Concerns About Enbridge's Dividend Are Overblown

We think that the market is overreacting to the news flow and unjustly conjuring up the ghosts of Kinder Morgan. Enbridge sports a near-term CAD 22 billion in commercially secured capital projects in its growth portfolio, which is highlighted by the Line 3 replacement project. We think the project will receive approval to use its preferred route, as it offers $3.5 billion in economic benefits and limits its impact on Minnesota’s environment and tribal communities. Once placed into service, we expect the Line 3 replacement project coupled with various natural gas growth projects to generate CAD 4 billion in incremental EBITDA, which will support the dividend growth.

Accordingly, we expect Enbridge to maintain a healthy 1.45 times forward distributable cash flow coverage ratio, even after the impact of the proposed Enbridge consolidation; this would only decline to 1.35 times if the project doesn’t obtain final approval in Minnesota. If the recommended route by the Minnesota administrative law judge is approved, the ratio remains at 1.45 times once the project is placed into service.

While Enbridge offers an attractive 6.4% yield, it’s more than a just a dividend stock; the wide-moat company remains our top pick in the energy sector. We still see more than 50% upside in the stock and think the time is right for long-term investors to capitalize on this while collecting a steady stream of growing income.

Stock Suffers From Investors' Fear of Dividend Cuts Enbridge's stock offers investors a strong forward dividend yield, but more impressively, management intends to increase the dividend at an average annual rate of 10% throughout 2019 and 2020. Consequently, Enbridge has become a popular stock for dividend investors. Nevertheless, investors can't help but be reminded of the ghosts of Kinder Morgan. Like Enbridge, Kinder Morgan had a massive growth portfolio, high debt levels, and an attractive dividend with double-digit growth rates. But it was too good to be true. Kinder Morgan couldn't cover its dividend payments, interest expense, maintenance capital expenditures, and fund its growth portfolio without issuing additional debt. It significantly cut its dividend in 2015.

Investors have drawn a parallel to Enbridge, and the stock price has reflected their fear of a dividend cut. The stock is down 15% on the year and has been down as much as 25%. Investors appear to assume the worst when any news about the company is announced. Factors such as rising interest rates, the widening of the heavy oil discount, and the Federal Energy Regulatory Commission’s proposed tax disallowance have caused investors to retreat from the stock. As the nail in the coffin, Minnesota’s recommendation that the Line 3 replacement project follow its existing route led to the stock’s year-to-date rock bottom.

However, we think investors are blinded by Kinder Morgan’s failures and aren’t judging Enbridge on its own merits. We think fears of a dividend cut are overblown, regardless of the Line 3 replacement project’s outcome. The following analysis highlights Enbridge’s strong position to support its dividend and examines each of the Line 3 replacement project scenarios and the corresponding impact on the dividend and our fair value estimate.

Enbridge Is Not Kinder Morgan of 2015 Unlike Kinder Morgan, Enbridge does not need additional debt to fund its near-term growth portfolio or to maintain its dividend, interest, and maintenance capital obligations. We expect Enbridge to fund its growth projects with cash flows, previously issued hybrid and equity securities, dividend reinvestment, and recently announced noncore asset sales. Enbridge can undertake its growth projects and pay down CAD 4 billion in debt without significantly diluting shareholder returns.

Enbridge’s growth portfolio is impressive, but it has negative consequences: the near-term balance sheet. Enbridge has supported elevated leverage levels, currently near 6 times adjusted EBITDA, because of the industry investment cycle. Fortunately for investors, approximately 90% of Enbridge’s debt is at fixed interest rates, which should alleviate concerns about significant increases in interest expense. We forecast leverage levels to drop drastically once the near-term growth portfolio is fully operational--from current levels to 3 times EBITDA within the next five years, a 45% decline, and to 1 times EBITDA in the next decade.

Before its dividend cut in 2015, Kinder Morgan maintained a distributable cash flow coverage ratio of 1.1 times the forward dividend, which left little room for error. In contrast, we expect Enbridge’s 2018 ratio to approximate 1.7 times the forward dividend, which doesn’t bear the slightest resemblance to Kinder Morgan before the dividend cut. Even after all the growth is funded, we expect the ratio to normalize near 1.45 times.

Growth Portfolio Supports Dividend Growth in All Line 3 Scenarios Enbridge's dividend growth is supported by its attractive growth portfolio. Through 2020, the company boasts CAD 22 billion in commercially secured capital projects in the portfolio. The Line 3 replacement project is the crown jewel, representing 35% of the near-term growth portfolio. However, the portfolio's diversity into natural gas projects will aid in dividend growth and act as a hedge if Line 3 experiences any hiccups.

