Capital-intensive businesses have had a free ride for the last decade and a half as regards interest rates on their debt. Many have funded capex for expansion, and generous dividend/distributions through bond sales and other forms of debt. Petroleum pipeline companies in particular have carried a heavy debt load in relation to their EBITDA or capitalization. That practice is becoming more expensive and the much sought-after dividends these companies have been paying may be in jeopardy. The western world seemed to have arrived at a very modest rate of inflation post-the Great Financial Meltdown of 2008 that allowed Money Center banks-The Federal Reserve in the U.S. for example, to maintain discount rates-rates charged for interbank lending, at or near zero. This period of “easy money” facilitated corporate balance sheets by keeping interest payments on their debt to manageable levels.
Inflation returned with a vengeance in early 2022 forcing central banks to begin tightening the money supply, and interest rates began to rise accordingly. In the case of the U.S., the current Fed Funds target rate is 4.5-4.75%, and a terminal rate of 5.5-5.75% is forecast. In this article, we will look at the effect this sea change in the interest rate landscape may have for heavily indebted pipeline companies, and in particular for Enbridge Inc. (NYSE: ENB). This will be of interest to many readers as this company pays a dividend yielding nearly 8%, and is a favorite vehicle for retirement income seekers for this reason.
The problem on the horizon for ENB and other midstream high-yield payers is there is not a lot of buffer space between cash flow and maintenance and growth capex outlays, interest payments, and dividends. The fear is as debt maturities are rolled over and extended the interest increases that result will increasingly put dividends at risk.
Enbridge Inc. (NYSE:ENB) is a solid dividend payer with a strong track record of paying a fairly stable high yielding dividend-through good times and not-so-good times. Probably no higher compliment can be paid to the company. Except for one little thing. They have been balancing the books (dividends, growth capex, interest payments) with debt. The TTM payout ratio is 269% for 2022.
Enbridge is a dividend play, pure and simple. Investors looking for growth should probably continue their search. Enbridge stock is already selling for 13X EBITDA, and I don't see that multiple expanding a lot in the current environment. What they offer is above-average, long-term, low-risk income - for now. The debt monster could come calling in years ahead. I regard ENB as Best in Class, in no small part for their Class-C Corp structure which avoids the IRS K-1 morass. (Feel free to take this up with your tax advisor if you wish more information on K-1s.) This not necessarily a reason to buy the stock at this level, as we will discuss in the rest of this article. Best in Class, does not mean, "First Class," in a rising interest rate environment.
The $53 bn problem for Enbridge
The company is in the business of moving different classes of hydrocarbons from one place to another through pipes buried underground-mostly. They also have end point storage along the Texas Gulf Coast and Suezmax/VLCC wharfage in Corpus Christie.
You can get an idea of their various footprints from the slide below. Recently the company has made a low-carbon foray into windfarms in Europe to leverage high electricity prices, and in the U.S. made a $3bn acquisition of an onshore windfarm developer - Tri Global Energy. We won't elaborate much on the low-carbon stuff, as it's an obvious play on the Inflation Reduction Act - IRA. The bottom line, it's a Federal Pork-barrel cash grab, and they would be poor stewards of capital if they didn't haul some in.
ENB Footprint Slide ((ENB))
The Enbridge "tolling" business model is fairly standard in the industry. Units go into the system, usually under long-term contracts, and a fee is paid for transit. Conceptually it insulates them somewhat from fluctuations in commodity prices, but as a practical matter, they feed at the same trough as producers. When the market turns sour, they catch the flu, too, albeit with a delay of sorts as their volumes decline. ENB is currently beset with the oil and gas price "flu" which creates the opportunity we now have to scoop up shares at a discount to recent pricing. But, should we?
They are in a capex-intensive business and carry an inordinate amount of debt - currently some $53 bn USD, a figure at which they've been chipping away recently as interest rates have risen. It was $56 bn a year ago, so that's $3 bn to the good. You might explain away carrying this amount of debt in the interest rate era that wound up in late 2021. It's already starting to show up on the balance sheet as ENB paid about $250 mm more interest YoY from 2021-2022. It should be noted, as they do in the slide below that ENB doesn't consider this debt excessive, and it is well managed with cash flow on their balance sheet....so far. The debt here is worrisome in a rising interest rate environment... to me, anyway.
ENB Capital Allocation ((ENB))
Now, this debt concern is certainly not to cast any present doubt on their liquidity, about $10 bn at present. I am speaking to dividend investors here, and the company is currently paying out ~$3.5 bn in interest on a TTM basis. Much more of this type of action and the math might not work on the dividends. The company has very little cash, so capex and dividends are funded with cash flow...and debt.
You can see below what their near-term debt picture looks like. 2027 is a long way off, and who knows what interest rates will be then.
ENB Near-Term Maturities ((ENB))
2022 was a year of substantial debt rescheduling for ENB. They have $1.9 bn due in May, '23, $5.5 bn in July of '24, and another $12.7 bn due between 2024 and 2027.
With TTM cash flow running in the range of ~$8.3 bn, normalized capex of ~$4.5 bn, $3.5 bn of interest charges, and an annual dividend obligation of ~$5.1 bn, you can see we are deeply into "new math." ENB is going to have to dip into that pool of liquidity to make ends meet. In that scenario, interest charges are going higher, leading to concerns in the next few years about the ability to fund the dividend at the current level.
Speaking to dividend investors, of which I am one, I can't think of a high-yielding sector with less risk than pipelines over the short term. They may have their ups and downs, but they provide an essential service to millions of people on a daily basis, and I am betting they are here for the long haul. But is Enbridge Inc. the one to buy? Best in class or not, there are other options in this space.
I waxed on a good bit about the debt in this article, and with some justification in my view. That said, I am in no way suggesting Enbridge Inc. is in any sort of debt crisis. There are many levers to pull when these maturities come due. I am just saying interest costs are rising and may rise faster than cash flow. In that scenario, the dividend could come under the axe.
ENB is deeply discounted in relation to its recent high, but not cheap in comparison to its main competitors. It is trading at 13X EV/EBITDA, right in line with its 10-year historical average. For reference competitors Energy Transfer LP (NYSE:ET) and Enterprise Products Partners L.P. (NYSE:EPD) are yielding slightly higher-9.3% and 7.5%, respectively, and with lower EV/EBITDA multiples-both at about 7.5X. It should be noted that these companies also carry tens of billions in debt on their balance sheets and may present the same potential debt conundrum as ENB in the coming years.
As with all investments, investors should do their own due diligence before taking the plunge into a stock.
By David Messler for Oilprice.com
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