Enbridge (NYSE:ENB ) is a Canadian pipeline stock well known for its 6.18% yield. The stock has had an above-average yield for many years, due to a combination of dividend increases and poor capital gains. The stock spent most of the last five years tumbling, having emerged from a very long downtrend only this year.
Enbridge 5 year chart (seeking Alpha Quant)
Enbridge 5 year chart (seeking Alpha Quant)
Many income investors are drawn to ENB’s yield. The S&P 500 only yields 1.62%, so ENB yields nearly four times the average stock. If you invest $100,000 in ENB, you get $6,180 in annual dividends, assuming the payout doesn’t change. But the payout does change–in a good way. Enbridge has grown its dividend by 10% CAGR over the last 27 years. Even during the 2020 bear market, when oil prices went negative, ENB managed a small 3% dividend hike. So if the future resembles the recent past, this stock could give investors a double digit yield on cost in short order.
However, Enbridge’s dividend is not without its issues. The payout ratio, based on earnings, is 122%, which suggests that the company is paying out more in dividends than it is earning. On the other hand, Enbridge touts its “distributable cash flow” payout ratio as more indicative of its dividend-paying ability. That payout ratio is just 69% - which is high, but not unsustainable. The question is whether Enbridge’s “distributable cash flow” is trustworthy, and whether the company can grow it over time. In this article I will argue that Enbridge will probably be able to keep paying its dividend, but has some financial drawbacks that may impede its total return.
To evaluate whether ENB’s dividend is sustainable we need to look at the company’s chosen payout ratio. The dividend is not sustainable based on earnings, so we need to explore the metric it uses as an alternative. Sometimes, earnings are impacted by non-cash factors that don’t reflect dividend paying ability. So, perhaps ENB’s cash flow based approach is valid.
According to Enbridge, distributable cash flow (“DCF”) consists of the following items:
Change in net operating assets.
Cash receipts not recognized in revenue.
Dividend payouts that aren’t included in CFO.
Basically DCF is CFO only with some investing cash flows added in and financing cash flows subtracted. Apart from the change in operating assets, these adjustments to CFO look reasonable. Positive investing cash flows add to your cash, preferred dividend payouts subtract from it. So Enbridge is probably right that DCF is a better gauge of dividend paying power than CFO is. Additionally, in Enbridge’s statements, DCF is not always higher than CFO, so this isn’t some ‘crazy’ non-GAAP metric being used to mislead investors.
Enbridge: distributable cash flow (Enbridge)
Enbridge: distributable cash flow (Enbridge)
As we’ve seen, Enbridge’s DCF metric is likely a decent measure of dividend paying ability. It seems reasonable, then, to trust its use. However, like any other business, we need to know Enbridge’s growth prospects to know whether this ‘DCF’ can grow over time. So, we have to look at the nature of the business.
Enbridge is a pipeline company that also functions as a natural gas utility. It supplies natural gas to Ontario and exports crude to the United States. It has a favourable competitive position. It has the second longest crude oil pipeline network in the world, stretching 20,971 miles. This gives it an edge in being able to reach various destinations that other pipelines can’t. Additionally, Enbridge has the financial advantage of long term contracts. Most of ENB’s contracts last for a period of years, in which ENB customers reserve a portion of the pipeline network for their use. Because the customers are “renting” pipeline space rather than giving ENB a cut of sales, ENB makes money even when volume is low. According to writer Matthew DiLallo, only 4% of Enbridge’s EBIT is exposed to short term volume fluctuations, the rest comes from long-term tolls, which are basically a kind of “rent.”
What this means is that the bullishness or bearishness of the oil market is of little concern to ENB. Once it locks in a contract with a client it becomes like a landlord with a lease. Its contracts typically last several years. Last year, it attempted to increase its contract length to an eight year minimum. Unfortunately for shareholders, Canadian regulators shot that one down, but ENB’s contracts are still reliable enough to produce less earnings volatility than the average energy company.
The long term outlook for ENB’s business is therefore pretty good. As long as people are shipping oil by pipeline, ENB will have a book of business. The competitive landscape also favors Enbridge. Many of Enbridge’s competitors’ projects are getting shot down by regulators, while the company’s own projects are thwarting regulatory challenges. For example, TC Energy (TRP) had its Keystone XL project shut down in 2021, while Enbridge defeated Michigan’s attempt to shut down Line 5. So Enbridge faces less competition in the next 10 years than it appeared it would a few years ago.
