Enbridge (NYSE:ENB) is the owner operator of arguably the world's longest liquids pipeline network. This breaks down into a liquids pipelines business from Western Canada to the Gulf Coast along with gas distribution division serving customers in Ontario, Quebec, and northern New York State.
The majority of the earnings in liquids segment come from the Enbridge Canadian Mainline, with capacity of 2.5 million bpd, stretching from Edmonton to Chicago. The Southern Lights pipeline ships condensate from Chicago to Edmonton. While the Spearhead system delivers liquids from Chicago to Cushing and the Seaway pipe transports crude from Cushing to the Houston refineries.
Gas pipelines, processing, and energy services segment includes gas transportation systems running along the mainline, in Texas, and offshore in the Gulf Coast. These gas gathering and transportation networks are complemented by gas plants for processing near Fort St. John, the Bakken, and the Aux Sable plant for gas fractionation and extraction near Chicago. While the firms sponsored investments include Enbridge's 20.6% ownership of Enbridge Energy Partners (NYSE:EEP) and 67% interest in Enbridge Income Fund Holdings. While a complicated structure management doesn't shy away from pointing out that we should pay attention to the liquids segment, the dominant driver of future earnings growth, and so we will.
When looking at the pipeline universe we are searching for firms that aren't simply yield plays, but businesses that have significant growth opportunities. We believe Enbridge has significant capacity to expand its liquids pipeline business in the medium term and offers a buffer against firming interest rates. These are necessary criteria at this point of equity cycle with the Federal Reserve tightening the reins and rate increases to come in 2015.
The growth potential is driven by macro industry trends along with Enbridge's successful capitalization on those opportunities through unprecedented investment in its business. It is no secret that going forward emerging economies, non - OECD, will drive the demand for oil and other sources of energy. The Western Canadian Sedimentary Basin has ample resources and is located in a politically stable region. Enbridge comes into the picture by allowing producers to transport their resources to the highest bidder markets and allows refiners, PADD 1 to 3, to get the correct crude. The increasing production along with limited pipeline infrastructure has contributed to volatile oil price differentials. Producers are scrambling to get their product to tide water markets to fetch a world price for their goods. While rail provides a short term fix the sustained economic solution will come from pipeline firms such as Enbridge.
Along with macro trends the catalyst for Enbridge going forward will be realization of the 10 - 12% compound annual growth rate in EPS, promised for 2013 to 2017. Majority of this growth will be driven by its liquids pipeline business. As of year-end 2013 the capital budget totaled $29 billion of commercially secure projects aimed at: increasing capacity stretching from Western Canada to refiners in the Gulf Coast, getting crude from Chicago out east to Montreal, and expanding the capacity for light oil flowing from the Bakken. The majority of these projects will come online by the end of 2014 and as result begin contributing to earnings in 2015. We believe these initiatives are not only critical to Enbridge, but to many producers of landlocked crude fighting for higher netbacks. Enbridge will further benefit from the return profile of these projects.
The returns of the capital projects are to increase with time having an upward sloping profile. Richard Bird, Enbridge's CFO, has highlighted that more than half of the commercially secure projects begin with returns in the high single digits and grow to the mid to high teens. While this still averages to a low double digit return on equity, as for most Enbridge projects, it provides for organic growth beyond the in service date. Organic in the sense that no extra capital investment directed to these initiatives will be required to increase returns. The positive slope of the return on equity arises from ship-or-pay contracts having increasing volume commitments or through a rising toll structure.
Simply put take or pay contracts stipulate that Enbridge receive payments over the life of the agreement regardless of the volume shipped with no refunds. For example the Alliance pipeline, moving 1.6 Bcf of gas a day, is governed by long term take or pay contracts and regulated by the Federal Energy Regulatory Commission. Regulation also ensures that Enbridge recovers its cost of service and is compensated through an allowed return on equity of 10.9%, on the Alliance pipeline. Moreover, the toll arrangements provide protection against inflation. The Enbridge Mainline is under a 10 year Competitive Toll Settlement which is adjusted yearly by 75% of the Canadian market price GDP index. So while regulation often is slow to provide permits for projects it also allows Enbridge to consistently out earn its cost of equity, which is in the 8 to 9% range.
While commercially secure projects support growing earnings with stable to rising returns on equity the unsecured such as Northern Gateway form the risk to our outlook. Current oil price differentials drive volumes on Enbridge's vast network, however supply of North American energy is growing and new export markets are needed. There are definite economic needs for the pipeline, but also needs from a competitive standpoint for Enbridge's operations on the west coast. With TransCanada (NYSE:TRP) receiving the go ahead from Progress Energy and another from Shell to construct natural gas pipelines Enbridge appears to be on the sidelines. Being unable to find new markets for its' clients products is a risk to all pipeline operators including Enbridge, but may also be a major boost to earnings if this risk can be turned into a catalyst. On balance we don't believe rejection of the Northern Gateway proposal will hinder the medium term thesis of liquids transportation growth, but may be a limiting factor longer term.
Valuation & Conclusion:
We have a target price of $57 CAD in the next twelve months, which represent at total return of 17 %, including the annual dividend of $ 1.4 CAD, from the recent share price of $49.78 CAD. We used a 7.5% weighted average cost of capital based on a 6.5% pre-tax cost of debt along with a conservative 9% cost of equity. We assigned Enbridge a low cost of capital as it has a strong competitive position in the North American pipeline business, as well regulation and competent management of assets helps Enbridge to consistently out earn their cost of capital and generate reliable returns to shareholders. With a majority of the commercially secure capital coming on in 2014 we have modeled strong revenue growth, translating into earnings increases, post 2014 through to 2017.
To gain a perspective on our target price management has provided their estimates at the 2013 Enbridge Day investor presentation. Assumptions to the table below include: 10 -12% EPS CAGR for 2013 to 2017, 10% growth rate in dividends post 2017 to 2022, dividend growth to approximate earnings growth, and the 4.5 - 5% dividend growth rate equals the long term North American pipeline industry average. In total, we believe Enbridge will be able to achieve our target price and management's expectations due to favourable industry dynamics and the resulting need of extra pipeline capacity. Enbridge will capitalize on this trend by the successful execution of their projects benefiting shareholders.
Disclosure: I am long ENB.
Business relationship disclosure: The article has been written by Turtle Street Capital; the author is the co-founder of the firm. Turtle Street Capital is not receiving any compensation for it. Turtle Street Capital has no business relationship with any company whose stock is mentioned in this article.