This is a guest post by Landlord Investor.
Disclosure: Landlord Investor owns EBGEF / ENB.PF.V
This article makes the case for buying a preferred stock from Enbridge (ENB). The first part of the article provides a description of the preferred stock. The second part provides five reasons for buying the preferred. The final part discusses some risk factors and projects a price target.
Part I: Preferred Stock Description
Enbridge's Series 5 Preferred Stock (OTCPK:EBGEF) is no ordinary preferred stock. To start with, the preferred stock is listed on the Toronto exchange but it is denominated in US dollars and pays dividends in USD. The ticker symbol for the preferred stock in Canada is ENB.PF.V but you can also buy it in the OTC market in the US under the symbol EBGEF. The two tickers track each other closely in price but I find that execution speed and execution price is a little better buying it directly on the TSX via ENB.PF.V. Interactive Brokers is one broker that allows you to trade Canadian tickers. If your broker doesn't allow that, then your only option will be to trade it via EBGEF.
EBGEF's coupon resets every five years based on a spread over US Treasuries. The stock recently reset for the first time on March 1 2019. An Enbridge press release states the new dividend rate is 5.3753%. This is based on the five-year United States Treasury bond yield of 2.5553 percent as of January 30 2019, plus 2.82 percent. January 30th was a pretty good day to lock in the new rate as the five-year Treasury is now about 15 bps lower. Since the preferred stock trades at $20 (80% of par value), the effective yield is 5.375/0.8 = 6.72%. Further details about the rate reset can be found in the prospectus.
Enbridge is a c-corporation so dividends are reported on a 1099 and there is no K-1. Dividends are qualified, so receive favorable tax treatment at a lower rate. However, dividends are subject to 15% withholding by Canada. You can recover this withholding by filing for a foreign tax credit with your tax return. Like any Canadian stock, if this stock is held in a non-taxable account then there is no withholding according to this source.
Symbol: EBGEF / ENB.PF.V Taxes: 1099 / Qualified
Dividend Rate: 5.375% Reset Rate: 5-Year UST + 282 bps
Price/Yield: $20 / 6.7% Next Reset: 3/1/2024
Last Ex-Div: 2/14/2019 Last Pay Date: 3/1/2019
Part II: Five Reasons to Buy EBGEF
#1: Size and diversity of operations
Enbridge is the largest North American midstream company based on common stock market cap ($75B), Enterprise Value ($120B), and EBITDA ($13B). They also have the most diverse operations based on geography, customer demand drivers, and business lines. Let's dive deeper into these characteristics.
Slide 1: Enbridge EV, EBITDA, and Geographies
Most North American midstream companies are US-based and exhibit a home country bias that puts a disproportionate share of their operations in the US. In contrast, Canada-based Enbridge has a more significant share of operations in Canada which creates more geographic diversity of their operations. Geographic diversity is important because geography-based factors can influence operational and financial performance. Some of these geography-based factors include weather, political and regulatory climate, and production & transportation economics. The latter is a big factor in creating diverse sources of customer demand for Enbridge's services.
Throughout North America, energy sources have different production & transportation economics which drives differences in customer demand. Broadly speaking, there are three types of land-based energy sources in North America: conventional, tar sands, and shale/tight energy. Spreading operations across multiple types of energy sources significantly decreases the company's sensitivity to market conditions.
Conventional energy customers are generally the most reliable sources of midstream demand. Conventional sources usually have high startup costs, slow declines, and low breakeven rates. As a result, once conventional energy goes into production, you can count on it as a source for midstream demand for a long time to come regardless of the spot price of oil/gas. Unfortunately, most midstream companies including Enbridge only have a small share (if any) of customer demand coming from conventional sources.