Having looked at Enbridge’s business outlook, we can now look at its financials. Enbridge is a highly profitable company with decent growth, but it does have a fair amount of debt. Over time, debt could eat into ENB’s ability to keep raising its already-high dividend, so it’s worth looking into.
First, the earnings and cash flow numbers.
According to Seeking Alpha Quant, ENB put out the following metrics in the trailing 12 month period:
Free cash flow: $-607 billion.
Apart from free cash flow, these are all solid numbers. Additionally, they are undergoing significant growth. In the last 5 year period, the CAGR growth rates in the metrics above were:
Free cash flow: N/A
As you can see, the growth has been solid apart from free cash flow, which is currently negative. ENB’s free cash flow is currently being negatively impacted by heavy spending on infrastructure. The company is working on upgrades to both Line 3 and Line 5, and these are very capital intensive projects. Shareholders are paying for all of this capital expenditure right now. However, the projects could come with future benefits. For example, the Line 3 replacement will increase the diameter of the pipe by 2 inches, allowing more oil to be transported. The increase in pipeline capacity could add revenue, because the width of the pipe determines how much oil can go in it. So, while ENB’s spending is adversely affecting FCF, the path to future profits off this spending is relatively straightforward.
Having looked at ENB’s earnings and cash flows, we can now turn to its balance sheet. In its most recent quarter, ENB had the following balance sheet metrics:
$56 billion in long term debt.
On a positive note, assets outstrip liabilities by quite a lot, which leaves a decent amount of book value. Less flatteringly, there is more debt than shareholder’s equity (a debt-to-equity ratio of 1.1), and not a great amount of liquidity (a current ratio of 0.67). Additionally, while ENB’s assets vastly exceed its liabilities, its debt load is quite high. The debt to operating cash flow ratio is 7.3. $56 billion in debt financed at 5% interest takes a $2.8 billion bite out of earnings. ENB’s actual interest expense in the TTM period was about $2 billion, so interest is already affecting net income quite a bit.
All of this has bearing on ENB’s valuation. At today’s prices, ENB stock is relatively cheap compared to the S&P 500. It trades at 19.5 times earnings, 2.13 times sales and 11.3 times operating cash flow. Those aren’t low multiples for energy stocks, but they are low compared to the weighted market averages. You could consider Enbridge a value play of sorts, but the balance sheet weakness detracts from that idea somewhat. Enbridge’s debt is already taking huge chunks off of net income, what happens if it has to borrow $10 billion more to complete one of its many infrastructure upgrades? Interest rates are rising these days, so the impact could be quite large.
As I’ve shown in this article, Enbridge is a dividend stock whose payout is reasonably well covered by cash flows. Its enormous interest expenses will probably hold back total return, but you can rely on it as a pure income play. With that said, even that part of my thesis faces some risks and challenges, including:
Rising interest rates. Central banks are raising interest rates this year, and the hikes are set to continue. This is bad for Enbridge because it is extremely indebted. Unlike E&Ps, Enbridge is not generating “windfall” profits this year that can be used to retire debt. Instead, it is making massive capital expenditures. If it has to borrow more to complete Line 3 and Line 5 work, then its interest expenses will go higher. That could negatively impact its ability to keep raising its dividend.
Regulatory hurdles. Enbridge faces considerable pressure from regulators, including environmentally-minded politicians in the U.S. and pro-energy regulators in Canada. In the U.S., ENB has got governors trying to shut down Line 5 for environmental reasons. In Canada, it has regulators prohibiting longer term contracts for fear they’ll hurt E&Ps. The pressure on both sides of the isle is pretty strong here, and it could impede Enbridge’s efforts to lock in more of that recurring revenue investors expect from it.
Taking these risk factors into account, I rate Enbridge a ‘hold.’ Its dividend as it stands today is sustainable, but continued hikes could cause problems in the future. The amount of debt this company carries on its balance sheet is staggering. It is not a threat to the dividend in the near term, but it could complicate matters in the long run.
This article was written by
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.