We expect the Line 3 project to be placed into service by early 2020. There has been some concern as to what impact the Keystone XL and Trans Mountain expansion projects will have on the Mainline system’s utilization, including the Line 3 replacement. We expect Canada’s crude oil supply to increase to 6.2 million barrels per day within the next decade from 2017 levels of 4.6 mmbbl/d. With current pipelines running near full capacity, expansion projects are desperately needed. We expect the Line 3 replacement to alleviate some of the need for new pipelines. However, we expect the Mainline system to experience a temporary slight underutilization when competing pipelines come into service and Canadian supply ramps up to our forecast levels. We expect all the major pipeline expansions to be operating near full capacity within the next decade.

Enbridge's Preferred Route In April, Minnesota Administrative Law Judge Ann O'Reilly issued a nonbinding recommendation for the Minnesota Public Utilities Commission to approve Enbridge's Line 3 replacement project, but with a big caveat: She recommended that Enbridge follow its existing Line 3 route (recommended route), not the route proposed by Enbridge (preferred route). Despite the nonbinding recommendation, we think the project will receive approval to use its preferred route. The preferred route offers $3.5 billion in economic benefits to Minnesota and limits its impact on the environment and tribal communities residing in the state.

Minnesota Judge's Recommended Route If the Minnesota Public Utilities Commission approves the existing route, we expect increased costs and delays associated with obtaining approval from tribal communities. Accordingly, we expect the $7.5 billion project to increase to $9 billion. We also expect the expansion to be placed into service one year later, in early 2021. Using this route, the existing Line 3 would be shut down for 12 months beginning in 2019 and ending in 2020 to complete the construction, resulting in 400 mbbl/d of lost throughput.

Despite the temporary decrease in Mainline volumes, we expect Enbridge to weather the near-term storm and comfortably support its dividend growth. We expect distributable cash flow coverage to normalize at 1.45 times, the same level as the preferred route, with a near-term dip in 2019 and 2020. In this scenario, we would expect our fair value estimate to decrease modestly to $49 (CAD 62) from its current $50 (CAD 64).

What If Minnesota Doesn't Approve Line 3? Unlike competing pipeline proposals, the Line 3 replacement project is a National Energy Board-approved integrity replacement project. What investors may not realize is that the integrity status allows Enbridge to recover the additional capital expenditures, operating costs, and a healthy return on capital associated with the replacement--even if the pipeline expansion is not placed into service. Accordingly, the company is currently constructing the replacement where it has been approved: Canada, Wisconsin, and North Dakota. Because of this status, we expect distributable cash flow to drop only modestly above 1.35 times the forward dividend, which still allows for margin of safety.

In an integrity replacement scenario, we expect incremental EBITDA to decline by about a third, as opposed to nearly 75% if Enbridge couldn’t recover a return on any of its capital. With its limited downside, we expect a minimal impact on our fair value estimate if the project does not receive final approval. In that scenario, our fair value estimate stands at $45 (CAD 58) per share.

Dividend Looks Safe With its extensive growth portfolio, we expect Enbridge to meet its annual average 10% dividend growth target throughout 2019 and 2020, after which investors can expect modest growth of 2%. Even with some temporary minor underutilization of the Mainline, we expect Enbridge to generate sufficient distributable cash flow to cover its obligations, including its investor-friendly dividend. After the growth projects are placed into service and Canadian crude supply ramps up to our forecasts, we project distributable cash flow coverage to normalize around 1.45 times the forward dividend. This appears to be a comfortable level at which Enbridge has a significant buffer.

Significant Upside to Go Along With Yield At about $32 (CAD 42), the stock is trading at a 35% discount to our fair value estimate of $50 (CAD 64) per share. We think investors are too narrowly focused on Enbridge as a dividend stock and overlooking the big picture. Because of this, we think the market is too caught up with the near-term state of the balance sheet, which is inflated because of the industry investment cycle. In the near term, investors are skeptical of Enbridge's ability to fund its planned dividend growth while undertaking its growth portfolio. We think they are overlooking cash flow from the growth portfolio, especially the Line 3 replacement project and the numerous natural gas projects. Once placed into service, we expect the projects to generate CAD 4 billion in incremental EBITDA, which will fuel dividend growth while improving the balance sheet from current levels.

Concerns about the widening of the heavy oil discount also look overblown. Together, we expect all three of the major pipeline growth projects (Keystone XL; Enbridge’s Mainline expansion, the Line 3 replacement; and Trans Mountain expansion) to add 1.8 mmbbl/d of new pipeline capacity and be fully placed into service and fully operational by 2022. Before the pipelines are placed into service, we still expect growth from oil sands production. Oil sands operations are quite different from U.S. shale production. Most of the capital associated with oil sands projects is spent up front on infrastructure and heating the reservoir. Once production is up and running, it’s common to maintain steady production levels for more than 30 years with minimal capital commitments.

We don’t expect the lack of current pipeline capacity to discourage growth. Producers are aware that the current U.S. political environment holds the best opportunity for pipeline expansions and that oil sands expansion projects are long-term investment decisions. Accordingly, we don’t expect oil sands producers to allow near-term headwinds to derail the growth needed to support the new pipelines that will lock in long-term price economics.