Regulation Works in Enbridge's Favor

Although  Enbridge's (ENB) second-quarter results missed our estimates, we remain confident in the company's ability to execute on its growth projects and think the shares are trading well below what they are worth.

Enbridge is one of a handful of experienced midstream companies with the expertise, scale, access to capital, and geographic reach to successfully expand its pipeline transportation business. It has the capability to do this through the simultaneous execution of multiple projects, spanning several jurisdictions. This includes a portfolio of opportunities that are developing from the explosive growth in liquids in Alberta's oil sands, the Bakken, and overall volume growth flowing into the major oil hub of Cushing, Okla. In addition to its liquids opportunities are growth opportunities in its natural gas, distribution, and electricity business units.

Enbridge has an extensive network of liquid pipelines spread across parts of Canada and the United States, in addition to a distribution and storage business in Ontario and a 23% interest in a master limited partnership, Enbridge Energy Partners. Key to its liquids success is its Mainline, which carries into the Chicago area the bulk of Canadian crude oil exports from the Alberta hub at Hardisty.

While main rival TransCanada has been seeking approval of the Keystone XL pipeline (running from Hardisty to Nebraska), Enbridge has taken some of TransCanada's thunder with its 50% acquisition of the Seaway Pipeline, which competes with TransCanada's Gulf Coast Pipeline running from Cushing to the Gulf Coast and was originally part of the proposed Keystone pipeline system. This strategic acquisition allowed the company to leapfrog over TransCanada, as it relates to moving liquids from Chicago to the U.S. Gulf Coast. Following the acquisition, Enbridge quickly reversed Seaway, and now it is flowing more than 150,000 barrels per day of oil from Cushing to the Gulf Coast, with 400,000 bpd in capacity. By 2014, we look for the pipeline to grow to 850,000 bpd. Additional growth in liquids is expected from more than CAD 3 billion worth of oil sands-related pipeline, terminal, and tank projects in Alberta.

The growth of liquids production in North America is a tailwind for the business unit. Its secured (or allocated) liquid-related growth projects are approximately CAD 21 billion over 2013-17; unsecured (or unallocated) capital is CAD 1.4 billion. This represents 85% of its growth capital. Combined, these should provide more than CAD 1 billion in unadjusted earnings growth over 2013-17, and the majority leverage the firm's existing infrastructure, such as the Mainline, Spearhead, and Seaway pipelines.

Enbridge also operates natural gas midstream assets and the largest gas utility in Canada, serving Ontario, Quebec, New Brunswick, and parts of upstate New York. It has regulated rates that cap potential returns but provide steady cash flow for investors, with some upside for the distribution business. Included in the gas pipelines, processing, and energy services business unit is a small but growing portfolio of electricity assets.

Nonliquids projects account for CAD 4 billion in capital spending. Approximately CAD 1 billion is directed toward power generation, and CAD 600 million is directed to the GTA project for gas distribution growth. The remaining is for gas plants (included in the nonliquids unit) and pipeline expansions. Unallocated capital is estimated to be around CAD 0.6 billion. We look for modest unadjusted earnings growth (CAD 0.5 billion over 2013-17) in this unit and expect gas-related opportunities to improve with natural gas prices.

We are confident in Enbridge's ability to execute the CAD 27 billion of growth projects (more than 90% secured). However, success depends on the exploration and production industry and its ability to bring projects on line.

Fee-based contracts, many of which include take-or-pay arrangements or cost-of-service provisions, insulate Enbridge's cash flows. Low- to mid-teens returns on equity are the norm for most pipeline projects, which we consider attractive considering the favorable contract provisions Enbridge typically requires. Conversely, gathering and processing cash flows from Aux Sable and Enbridge Energy Partners are not regulated, resulting in greater earnings volatility for this small subset. Compared with other pipeline C corporations, however, Enbridge has among the least commodity exposure.

Regulation Nearly Guarantees Enbridge Can Outearn Its Cost of Capital
We give Enbridge a wide Morningstar Economic Moat Rating, the result of the regulated nature of its assets, its ability to lock out competing pipelines, its significant growth opportunities, and our belief that it will continue to develop projects that achieve a return on capital in excess of its cost of capital, beyond our 2013-17 projection period.

Enbridge operates one of the largest liquids pipeline networks in North America, with more than 2.5 million bpd of export capacity from Canada into the United States. It is the dominant operator of feeder pipelines in Canada's oil sands, which are expected to double production in the next decade, and it has a growing position in the surging Bakken shale play. The liquids pipelines can move light, heavy, and synthetic crude oil from as far north as the oil sands all the way into the Chicago hub. Its recent acquisition and reversal of the Seaway Pipeline allows Enbridge to move crude from Chicago into the largest refining market in the world, the U.S. Gulf Coast. Its existing assets are high quality on a stand-alone basis, but together form an integrated pipeline network that allows the company to capture greater returns through the midstream value chain.

