Enbridge: Spectra Merger Creates A Compelling Value Proposition

Enbridge Pipeline Picture

With the continuing downtrend in oil prices, many readers may be surprised that I am writing about an energy stock.

However, Enbridge is not your typical energy company. Compared to other Canadian energy giants like Suncor or Canadian Natural Resources, Enbridge’s earnings are highly isolated from changes in interest rates, foreign exchange rates, and commodity prices. They also have operations that are diversified by sector, geography, and currency.

This leads to a very low-risk business model that is unlike that of any competitor. This low-risk model, along with Enbridge’s potential merger with US pipeline company Spectra, has created a fantastic value proposition for Enbridge shareholders. Here I’ll outline why.

Company Overview

Enbridge is an energy transportation company based in Calgary, Alberta. In their 2015 annual report to shareholders, they divided their company into three main lines of business:

“We Transport Energy. Whether moving across town or across the country, no one is better equipped to deliver energy than Enbridge. We operate the world’s largest and most sophisticated transportation network for crude oil and liquids. We also have a growing ability to move natural gas and electricity. And we take pride in delivering it all with an unrelenting focus on safety.

We Distribute Energy. Our customers rely on the clean-burning natural gas we deliver to cook their food and heat their homes, water and workplaces. As owner and operator of Canada’s largest natural gas distribution company, we provide safe, reliable service to more than two million residential, commercial and industrial customers in Ontario, Quebec, New Brunswick and New York State.

We Generate Energy. We never stop thinking about the future of energy and sustainability, which is why we’re now a major and growing renewable energy company. Since our initial investment in 2002, we’ve invested approximately $5 billion in wind, solar, geothermal, hydropower and waste-heat power generation assets. Based on their gross generation capacity, our assets have the potential to supply more than one million homes with clean energy.”

The following photo summarizes their business operations:

Source: 2015 Annual Report
Source: 2015 Annual Report

While Enbridge operates in the broader energy industry, they have been largely isolated from the downturn in energy prices.

This is because they are in the energy transportation business, not the production or exploration business.

A Proven Track Record of Creating Wealth For Shareholders

Investors who purchased Enbridge sixteen years ago in 2000 would have enjoyed annualized returns of 18.02%. These returns are reminiscent of legendary stocks like Berkshire Hathaway or Brookfield Asset Management, and have greatly outpaced the total return of the S&P/TSX Composite Index:

Enbridge's Performance vs the S&P/TSX Since 2000

Granted, that chart is a bit mis-representative because it starts at essentially the peak of the dot-com bubble. Since Enbridge is not a technology company, they did not suffer as much as the S&P/TSX Composite Index, which contains many tech stocks.

Even comparing Enbridge’s total return to the S&P/TSX Composite Index since the bottom of the 2008 global financial crisis shows the same sort of outperformance:

Enbridge's Performance Since 2008 vs the S&P/TSX

This begs the question – what has driven Enbridge’s stock price growth? Management has delivered on a few key factors that I believe are key to growing intrinsic value.

First, they have done a fantastic job of compounding book value per common share, which is my favorite proxy for intrinsic value. I’ve picked up this philosophy from Warren Buffett, who said in his 2011 annual report:

“Charlie and I believe that those entrusted with handling the funds of others should establish performance goals at the onset of their stewardship. Lacking such standards, managements are tempted to shoot the arrow of performance and then paint the bull’s-eye around wherever it lands.

In Berkshire’s case, we long ago told you that our job is to increase per-share intrinsic value at a rate greater than the increase (including dividends) of the S&P 500. In some years we succeed; in others we fail. But, if we are unable over time to reach that goal, we have done nothing for our investors, who by themselves could have realized an equal or better result by owning an index fund.

The challenge, of course, is the calculation of intrinsic value. Present that task to Charlie and me separately, and you will get two different answers. Precision just isn’t possible.

