Enbridge: A Safe Bond Substitute But Not Much More (Upgrade)

Holding Steady, Dominion Gas Deal Not A Game Changer

Note: All dollar values mentioned are in Canadian dollars unless specifically indicated otherwise.

I last covered Enbridge common stock (NYSE:ENB) (TSX:ENB:CA) in September 2023 when a deal was announced for Enbridge to acquire three US-based natural gas distribution utilities from Dominion Energy (D). In that article from September 2023, I noted that Dominion was selling the gas utilities for questionable non-economic reasons, earning that company’s stock a rare Strong Sell. Enbridge is acquiring some good assets, but the dilution from the stock and debt issued to fund the deal will make it barely accretive to earnings per share. This deal will do little to enhance the low growth rate of Enbridge that I have mentioned in an earlier article from June 2022. I rated the common stock a Sell but reiterated that I still liked the US dollar denominated preferred shares, which provide a similar yield but are safer due to their higher position in the capital structure. Given Enbridge’s low single digit EPS growth, investors were not sacrificing much growth potential for the higher safety of the preferreds. As a reminder, there are three different USD preferreds trading under the following tickers:

• Series L (OTCPK:EBBNF) (TSX:ENB.PF.U:CA)
• Series 1 (BOIN:EBBGF) (TSX:ENB.PR.V:CA)
• Series 5 (OTCPK:EBGEF) (TSX:ENB.PF.V:CA)

Since that article, the various securities have performed in line with my expectations. The three preferreds performed the best of the group with total returns in line with the S&P 500 index fund (SPY). Enbridge common stock returned about 5% while Dominion stock was flat over that period.

Also since the gas deal announcement, Enbridge released 2024 guidance for the base business in November, then released 4Q earnings in February. The 2023 results came in ahead of expectations on EBITDA at $16.5 billion Canadian, up 6% from 2022 and at the top end of previous guidance. The company also delivered distributable cash flow per share of $5.48, up 1% from 2022 despite dilution from shares already issued to fund the gas utility deal. For 2024, Enbridge is forecasting EBITDA and DCF growth outside of the gas deal to be 2% at the midpoint but 4-5% at the high end. With additional detail on financing and 2024 earnings expectations for the Dominion gas utilities, I also now expect the deal to be slightly accretive, as opposed to slightly dilutive in my September article. Enbridge raised the common dividend for 2024 to $0.915 Canadian quarterly from $0.8875, a yield of 7.9%.

These positive developments earn Enbridge common stock an upgrade from Sell to Hold. I have few worries about the safety and stability of the common dividend, although there are other pipeline companies out there with lower valuations, better growth, and higher yields. That makes it more of a bond substitute than the dividend growth stock it was in the 2010’s. The US dollar preferreds will probably produce similar returns but remain a Buy due to their higher position in the capital structure. Series 1 and Series 5 are now earliest in their 5-year rate reset period and will provide steady income with capital gain potential as rates go down.

Improvements In The Base Business

The Mainline system is the oldest and probably best-known part of Enbridge, carrying crude from the oil sands of Alberta to multiple refineries in the Great Lakes region now specifically designed to process it. While no longer a major area of capital spending, the Mainline still managed to set a throughput record in 2023 of 3.1 mmbpd. The company also finished a long negotiation on pipeline tolls for this system, setting it up as a steady cash cow for the foreseeable future.

Enbridge still faces some risks around upgrade projects for Line 5, which carries mainly light crude across both peninsulas of Michigan to Sarnia, Ontario. One current challenge is natives in Wisconsin pushing for a shutdown even though Enbridge is already planning to reroute the line around the reservation. The other involves the planned underground crossing of the Strait of Mackinac, which encountered several hurdles from the state of Michigan before receiving approval from state regulators. It is now waiting for approval from the US Army Corps of Engineers. My expectation is that Enbridge will ultimately prevail as they did with Line 3 in Minnesota.

The real growth area for the Liquids Pipelines segment is the US Gulf Coast, where the company is a beneficiary of US government moves to block TC Energy’s (TRP) Keystone XL pipeline. The company recently completed open season for 110 kbd of volume on its Flanagan South pipeline and sanctioned the 2.7 mmbpd Enbridge Houston Oil Terminal. The company is also expanding the Grey Oak pipeline, which runs from west Texas to the Gulf Coast.

On the gas transmission side, Enbridge recently completed purchase of the 77 bcf Aitken Creek gas storage facility in northern British Columbia. The company is also expanding the T-South pipeline from northern BC to the Pacific coast, where it is also building the Woodfibre LNG export facility. The company is also active with gas storage, pipelines, and LNG export on the US Gulf Coast.

The US gas utility deal will give Enbridge about a 50/50 split between liquids and gas, but the company is already active in gas distribution with its utility in Ontario. This existing business was discussed heavily on the latest earnings call, as a new rate case is up for approval. While some parts of the provincial government recognize the importance of natural gas for industry and heating much-needed new homes, the Ontario Energy Board has thrown up some obstacles. These include ending the practice of amortizing the cost of a new residential gas hookup over a period of years. The OEB wants customers to pay for this up front, reducing the attractiveness of gas as a heating fuel and making new homes less affordable. The company is currently fighting this in court. While it will not make a huge impact on Enbridge’s bottom line, it does seem to justify the decision to expand into friendlier regulatory regimes in Ohio, North Carolina, Utah and Wyoming.

These key projects in the base business are responsible for an increase in EBITDA in 2024 to $16.9 billion at the midpoint of guidance. Because the company delivered at the top end of the EBITDA range in 2023 ($16.5 billion), this is a $400 million improvement, or 2.4%, rather than the $700 million improvement expected vs. the original 2023 guidance.