Tar sands are primarily located in Canada and also have high startup costs and low decline rates but have higher breakeven rates. While a low price of energy has little impact on the amount of tar sand energy produced in the short run due to low decline rates, in the long run, if energy prices do not exceed breakeven costs, then tar sand energy production (and transportation demand) will decline. Tar sands are also subject to tight transportation constraints that are unlikely to reverse completely. As a result, demand for Enbridge's tar sand transportation services will remain well bid even if production decreases.
Shale/tight energy is the dominant source of energy transportation demand for virtually all North American midstream companies but especially US-based ones. Shale/tight energy has the least desirable economics. They have low startup costs, fast declines, and higher breakeven rates. Fast decline rates mean a drop in energy prices can quickly result in declining energy production and demand for transportation. While long term fixed contracts for Enbridge's transportation services can delay the impact of decreased demand for transportation, a sustained drop in energy prices will likely hit shale/tight energy transportation demand the hardest.
Another source of diversity for Enbridge is their split between oil and natural gas transportation. I'm particularly bullish on the demand for natural gas transportation as volumes should rise over the next few years. Natural gas demand should increase from higher LNG exports and greater share for natural gas in electricity generation.
#2: Low risk business model
Enbridge's business model is designed for revenue and financial stability in all market conditions. Their business model is comprised of a low risk operating model and a low risk financial model.
Slide 2: Low risk operating model
Enbridge's operating model is characterized by long term, fixed contracts with creditworthy counterparties. Their revenue also comes from fee-based services with insignificant direct commodity price exposure. As a result, they have grown EBITDA in all market conditions.
Enbridge also derives 15% of EBITDA from a low risk utility business. They are the largest natural gas utility in North America by send out volume. Not only does the utility business add diversity to Enbridge's operations, it is also a more stable business than liquids or gas transportation.
Another factor decreasing risk at Enbridge is the high barriers to entry for many of the markets they serve. Enbridge has several interstate and trans-national pipelines where it is very difficult to add capacity due to regulatory constraints. They also have pipelines in the densely populated Northeast US where it is also difficult to add capacity.
Slide 3: Low risk financial model
Enbridge's financial model is also low risk as demonstrated by their leverage and credit ratings. Leverage, as measured by Debt/EBITDA, was high as recently as 2017, however, they reduced it to their target range by 2018. It is currently about 4.7x and they plan to reduce it to 4.3x by 2020. While that is a conservative leverage level, a best-in-class leverage ratio would be under 4x. By comparison, the standard-bearer on leverage in the midstream space is Enterprise Partners (EPD) and their ratio is 3.5x.
Despite slightly higher leverage, Enbridge does sport a best-in-class credit rating of BBB+, the same as EPD and Magellan (MMP). As is typical, the preferred stock is rated two notches lower at BBB-. That puts EBGEF in the elite class of investment grade preferreds. No other energy company has issued an investment grade preferred stock.
#3: Undervalued based on comparable preferreds
EBGEF is undervalued because its yield is higher than any other investment grade preferred stock. This is demonstrated in the following charts.
Chart 1: Investment grade preferreds with a yield >5% that are below par
The highest yielding preferred stock from the above is APO-B which yields 6.41% as of 4/15/2019. While APO-B is a fine stock, it issues a K-1 and dividends are taxed at the ordinary rate. There's a significant gap to the next highest one which is AHL-D (Aspen Insurance) and yields 5.71%. It appears that Aspen's common stock is unlisted. The next highest are KIM-K (Kimco REIT) yielding 5.64% and AXS-E yielding 5.58% from Axis which is a $5B market cap insurance company. Overall, we can see that IG preferreds below par generally yield between 5-5.6%, well below EBGEF's 6.7%. The exceptions are the K-1 issuing asset management company preferreds from Apollo (APO) and Oaktree (OAK).
Chart 2: Investment grade preferreds above par
When preferreds trade above par, yield-to-call is the appropriate measure of yield. In the above chart, we can see that no IG preferred yields above 6%. The highest yielder from the chart is RNR-F which yields 5.74% as of 4/15/2019.
