Enbridge: A High-Yielding Midstream Play

Summary

• Enbridge is the largest pipeline company in North America.
• The company boasts a dividend of 6.6% and will likely be able to increase its dividend at a 10% CAGR until at least 2020.
• The dividend appears to be relatively safe due in large part to the secure cash flow that Enbridge's long-term contracts provide it.
• Growth after 2020 depends largely on the capital markets but seems likely due to the projected increase in natural gas and oil production on the continent.
• The stock is not the cheapest in the pipeline space, but it appears reasonably cheap and could be a good long-term holding for energy investors.

Over the past few weeks, I have been seeing quite a few bullish cases on Canadian pipeline giant Enbridge (NYSE:ENB), so I decided that it might be worth revisiting the company as I have not published anything on it for a few years now. I must admit to having a certain fondness for pipeline and other midstream companies due to the fact that they typically have large and stable cash flows that provide these firms with a significant amount of capacity to pay out substantial dividends to their shareholders. Enbridge is no exception to this, boasting a 6.6% dividend yield at the current share price. The company also owns the largest pipeline system on the North American continent and is therefore an integral player in the energy infrastructure of both the United States and Canada. The company is also currently trading at a very attractive valuation, so it certainly looks like it could be an appealing addition to an energy investor's portfolio.

As I just mentioned, Enbridge has the largest pipeline network in North America, which transports approximately 28% of the continent's crude supplies and 20% of its natural gas.

Source: Enbridge, Inc.

In addition, the company has been steadily growing and expanding its capacity over time, which is partly due to capacity upgrades and partly due to its customers increasing their use of the company's services. As shown here, the company's mainline transported an average of 1,737 thousand barrels of oil equivalent per day in 2013, which grew to approximately 2,733 thousand barrels per day in December 2017. This represents an increase of 57.34% over the four-year period.

Source: Enbridge, Inc.

The company expects to deliver similarly strong performance in 2018, which will likely be helped by the CAD$12 billion ($9.48 billion) worth of new projects (primarily pipelines) that Enbridge brought online in 2017:

Source: Enbridge, Inc.

Enbridge expects that these new pipelines will do more than simply stimulate strong performance in 2018. Indeed, in its fourth quarter 2017 results presentation, the firm predicted that these new projects will result in DCF growth for the company until 2020. As my fellow Seeking Alpha contributor Jason Phillips points out, this has prompted Enbridge to publicly state its plans to grow its dividend at a 10% compound annual growth rate between now and 2020.

Source: Enbridge, Jason Phillips, CFA

As might be expected, Enbridge generates the majority of its revenue by transporting crude oil and natural gas for its customers. Therefore, we can expect these pipelines to increase the amount of revenue that the company generates by increasing its capacity to transport these resources.

In truth, however, things are somewhat more complicated than this. This is due to the way other energy companies compensate the pipeline owner for transporting their oil or gas. In short, the company's customers enter into long-term (5 to 25) year contracts to move the resources to another location. Thus, just because the company expands its capacity, it does not necessarily mean that it increases the company's cash flow. In order for that to happen, Enbridge needs to secure contracts that use the new capacity. Fortunately, Enbridge has already obtained contracts for the use of the transport capacity that it added by the completion of these pipelines.

These new pipelines that came online over 2017 are not the only new ones that Enbridge expects to drive its forward cash flow growth. In fact, between now and the end of 2020, Enbridge has approximately CAD$22 billion ($17.39 billion) worth of new projects scheduled to come online, all of which have already obtained contracts:

Source: Enbridge, Inc.

It is important to note that Enbridge has already secured financing for each of these projects. This is important because it means that we can have faith that the growth that will come from these projects will occur. It also means that the company will not have to tap the capital markets to raise money. We will discuss why this is important in just a few moments.

Enbridge also has further growth projects that are scheduled for completion after 2020, but these have not acquired contracts yet, so remain speculative at this point. While it is certainly possible that Enbridge will able to continue to grow its dividend due to the cash flow from these projects as they come online, there is no guarantee that this will be the case, although it does seem likely. This is due to the fact that production of both oil and natural gas is expected to increase all across the North American continent over the next several years.

