Article Thesis

The market does not like anything oil-related right now, due to a combination of low oil prices and the fact that oil consumption impacts global climate change. Oil is, however, still an integral part of our lives, and that will not change anytime soon. Low oil prices, meanwhile, are not a problem for those that make their money transporting it. Enbridge (ENB), one of the biggest midstream companies in North America, has a diversified business model transporting oil & natural gas, while also building out its renewable energy portfolio. The market treats the company like it will be significantly impacted by low oil prices, but the truth is that its cash flows are very resilient versus commodity price changes. At the current valuation, and with a juicy 8%+ dividend yield, Enbridge looks attractive.

Here is a short comparison between Enbridge and other large-cap midstream players:

ENB versus peers

Source: Stock Rover

We see that Enbridge is one of the biggest one by market capitalization. It should be noted that Enbridge’s and TC Energy’s (TRP) market caps are given in CAD in this table, which equates to US$60 billion and US$41 billion, respectively. Enbridge does not offer the highest yield in the peer group, but still a quite attractive one. It also is not the cheapest, but it offers an above-average balance sheet strength and overall quality properties, such as a lot of diversification, with assets not only in the US and Canada but also in Europe.

Enbridge Provides Critical Infrastructure In North America

Whether we like it or not, the world is reliant on oil and natural gas. We need these to power most cars, basically all ships, trucks, airplanes, we need these products to heat homes and to generate electricity, and we need them to manufacture a wide range of products, from plastics to drugs. Burning these products releases CO2, which is not a positive, but modern life wouldn’t be possible without them, and that won’t change anytime soon. Phasing out coal and replacing it with much cleaner natural gas is one of the easiest ways to reduce CO2 emissions and air pollution at the same time, thus a push towards lowering CO2 emissions may actually increase natural gas consumption. That’s what happened over the last 20 years, and especially over the last decade:

Chart

Data by YCharts

Consumption of the cleaner, easy-to-handle natural gas that is abundant in North America has gone up as it continues to replace coal, which is a significantly dirtier fuel, for electricity generation. It seems likely that this trend will remain in place – after all, squeezing out coal as a power source is in basically everyone’s best interest.

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This, in turn, means that natural gas consumption could easily continue to trend up instead of only remaining stable, while oil remains another very important fuel source for use cases where energy density has to be high (cars, trucks, airplanes, etc.). Since oil and natural gas will thus likely remain in use for decades, that means that they also will have to be transported for decades. Which gets us to Enbridge, one of the leading midstream players in North America. The company itself also notes that consumption of both oil and natural gas will likely continue to grow over the next decade:

Enbridge outlook

Source: Enbridge Q2 2020 earnings call presentation

Consumption will not necessarily grow in North America, although that seems likely for natural gas at least, but even if consumption were to grow solely in other markets, US energy companies could increase their output and sell to these international customers. In that case, it would still have to be transported to terminals. Which gets us to Enbridge’s assets once again – any way you want to slice it, Enbridge’s infrastructure is in need and will most likely remain in use for decades.

Over the years, Enbridge has built out a huge asset portfolio through organic investments and M&A:

ENB asset base

Source: Enbridge Q2 2020 earnings call presentation

The company now serves natural gas to more than 170 million people, equivalent to about half the US population, while also being a major player when it comes to moving oil and other liquids. The growth investments and takeovers Enbridge has engaged in have allowed the company to grow both its EBITDA and its dividend at a very attractive pace over the last decade. A fact that may be surprising to some is that Enbridge even forecasts to grow its cash flows this year, despite the oil price crash and the pandemic impact.