These charts indicate that EBGEF is significantly underpriced. It's yield of 6.7% is much higher than other investment grade preferreds which all yield below 6% with a couple of exceptions.
#4: Strong common stock track record
A preferred stock is only as good as the common stock cushion ahead of it. For this reason, I always look closely at the common stock track record to determine if the cushion is stable-to-growing and for evidence that management is creating value (in excess of their compensation) rather than destroying it over time.
Enbridge common stock has a strong track record on all fronts. The company was founded in 1949 and came public in 1996, so its track record is long. Since IPO, the common stock has provided a total return CAGR of 17%. This greatly exceeds the total return of the S&P 500 and the S&P 500 Energy Sector during this period.
Since the preferred dividend is paid ahead of the common dividend, I also look at the common dividend track record. Once again, Enbridge has performed admirably.
Slide 4: Dividend growth track record
The safest dividend is the one that has just been raised and Enbridge has raised its dividend every year since 1996. In 2020, Enbridge will likely achieve Dividend Aristocrat status by raising the dividend 25 consecutive years.
#5: EBGEF is under the radar
A confluence of factors have caused EBGEF to be unnoticed by preferred stock investors and remain undervalued. The first is confusion about the dividend rate. Online brokers are still listing EBGEF with the old dividend rate and even Enbridge's own website has not been updated with the correct dividend information. EBGEF also flies under the radar by only being listed on the OTC in the US and mainly trading in Toronto. However, Canadians are unlikely to be interested in a US dollar denominated preferred stock. Frankly, it was a mistake for ENB (and the underwriting bank) not to list the preferred on the NYSE.
Strangely, at least at E-trade, no bid/ask is available for EBGEF. To obtain bid/ask numbers, I have to get them from Interactive Brokers for ENB.PF.V. I'm sure this also keeps people from buying EBGEF.
Flying under the radar has kept this preferred stock from getting fairly valued. It has significantly lagged the improvements in all the sectors it is associated with: energy/oil, preferred stocks, and investment grade credit. Based on correlations, EBGEF should have rebounded higher since the Q4 2018 swoon.
Part III: Risk Factors
While EBGEF is a safe preferred stock, every investment has its risks.
Low liquidity -- While there are 8M shares of EBGEF, which is not a small number for a preferred stock, few shares trade daily. Most days, volumes are in the single thousands. So, getting in and out of this investment without moving the market may be difficult. Use limit orders.
Above average volatility -- For an investment grade security from a stable dividend growth company, there is a surprising amount of volatility. Within months of the IPO, EBGEF was down to 23, likely because it was overpriced at IPO. Preferreds with a history of breaking par are generally more volatile. EBGEF did get back near par by the end of 2014 but then dipped down to 14 by February 2016. That's an absurdly low price for a preferred stock unless is severely distressed and in imminent risk of suspending its dividend. It rebounded back to 22-23.50 and then dipped to 18 in December 2018. It's now back to $20. That's an awful lot of volatility for a five year history.
Technological obsolescence -- There is an emerging technology for transporting tar sand energy that could displace some demand for pipelines. Balls of Bitumen is a new way of transporting tar sand energy by rail that allows you to use ordinary freight railcars. The cost of railcar transportation by this means could rival pipeline transportation costs.
If EBGEF traded on the NYSE as a normal fixed-to-floating preferred stock with normal liquidity, analyst coverage, and accurate data feeds from online brokers, then it should trade at a 5.75% yield. This would be just above the top end of the range for investment grade preferreds. The top end of the range is appropriate since EBGEF has the lowest investment grade rating and energy sector preferreds are not as desirable as preferreds from other, more stable industries such as insurance.
However, to account for the low liquidity, above average volatility, and quirky TSX listing, I think 6.2% is an appropriate yield for EBGEF. That would translate to a price of $21.70. Since $0.16 of dividends have accumulated since March 1, that results in a price target of $21.86.