One of the things that investors need to consider when investing in any company for its dividend is how sustainable that dividend is. One of the best ways to do that is to look at the company's free cash flow. Free cash flow is essentially the money that a company has left over after it pays all of the costs of its operations as well as the costs of maintaining and expanding its asset base. It is calculated by subtracting a firm's capital expenditures. This chart shows Enbridge's free cash flow over the past three years:

Source: Author, data from ENB Company Filings

Here, we see a definite problem as Enbridge appears to be spending all of its operational cash flow on its capital expenditures (growth projects) and then some. This would leave it with no money to pay its dividend, yet it continues to make sizable distributions to its shareholders, totaling CAD$3.389 billion ($2.68 billion) in 2017.

The company's capital expenditure and dividend strategy appears to resemble that of a master limited partnership. That is clearly visible if we look at the company's statement of cash flows.

Source: Yahoo Finance

As we can see here, Enbridge brought in a not insignificant amount of money from the issuance of new stock in each of the past three years. It also borrowed a fairly large amount of money in two of the three years. It appears that the company's strategy is to raise debt and equity financing to pay for its growth projects and then use the cash flow generated by the new pipelines to pay its dividend.

It is nice to see that the company is using both debt and equity financing to raise money. This is likely an attempt to manage its capital structure and avoid becoming too levered. Overall, it appears to have had some success at this. Here are the company's debt-to-equity ratios over the past three years:

Source: Author, data from ENB Company Filings

As a general rule, I start to get concerned if I see an energy company with a debt-to-equity ratio over 1.00. With that said, midstream pipeline companies can usually maintain a higher amount of leverage than other energy companies due to the revenue stability that their long-term contracts provide them. It is however still nice to see that the company has been aggressively reducing its leverage even as it expands its capacity and constructs additional pipelines.

The fact that the company has been reducing its leverage ratio increases the margin of safety for shareholders. Over the past few years, we have seen numerous energy companies get into trouble because of debt. Those companies with much lower amounts of leverage relative to their equity have had a much easier time weathering through the bear market in oil and natural gas. This has a second advantage, however; both debt and equity investors are likely to maintain or increase their faith in the company. As we have already established, Enbridge has to maintain its access to both the debt and equity markets in order to finance its growth ambitions. It therefore needs to maintain investor confidence in order to continue growing and improving its leverage ratios will help with this task.

We are still concerned with how sustainable the dividend is. Well, the company's operating cash flow has significantly exceeded its dividend in each of the past three years:

Source: Author, data sourced from company filings

What this tells us is that Enbridge probably could maintain its dividend at the current level if it cut its capital expenditures significantly. This would, of course, curtail the company's growth and will likely prevent it from increasing its dividend after 2020 (as all growth prior to that has already been funded). Thus, the company's current long-term plans are only possible if it continues to be able to access the capital markets at favorable terms, which will probably be the case barring a major financial panic, but it probably could also maintain its dividend at its 2020 rate regardless (by cutting growth projects beyond that date).

Earlier in this article, I stated that Enbridge appears to be trading at a fairly attractive valuation. The most common metric used to value an MLP (which Enbridge acts like even though it is technically a corporation) is price/DCF. As of the time of writing, Enbridge had a P/DCF ratio of 8.67. Here is how that compares to a few other MLPs (or MLP-like companies):

Source: Author, using data from company filings

As we can clearly see, Enbridge is not the cheapest pipeline company in the market, but neither is it the most expensive. The company is trading at a single-digit valuation which is something that, especially in recent years, was only seen when a company was either suffering from or at risk of suffering from serious financial trouble. This does not appear to be the case with Enbridge, however, and, in fact, we could even consider the fact that the company is one of the more expensive players in the pipeline space to be a confirmation of that fact. In short, the market appears to believe in the company.

In conclusion, Enbridge appears to have a lot to offer a potential investor. The company boasts a relatively cheap valuation, high dividend yield, and strong growth prospects. It is also quite strong financially with its leverage decreasing year over year while its DCF continues to increase. The long-term contracts backing its revenue should also provide some comfort for investors that it will not suddenly see its revenue fall off of a cliff. All in all, this looks like an investment worth considering.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.