This is the slow but steady growth we have come to expect from Enbridge. The US gas utilities will provide a significant EBITDA boost when complete, but will have little impact on DCF per share because of higher interest expense and dilution from stock issuance. Nevertheless, it now looks slightly accretive overall as I will show below.

US Gas Utility Deal Update

All three gas utilities are still on track to close in 2024, but Enbridge did not provide any more specific timing. As noted on the earnings call, they have received federal approval under the HSR Act as well as from CFIUS, which approves foreign takeovers. They are still awaiting final approval from the FTC and from state regulators, where things are progressing well, according to the company.

I have updated my estimated earnings from the gas deal with 2024 values based on the original Dominion slide in my September article. The utilities will earn $570 million US, or $760 million Canadian in 2024. Assuming a 5.6% interest rate on utility debt, a 20% tax rate, and depreciation of 2.8% of the rate base per year, I calculate EBITDA of $1.23 billion US or $1.65 Canadian.

We also have more information on the financing for the deal. Enbridge has issued 100 million shares of common stock at about $46 Canadian for $4.6 billion total. The company has also issued $3.7 billion CAD worth of hybrid bonds with 60-year maturity and yielding around 8.5%. Enbridge also raised $1.6 billion from asset sales. The company still needs to raise $2.9 billion to fully fund the deal, which it could do by further stock sales, bond issuance, or asset sales. For my model, I assume further debt issuance at 8.5% yield.

Looking at the impact of the deal on DCF, Enbridge is forecasting DCF of $11.34 billion based on a midpoint guidance of $5.60 per share and 2.025 billion shares outstanding before issuance of new shares for the deal. I estimate DCF of the gas utilities to be about $1.04 billion, using the earnings estimate above and assuming maintenance capex is about 20% of depreciation. I then subtract interest on the debt already issued as well as the incremental debt still needed, offset by the tax deduction for interest expenses. Adding all this up, Enbridge DCF after the deal is $11.93 billion. However, share count also increases by 100 million shares to 2.125 billion. This dilution takes DCF to $5.61 per share. Compared to the starting pre-deal guidance, that is just $0.01 per share above the midpoint, just on the accretive side, compared to my $0.02 dilutive estimate in September.

Valuation And Peer Comparison

This is an update to the peer comparison in my June 2022 article. The quick comparison using Seeking Alpha’s Quant Ranking system puts ENB 29th of 54 in its industry, a mediocre spot in between US midstream giant Kinder Morgan (KMI) and Canadian competitor TC Energy.

This should always be the starting point, not the end of any peer comparison. I encourage you to go to the peer comparison page and look at the other metrics. In the Valuation section, you will see that Enbridge is second most expensive of the group based on forward P/E, the same as in the June 2022 article. It is also second most expensive on EV/EBITDA and fourth most expensive on Price / Operating Cash Flow. Enbridge’s P/OCF has considerably improved since June 2022 when it ranked the worst of the group.

In the Profitability section, Enbridge now beats its Canadian rival TC Energy on Return on Assets and Return on Total Capital. This is a reversal from June 2022 when TRP was more profitable. It also beats KMI when it comes to ROE. However, Enbridge remains less profitable than the other 3 US pipeline peers on these metrics.

On dividend yield, Enbridge has pulled ahead of KMI but remains behind WES. One red flag is a payout ratio above 100%, however this can be sustainable as long as new financing can be secured for growth capital projects. So far, this has been the case with Enbridge. As I have mentioned in prior articles, KMI and WES got into trouble in the past by relying on DCF and now pay out lower dividends supported by true free cash flow after all capex. Enbridge’s dividend growth has stalled out in the last couple years, also hurt in US terms by the weaker Canadian dollar. So, while I do not argue with Seeking Alpha’s dividend safety grade of B-, I would much rather own (and do own) the Enbridge USD preferreds with no forex risk or WES, which offers more growth.

An Update On The USD Preferreds

The key development in Enbridge’s preferred shares is that Series 5 (EBGEF) reached the reference date for its 5-year reset on 1/31/2024. The 5-year US Treasury was yielding 3.863% at the time, so adding in the 2.82% premium, the new coupon for Series 5 is 6.683% based on $25 par value. I don’t know how they do it, but once again Enbridge got lucky with the reset timing, as 5-year yields hit a local minimum before rebounding.

With the reset, Series 1 will pay a quarterly dividend of $0.41769 starting on 6/1/2024, an increase of 24% from the current payout. The Series 1 and Series 5 dividends are now very close to each other, barely more than a tenth of a cent apart. The share prices and yields also trade close together, as Series 1 is just 9 months further ahead in the reset cycle compared to Series 5. Either one of these preferreds is now a Buy. While the current yields are about 30 basis points or so below the common stock, they are higher up in the capital structure for investors who want an added measure of safety. Given the low trading volume, prices can wobble around a bit, so buying the cheapest one on the day you want to do the trade is the way to go.

Series L (OTCPK:EBBNF) yields less than the other two. It has a shorter time span of 3.5 years left to the next reset, so the market may already be anticipating lower rates at that time. With its lower coupon, Series L is a Hold here, unless the price gets knocked down enough to make the yield similar to Series 1 and 5.

Conclusion

Enbridge has demonstrated slow growth in its base business. The US gas utility deal will give it a boost in EBITDA, but almost no change in earnings or DCF due to higher interest expense and share dilution. Nevertheless, a yield near 8% with slight growth in Canadian dollar terms makes the stock a good bond substitute. I expect the stock to make bond-like moves higher as interest rates start coming down at some point in the next couple years. This is enough to upgrade the common stock to Hold from Sell.

Investors who want an added measure of safety should consider the Series 1 and Series 5 preferred shares. The higher priority of payment compared to the common dividend is worth the slightly lower current yield. These preferreds are also US dollar denominated, eliminating forex risk for US holders.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.