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The mainstay of Enbridge's pipeline model is its regulated rates of return. The vast majority of Enbridge's pipelines are regulated by the National Energy Board in Canada and the Federal Energy Regulatory Commission in the U.S., and allowed returns on equity are attractive enough to lock in economic returns on capital. By virtue of regulation, Enbridge is all but guaranteed to outearn its cost of capital. This is the fundamental driver of the company's economic moat.

Regulation also provides Enbridge with strong barriers to entry. A competitor seeking to develop a new pipeline in an area with existing pipes is at a structural and regulatory disadvantage if the existing line has either spare capacity or the ability to expand the pipeline using compressor stations or adding a pipeline on an existing right-of-way. These types of expansions are usually at a significantly lower cost than a new pipeline, with a lower risk of regulatory or landowner intervention, and they represent a structural advantage for an existing pipeline, which should be able to lock out competitors.

In addition, regulators will often consider whether a new pipeline is needed in an area already serviced. Regulators tend to consider whether a new pipe would result in higher transportation costs, for example, if it could result in a significant reduction in utilized capacity. Because of the cost-of-service nature, a reduction in long-term utilization will result in lower revenue for a given toll. This lower revenue may no longer offset the cost to maintain and operate a pipeline. When this happens, either the pipeline would need to be shut down or the tolls would need to be increased. For this reason, existing pipelines have a regulatory advantage that reinforces the structural advantages.

The most significant shift is taking place in Enbridge's wide-moat liquids-rich business unit, which should benefit from the growing volumes associated with the oil sands and Bakken plays. These plays will require gathering systems in order to move the liquids out of the regions, and Enbridge is well positioned to construct and operate these unregulated pipelines, which tend to provide returns in excess of the regulated common-carrier pipelines such as the Mainline. Moreover, many of these opportunities will provide long-term support and potential growth for the Mainline, as the Bakken and oil sands volumes will connect directly into its existing pipeline network.

We Like Enbridge's Ability to Execute on Projects
Our $54 fair value estimate reflects the most recent information on new projects, the expected annual impact of the Seaway expansion, and long-term development plans. We like Enbridge's ability to execute on projects, and with more than $37 billion in potential projects (2013-17) there is room to grow. Of those potential projects, roughly $27 billion is considered commercially secure, and we estimate $2.3 billion worth of unallocated projects are possible; these projects are risk-adjusted. Our five-year compound annual growth rate for earnings per share (diluted) is 12%, with additional upside depending on volume, regulatory risk, and acquisitions. Our model excludes the Gateway Pipeline, which we consider relatively high-risk at the current stage of development, and aboriginal opposition. Depending on the success of the joint review panel in 2013, we could add it to our list of secure projects, but the outlook for the pipeline continues to diminish.

Our base-case forecast factors in $5.8 billion of growth spending per year, on average, for 2013-17. These projects should provide average returns on equity of about 13%, with variability ranging from 10% to further in the double digits depending on the type of project, funding mechanism and method, volumes, and regulatory risk. We assume an 8% cost of equity because we think Enbridge's cost of equity has a below-average level of systematic risk. The company's pretax cost of debt averages 6.5% over the projection period, for a weighted average cost of capital of 6%. Our 2013 dividend forecast of $1.26 per share, in line with guidance, works out to 85% of our $1.49 EPS forecast and implies a 2.3% yield at our fair value estimate. Our U.S. dollar fair value estimate assumes an exchange rate of CAD 1 per U.S. dollar.

Cost Escalation and Leaks Are Ongoing Risks
While pipeline projects may be considered to have lower risks than the exploration and production projects that fill the pipes, risks exist for Enbridge's future operations. Cost escalation remains an ongoing risk, especially in Alberta and the Bakken, where unemployment rates are extremely low and cost of living remains relatively high. If oil sands and/or Bakken production slows down, Enbridge could be stuck with excess capacity. This situation could be exacerbated if competitors are successful at bringing new projects on line.

Pipeline leaks and leaks at pump stations remain an ongoing and extremely serious risk for Enbridge and the industry as a whole. Serious leaks, such as Line 6B, put a black eye on the industry, and as scrutiny focuses on every spill, including extremely minor leaks at pumping stations, the industry faces renewed threats from a reinvigorated opposition. Pipeline opponents may overhype even the most minor leak in an attempt to stir further opposition to pipelines, and by extension hydrocarbon development in general. This could affect future development plans and costs.

Non-Canadian investors should consider foreign exchange risk, although we think this risk is minimal for U.S. investors in light of Enbridge's hedging and continued heavy investment and borrowing south of the border.