Thanks to take-or-pay contracts that insulate Enbridge versus commodity price movements, the company forecasts to generate distributable cash flow growth of 2% this year. This is, of course, not an extremely high growth rate, but when one compares this to the fallout that can be seen in the energy sector overall, it is still a great feat. Even other large midstream players, such as Kinder Morgan (KMI), have seen their cash flows decline during this crisis, although, of course, not to the same degree compared to what happened at Exxon Mobil (XOM), Chevron (CVX), and so on. We can thus summarize that the midstream sector overall is rather resilient versus commodity price swings compared to the producers themselves, but even in this group, Enbridge stands out as a low-risk choice.

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Priced For Disaster

Despite its importance as a key infrastructure provider and its obvious quality metrics, including a strong track record and resilience versus crisis, Enbridge is not at all rewarded by the market.

Using the midpoint of management’s distributable cash flow guidance for 2020, C$4.65, which equates to US$3.49, we see that shares are valued at 8.5 times the company’s distributable cash flows. That is not a high valuation at all, and it clearly covers the company’s dividend, with a DCF coverage ratio of 1.42 (the DCF payout ratio is 70%). Enbridge’s dividend, which currently yields 8.3%, is thus looking relatively secure, as it is well-covered, while the company operates a very non-volatile, resilient business.

A valuation this low would be justified if Enbridge were a company with no growth or even a negative long-term growth rate. The company, however, plans to grow its distributable cash flows meaningfully going forward:

ENB growth outlook

Source: Enbridge Q2 2020 earnings call presentation

Rate escalators for existing pipes should result in 1-2% annual growth alone, while the growth backlog with additional investments in pipelines, distribution, and renewable energy will add another 4-5% per year to the company’s DCF per share. When we are very conservative and assume that Enbridge’s growth projects will only add half the projected growth, i.e., 2.5%, its DCF per share would still grow by 4% annually overall. The market thus offers Enbridge at a quite low valuation right now: Even in a bearish scenario, the company still offers a secure 8.3% yield that could grow by 4% annually, for total returns of about 12% at unchanged multiples. This seems like a quite good deal coming from a lower-risk stock such as Enbridge.

Chart

Data by YCharts

Looking at the company’s historical dividend yield, we see that it has been moving mostly in the 4-6% range between 2015 and early 2020. Right now, its dividend yield stands at 8.3%. Even a reversal to just the upper end of the historical range, i.e. to 6%, would mean that shares would rise to $41. Relative to the current share price of $30, this equates to upside potential of around 37%. On top of a high and secure dividend yielding more than 8%, coupled with a dividend growth rate of around 4% in a rather conservative scenario, shareholders could thus also benefit from a quite meaningful share price appreciation once things normalize and the pandemic is behind us. Enbridge traded at $43 in February, which shows that a share price increase back to the $40 range is not unthinkable at all.

Macro Picture

Back in late March, we at Cash Flow Kingdom theorized that natural gas demand would remain relatively unaffected by COVID-19 because much of its end-use demand, including for heating, cooking, and electrical production, would continue even in a COVID-19-affected world. This has mostly borne out to be true, with growth in usage for electricity production more than offsetting declines in export and commercial usage. June data, the latest available from the US Energy Information Administration (EIA), shows a slight 0.9% increase in overall natural gas demand.

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Takeaway

No stock is risk-free, and that holds true for Enbridge too. There are some political risks, execution risks when it comes to new projects, and finally, there is some currency rate exposure due to operations across several countries. Overall, however, Enbridge seems like a rather low-risk pick: the balance sheet is solid, its dividend coverage is more than sufficient, its track record is great, and take-or-pay contracts allowed the company to even grow its cash flows during the current crisis. Enbridge thus looks like a quite resilient pick, and its infrastructure will, we believe, remain in use for decades.

At the same time, however, Enbridge is priced as if its situation were dire: the dividend yield is high and well above the historical norm, while the share price has dropped by one-third from the 52-week high, despite the fact that the company is not seeing any material pandemic impact on its operations. This provides, we believe, a chance to buy a quality income stock at a discount for those that have a long-term horizon.

One Last Word

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Disclosure: I am/we are long ENB, KMI. 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.



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