To eliminate subjectivity, we therefore use an understated proxy for intrinsic-value – book value – when measuring our performance. To be sure, some of our businesses are worth far more than their carrying value on our books…But since that premium seldom swings wildly from year to year, book value can serve as a reasonable device for tracking how we are doing.” – Warren Buffett

Looking at Enbridge’s book value, they have clearly done a tremendous job of compounding this metric over time.

Source: Publicly available financial statements
Source: Publicly available financial statements

Growth of per-share book value from $3.74 in 2000 to $18.23 in 2015 represents a CAGR of ~11% – a fantastic rate of growth, especially considering this sample contains the global financial crisis.

The second metric that Enbridge has used to drive stock price appreciation is earnings per share.

Enbridge Diluted EPS

Growth from $0.58 in 2000 to $2.20 in 2015 represents a CAGR of ~9%, which though being a bit lower than their growth in book value is still impressive.

Obviously Enbridge has delivered value historically. Now I will present the reasons I believe this company will continue to do so in the future.

Impacts of the Spectra Merger 

Enbridge has been popular in the media lately because of their decision to purchase/merge with Spectra Energy Corp. Both shares of Enbridge and shares of Spectra jumped at the news, which signals that investors were pleased.

I’ll dive into the details after, but first – this photo does an exceptional job of displaying the potential benefits of the transaction:

Enbridge Dividend Growth Opportunity
Source: Enbridge Investor Document

The purchase of Spectra will turn pro-forma Enbridge into Canada’s fourth-largest publicly traded corporation by market capitalization, coming in just behind the Bank of Nova Scotia:

Pro-Forma Enbridge is one of Canada's largest publicly-traded corporations
Source: Enbridge Investor Document

The purchase of Spectra will create an energy transportation giant that moves natural resources across North America. They will have a fantastic competitive advantage, and synergies after the purchase should result in significant savings for the pro-forma company.

The Spectra purchase effects many of the other points of my investment thesis, so that’s all I’ll write about it here – but stay tuned as the transaction will be brought up continuously throughout the rest of this analysis.

A Safe and Growing Dividend

First of all, I want to say that I view Enbridge as one of the premier Canadian dividend growth stocks for the next ten years. This is because:

  1. Enbridge has historically grown their dividend at a rapid rate
  2. In the 2015 annual report, management forecasted 12-14% cash flow per share growth and 10-12% dividend growth through 2019, meaning payout ratio should decrease over time even though the dividend is increasing at a fantastic rate
  3. The Spectra transaction increases the dividend prospects of the pro-forma company

First of all, Enbridge has a fantastic history of growing their dividend over time. The growth of their dividend from $0.35 in 2001 to $1.86 in 2015 represents a CAGR of 12.6%.

Enbridge Dividend Growth History
Source: Data from Enbridge Investor Document, graph my own

One of the highlights of the proposed Spectra purchase is the impact on Enbridge’s dividend. Management is promising an immediate 15% dividend increase when the deal closes (expected to be in the first quarter of next year), and a further 10-12% annual dividend growth through 2024. In the best-case scenario, a 15% dividend increase followed by seven years of 12% dividend increases will grow the annual Enbridge dividend to $5.39 in 2024:

Enbridge Dividend Growth Prospects
Source: Enbridge Investor Document
Enbridge Dividend Growth Propects After Spectra Acquisition
Source: Enbridge Investor Document

Buying shares of Enbridge now at $58 and holding to 2024 for a $5.39 annnual dividend means that investors will be receiving a ~9.5% yield on cost, which is a fantastic way to generate meaningful income (for retirement or otherwise).

Since dividend yield plus dividend growth is a good proxy for total return expectations (according to Morningstar), then if the Spectra deal is closed, investors should be able to expect total returns from Enbridge exceeding 15% (yield of >3% + growth of 12%+).

Taking all of this into account, it’s important to recognize that there are a lot of variable at play here – most notably whether the Spectra deal will actually close. Only time will tell.

