Pembina Pipelines Series 5 Preferreds: Strong Upside Potential Ahead (NYSE:PBA)

Investment Case for Pembina Pipelines Series 5 PPL.PR.E fixed dividend preferred shares

I expect a strong upside for the Pembina Pipelines Series 5 (TSX:PPL.PR.E:CA) (OTCPK:PPLAF) preferred shares over the next six to twelve months. The five-year fixed dividend for these shares will be recalculated on May 2, 2023, 30 days before June 1, 2024, when the new fixed-rate period begins. Pembina Pipelines is a low-risk Canadian infrastructure company with a rock-solid balance sheet and spotless dividend track record.

As of April 25, 2024, the yield for (PPL.PR.E:CA) was 5.34% based on the CAD $1.14 annual dividend (all the figures are in CAD unless otherwise stated) and the market price of $21.41. The new fixed 5-year dividend payments, determined based on the 3% spread and Bank of Canada (BOC) 5-year bond yield, will result in a much higher five-year fixed annual dividend. Based on the assumptions provided in the table below, I calculated an annual dividend of $1.73 per share or 8.07% yield at the current market price. This would offer an attractive 52% increase over the current dividend, presenting a significant upside for investors. If acquired before April 30 (the ex-dividend date), the (PPL.PR.E:CA) shareholders will receive a $0.2858 quarterly dividend, payable on June 3, 2024.

Today, the Government of Canada’s 5-year bond yields are much higher than five years ago. At the same time, recently published inflation and unemployment data in Canada support the beginning of the Bank of Canada’s key interest rate cuts in the second half of the year, though later than expected. Any delay with rate cuts would make a mandatory offer to convert fixed dividends to floating dividend shares a promising alternative.

At the same time, the Bank of Canada’s decrease in key interest rates in the second half of 2024 should result in meaningful capital appreciation of the PPL.PR.E:CA and their floating rate alternative Series 6 preferred shares, given the conversion happens.

Terms of the fixed rate reset

According to the prospectus, the Class A Preferred Shares Series 5 (PPL.PR.E:CA) were issued at $25. The dividend for these preferred shares is calculated as a sum of 5-year Government of Canada bonds yield “on the Fixed Rate Calculation Date plus a spread of 3.00%.” For the current period, the annual dividend was set at $1.143252 per share. This implies a 5-year GOC rate of 1.5728% at the time. As of closing on April 25, 2024, the 5-year GOC rate was 3.913% or approximately 2.3% higher.

This difference represents a unique opportunity to lock into a historically high rate and fixed dividend for the next five years. The last time the 5-year GOC rate was at this level was in 2007 (17 years ago).

For the Series 5 (PPL.PR.E:CA) preferred shares, the fixed rate calculation date is set to be “the 30th day prior to the first day of such Subsequent Fixed Rate Period.” The subsequent fixed rate period starts on June 1, 2024, so the recalculation date is May 2.

As I wrote in my previous article, ‘TC Energy: Series 7 Preferred Shares Ready For Takeoff,’ in many cases, preferred share prices started to appreciate approximately one month before the recalculation date. In some cases, the upside exceeded 10%. This was less pronounced in the case of (PPL.PR.E:CA), as from the beginning of April, these preferred shares went up by only 1.71%. This could be explained by the increase in GOC yields resulting from a change in the market narrative towards higher for longer interest rates due to delayed monetary policy easing by the BOC and the Fed.

A little more than six months ago, the market consensus was that the Fed would make five rate cuts in 2024, and similar actions were expected from the Bank of Canada. Today, the number of cuts by the Fed decreased to only two this year, with key interest rates going down by 0.5%. The Bank of Canada is projected to cut rates more aggressively by 1.0%, with the year-end key rate decreasing to 4%.

Q1 US GDP numbers reported on April 25 came lower than expected. According to Trading Economics, “The US economy expanded an annualized 1.6% in Q1 2024, compared to 3.4% in the previous quarter and below forecasts of 2.5%.” The weaker-than-expected economic growth indicates that high interest rates put pressure on the economy, supporting the argument for the sooner rather than later rate cut by the Fed.

Other potential scenarios for Pembina Pipelines Series 5 (PPL.PR.E)

Two other potential scenarios indicate a sizable upside for these preferred shares. The first is the redemption of the shares. According to the prospectus, Pembina Pipelines may, “at its option, upon not less than 30 days and not more than 60 days prior written notice, redeem for cash all or any part of the outstanding Series 5 Shares by the payment of $25.00 per Series 5 Share plus all accrued and unpaid dividends.” We see this option as less likely due to a significant premium to the current market price of $21.41. However, this is not entirely impossible. With an average yield of 6% (which is close to the average over the last five years) and the new annual dividend of $1.73, the share price would amount to $28.83, which is higher than the repurchase price of $25.

The prospectus also defines an option for shareholders to swap their fixed dividend Series 5 preferred shares for floating dividend Series 6 shares, “The holders of the Series 5 Shares will have the right to convert all or any of their shares into cumulative redeemable floating rate Class A Preferred Shares, Series 6.” The holders of the Series 6 Shares will be entitled to receive quarterly floating-rate dividends. The floating dividends are calculated based on the sum of the 3% spread and an annual rate on 90-day Government of Canada treasury bills.

