- ENB is one of the largest pipeline operators in the continent.
- The company has been able to boost profitability without increasing leverage.
- The stock trades at a generous 7% dividend yield, but at 17 times free cash flow.
- I give my verdict if the stock is a buy, sell, or hold.
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Enbridge (NYSE:ENB) has seen a solid recovery since crashing last year. Still, the stock is yielding 7%, which is arguably high when considering ENB’s high growth rate. In this article, I explain why ENB has been one of the best pipeline operators in the continent. Leverage remains high, but if the company can continue executing, then the robust growth rates may more than make up for it. I give my final verdict regarding whether the stock is a buy, sell, or hold.
Enbridge Stock History
As the world came to a stand still, ENB saw its stock crash in March of 2020.
Since then, the stock has almost fully recovered to pre-pandemic levels. It appears that optimism regarding vaccine distribution has investors hoping for a swift rebound in the energy sector.
Enbridge: Pipeline Giant
ENB is one of the largest pipeline giants in the continent, as it transports 25% of crude oil and 20% of natural gas in North America.
ENB has gradually reduced its exposure to crude oil liquids and increased its exposure to natural gas, now totaling 43% of income in 2020.
That’s important to point out, because whereas crude oil seems to face strong secular headwinds from an ESG perspective, natural gas remains considered a relatively carbon-friendly alternative.
As a pipeline operator, ENB is one of those stocks frequently called the “toll roads” of the energy sector. The company was able to prove that title during the pandemic, as it was able to more or less maintain revenues in spite of a crash in the broader energy market.
How does one go about determining if ENB is a high quality operator? I use two metrics: return on assets (‘ROA’) and leverage. By looking at ROA based on distributable cash flow (‘DCF’) over time, we can see if the company is able to maintain profitability on its asset base. Stable or increasing ROA implies that profitability is increasing, with growth projects adding to that profitability. If ROA is decreasing, then that implies that profitability is decreasing and growth projects are merely hiding underlying weakness. ENB has managed to substantially grow ROA over the last 5 years.
(Chart by Best of Breed, data from annual filings)
I next look at leverage as measured by debt to EBITDA. It is important for leverage to be stable or declining because that implies that management is executing on project expectations and that the growing ROA is not simply due to increasing leverage. As we can see below, ENB has gradually reduced debt to EBITDA year after year.
(Chart by Best of Breed, data from annual filings)
Lower quality operators would see ROA decline and debt to EBITDA increase - ENB is solidly on the right side of both metrics. ENB projects the growth to continue, with 5-7% DCF per share growth through 2023.
Is Enbridge Stock Dividend Safe?
ENB yields 7% and thus is likely to be targeted by dividend investors. The main topic in mind might be: is the dividend safe? There’s several components to that answer. First, ENB’s dividend is covered by DCF with a 56% DCF payout ratio. However, ENB is highly capital intensive as it needs to invest in growth projects to drive growth.
Based on free cash flow, ENB has a 150% payout ratio, which may appear dangerously high. Furthermore, ENB’s leverage is rather high at 4.7 times debt to EBITDA.
I would feel more comfortable if ENB brought leverage down closer to the 3.5 times range seen at Enterprise Product Partners (EPD) and also improved its free cash flow payout ratio. However, one must also take into account ENB’s great track record. As discussed previously, ENB historically has strongly executed on growth projects, which has enabled it to earn BBB+ or equivalent credit ratings in spite of its high leverage.
If everything goes as planned, then ENB likely will be able to continue funding the free cash flow shortfall with excess debt because as it grows EBITDA, its capacity for debt also increases in line with its debt to EBITDA ratio.
Is Enbridge Stock A Buy?
The value proposition for ENB is quite simple: you get the current 7% yield, then adding the 5-7% growth suggests ~13% total returns excluding multiple expansion.
ENB has guided 2021 to see DCF of $4.85 per share at the midpoint. Shares trade at less than 8 times that number. However, because ENB must heavily invest in growth projects to drive growth, I believe that DCF multiples are useless and it is much better to value the stock on the basis of free cash flow. ENB trades at 17 times free cash flow - a markedly higher number than DCF. At a 5-7% growth rate, shares appear more or less fairly valued. However, the higher leverage position adds tail-end risk in the event that its counterparties are unable to maintain its contracts, or if it is unable to invest in accretive growth. While ENB touts its 1% annual escalators, I am skeptical of its ability to push those escalators if demand for its assets does not consistently increase. I would be more interested in ENB if it traded for 10 times free cash flow - roughly 40% lower. At that multiple, I believe the secular headwind risks would be better priced in. Unfortunately, the stock might not reach that valuation unless the secular headwinds come into full force.
ENB appears to be a very high quality pipeline operator as evidenced by its ability to increase profitability metrics without boosting leverage. The company has guided for solid growth over the next few years as it completes more growth projects. However, the high leverage load increases its downside risk, and shares aren’t that cheap when viewed based on free cash flow. I rate shares a hold pending an improvement in the risk reward proposition.
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This article was written by
Julian Lin is a financial analyst. He finds undervalued companies with secular growth that appreciate over time. His approach is to look for companies with strong balance sheets and management teams in sectors with long growth runways.Julian is the leader of the investing group Best Of Breed Growth Stocks where he only shares positions in stocks which have a large probability of delivering large alpha relative to the S&P 500. He also combines growth-oriented principles with strict valuation hurdles to add an additional layer to the conventional margin of safety. Features include: exclusive access to Julian's highest conviction picks, full stock research reports, real-time trade alerts, macro market analysis, individual industry reports, a filtered watchlist, and community chat with access to Julian 24/7. Learn more.
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