It’s important to also consider the safety of Enbridge’s dividend, so let’s consider their payout ratio. For the first half of this year, Enbridge has a payout ratio of 85%. Looking over the fiscal year 2015, the dividend payout ratio was identical at 85%.

While this is much higher than I would like, it’s not outside Enbridge’s historical level. I’m comfortable with a high payout ratio for Enbridge because they are low-risk due to the nature of their business model.

A Risk-Conscious Business Model

As far as company’s in the energy sector go, Enbridge operates a remarkably low-risk business model. This is mostly because they are in the business of energy transportation, not production or exploration. Enbridge makes money based on how much product they can move from Point A to Point B – the market price of the product they are moving does not effect their earnings.

Enbridge also hedges against changes in interest rates and foreign exchange, further reducing the risk of investing in this company. Because of this business model, Enbridge has survived and prospered, though many of their peers in the energy industry have struggled.

This strong risk management manifests itself in many quantifiable business metrics. Most notably, Enbridge has increase their dividend every year since 2001. Their earnings volatility through the financial crisis, and steady rate of increases in book value are also testament to their focus on risk.

And it all starts with their management team.

Competent & Tenured Management

Enbridge is known for their experienced management team. Most have been with the company for a long time, which is something that I consider to be very important.

It starts at the top with their CEO Al Monaco. After joining the company in 1995, Monaco has progressed through increasingly senior position until assuming the role of CEO on October 1, 2012. An accountant by trade, Monaco has an MBA from the University of Calgary and holds the CMA designation.

Monaco holds 374,780 shares of Enbridge common stock, worth ~$21 million. He also holds stock options allowing him to acquire an additional 2,593,700 shares – potentially increasing his stake in the company by an additional ~$147 million. These ownership quotes all assume a stock price of $57, and I’m stating them to show that Mr. Monaco’s interests are definitely aligned with those of the other shareholders. A promising fact indeed. And by the way, Enbridge proudly displays Monaco’s stock holdings on the company website (something I find commendable). Going through the company website it appears that other executives also have significant stakes in Enbridge common stock.

Under the terms of the Spectra merger, the management team is obviously going to change. Enbridge & Spectra have been very transparent in how this is going to occur. The company’s head office will remain in Calgary, while the natural gas business will be coordinated out of Houston (Spectra’s current headquarters). Al Monaco will continue to serve as CEO of the pro-forma Enbridge entity, while Spectra’s current CEO (Greg Ebel) will serve as the chairman of the board of directors.

The company’s new board of directors will have 13 members. Eight will be designated by Enbridge, and five will be designated by Spectra. While not explicitly stated in investor documents, I strongly believe that Al Monaco will continue to serve on the company’s board after the merger.

So to conclude, I have two main points about the management team here. First, the current team is strong, with major stock holdings that align the interests of executives with the interests of shareholders. Secondly, current Enbridge executives are set to form a major part of the pro-forma management team, which means we can expect today’s strong leadership to carry us forward in the future.

The Bottom Line

As long as the deal closes, I am confident that Enbridge is one of the best dividend growth stocks in Canada. Even if the deal does not close, their prospects are positive.

For me it boils down to two reasons. First, the pure opportunity for growth in dividends. Enbridge’s already promising 10-12% dividend growth through 2019 was sweetened by the Spectra merger. Growing dividends over time incrementally increases yield on cost, and for the dividend growth investor, Enbridge’s growth prospects are unique.

The second thing that stand out is the opportunity to gain exposure to the energy sector with minimal risk. More particularly, it is Enbridge’s low-risk business model that makes me so confident in my investment thesis. Their hedges against commodity prices, interest rates, and foreign exchange allows me to accept their 85% payout ratio and still sleep soundly tonight.

Readers, what are your thoughts on Enbridge?

Full Disclosure: I have a long position in Enbridge.

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