Using a 3-month Government of Canada bond yield of 4.94%, we find that the conversion would result in the annual yield to investors increasing to 9.26%. However, this will be recalculated quarterly.

In my previous article, ‘TC Energy Floating Preferred Shares: Double-Digit Yield With Relatively Low Risk,’ I analyzed the potential yield for floating preferred shares using the latest outlook for the Bank of Canada key rates at that time. Based on a similar analysis (the outlook for the timing of key interest rate cuts has moved forward since then), I can conclude that switching to floating dividend preferred shares could provide investors with a better average return over the next two years.

The table below shows the average yield of 8.34% until the end of 2025, which is higher than the fixed dividend yield of 8.03% after the reset. This is based on the current price of $21.41 and the latest assumptions of changes in the key interest rates from Trading Economics. However, there is a major caveat in the prospectus. The conversion will not go through if the requests for the floating dividend Series 6 preferred shares are less than 1,000,000.

Pembina Pipelines low-risk investment

Business and financial outlook

Pembina Pipelines ticks all the boxes as a high-quality and low-risk infrastructure company with strategically located, diversified assets, a great track record of financial results, a strong balance sheet, and years of growing dividends. PPL’s business is based on energy transportation and midstream services. The company owns and operates a strategically located integrated network of pipelines: conventional, oil, and gas, which provides 55% of adjusted EBITDA. It also owns and operates extensive gas processing fractionation, storage, and export facilities (30% of adjusted EBITDA) and integrated services (15% of adjusted EBITDA).

The company’s business is diversified across commodities, with crude oil and condensate representing approximately 40%, natural gas 25%, and natural gas liquids 35%. Strategically located with access to the major Pacific coast export facilities, the company has take-or-pay contracts for approximately 70% of its assets and services. Pembina’s business relies on more than 200 high-quality counterparts, 85% of which are investment grade.

The recently reported 2023 financial results were very strong, with a record EBITDA of $3.8 billion exceeding the high end of the Company’s original 2023 guidance range. Over the last 10 years, PPL’s CAGR for adjusted EBITDA per share reached approximately 10%. The company grew its operating cash flow and dividends per share at around 7% and 5% per year, respectively.

According to the latest projections (company presentation from April 2024, page 15), the 2024 EBITDA is expected to be between $4.05 billion and $4.30 billion, compared to the 2023 EBITDA of $3.82 billion, representing projected EBITDA growth year-over-year between 6% and 12.6%. According to the company’s presentation, the growth will result from higher ownership of Alliance and Aux Sable, higher loads of conventional pipelines, recovered business of the Northern Pipeline system, and full-year contribution from Nipisi Pipeline.

The company announced that it would report Q1 2024 financial results on May 10. The results should reflect the higher EBITDA guidance and improvement in earnings due to the low base effect. A significant part of the guided EBITDA growth relies on the increased ownership and operating improvements that were not present in Q1 2023.

Balance Sheet and dividends

Pembina Pipelines has a robust balance sheet, a BBB rating, and approximately $1.5 billion of liquidity. In 2023, the proportionately consolidated debt-to-adjusted EBITDA was around 3.3x. 88% of the company’s debt is fixed-rate. The debt average tenure is 14 years, and the weighted average interest rate is 4.4%.

Pembina Pipelines has an impressive track record of maintaining and growing dividends since 1998. In 2023, a standard payout ratio for common dividends was about 55%, and the dividends represented only 73% of fee-based Distributable Cash Flow. This indicates even stronger protection for the preferred dividends.

The risks to the company’s investment case

• Counterparty risk is one of the major issues that the company has to deal with. Pembina manages counterparty risks through comprehensive assessments of the counterparties and financial assurance measures;
• Liquidity risks are managed by the company through forecasting annual cash flows and financial requirements;
• Market risk includes changes in commodity prices, decrease in volumes transported, foreign exchange and interest rates. These are managed through financial derivative instruments, monitoring and analysis of the foreign exchange and interest rate trends;
• Low return on capital invested in development and M&A activities. This risk is managed by a detailed analysis of growth opportunities as well as a disciplined approach to required returns.

Conclusion

Pembina Pipelines is one of the safest investments in Canadian infrastructure. The company is characterized by low risk due to its diversified portfolio, relatively low leverage, and disciplined approach to growth. For many years, it has demonstrated solid financial results. The outlook for 2024 is also promising.

On May 2, the fixed dividends for the company’s Series 5 (PPL.PR.E:CA) preferred shares will be recalculated. Based on the available information, the fixed dividends for the next five years will be significantly higher. Other options, including the company’s redemption of the preferred shares and offer to convert fixed dividend to floating dividend preferred shares, could provide additional upside.

Recent macroeconomic developments caused the market narrative to change from five rate cuts in 2024 by both the BOC and the Fed to two cuts only. This resulted in a negligent price increase for the (PPL.PR.E:CA) during the month preceding the dividend recalculation. However, any future decline in interest rates should result in a meaningful upside for these preferred shares.

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.