regarding the future of IPL.
- Significant percentages of business are through contracts that are immune to commodity or throughput risks. The percentage of EBITDA that is commodity-based is only decreasing.
- IPL is a play on the world's second largest oil reserves, and the only diluents supplier to the Athabasca oil sands.
- Significant income and expansion projects are being made in Europe where some of the best current investment bargains are.
- Extremely strong financials compared to other pipelines.
- Buffett-endorsed by transference: Buffett has recently purchased Suncor and Phillips 66 . In Alberta IPL is a major diluents supplier (with room for higher capacity) to Suncor, and in Europe, some of IPL's liquids storage facilities are integrated with a PSX refinery.
- Significant Insider buying.
- IPL is embarking on a largest-in-company-history capital project at its lowest historical interest rates.
- And finally, conversion to a corporation has now expanded the pool of potential investors from just Canadians to the entire world, a significant inflection point for the company. This also means they have no more fees to the former general partner, further increasing cash flow.
With all this in mind, how much of an upside do we see for Inter Pipeline? To get a rough estimation we will use the method used in Warren Buffett and the Interpretation of Financial statements and in a previous article. Through the treatment of the company stock as an equity bond, the market over time will price the company relative to the long-term corporate bond yield. By dividing the pretax EPS for 2012 (1.26) by their corporate bond rate (we will use the 3.8% obtained for their large current capital project) a projected share price of $33 is obtained, an over 25% upside from current. Extrapolated into the past using historical average corporate bond yields, this method has traditionally aligned well with share price. This method does not take into account the lack of future fee payments to the former general partner, nor an increase in international interest, so the predicted 25% upside is a conservative estimate. Because of this, we rank IPL as a strong buy at current prices, as a low risk, high reward opportunity.
Additional disclosure: I will be purchasing as IPL on the TSE, not as IPPLF on the OTC markets.