CA - Enbridge: High Yield Choices Aplenty

2023-11-27 18:00:00 ET

Summary

• S&P Global has a negative outlook on Enbridge due to potential weaker credit measures related to the acquisition of Dominion Energy's assets.
• Enbridge's Q3-2023 hit hard against that thesis and showed that the narrow cushion on credit metrics will likely be sufficient.
• We examine the preferred shares today and tell you why the fixed rate is not the best choice.

Note: All amounts discussed are in Canadian Dollars unless disclosed otherwise

On our last coverage of Enbridge Inc. ( ENB ), we stepped off the sidelines and offered up our first buy rating. The rationale was that the poor capital allocation decision to purchase Dominion Energy's ( D ) assets was more than offset with the compelling valuation. After all, we cannot recall a single instance where a compelling buy point was offered on positive news. The contrarian stance has worked out, at least nominally, though ENB trailed both TC Energy Corp. ( TRP ) and Pembina Pipeline Corp. ( PBA ).

As we talked about previously, we have the covered calls in place for the common shares which provide a nice 13.78% annualized return for a flattish price. Today, we will step away from the common shares and look at the preferred shares that offer yield seekers more attractive risk-adjusted opportunities.

Credit Watch

Before we get to the preferred shares, it is important to consider that ENB did stretch a bit to fit Dominion's assets into the fold. While there was an equity issuance, and the transaction is not going to close any time soon, its debt metrics will now be borderline with the current ratings. S&P Global had this to say about ENB

The negative outlook reflects the potential for weaker credit measures related to the acquisition of the three regulated gas distribution companies and a level of uncertainty related to the remaining financing plan for the acquisition. This uncertainty is related to potential receipt of proceeds from discrete noncore asset sales, the issuance of hybrid capital, the use of the at-the-market program, the dividend reinvestment plan, and incremental debt that will be used to fund the purchase price. We forecast pro forma debt to EBITDA will be about 4.9x, which provides limited cushion with respect to our target for the rating.

We could lower our rating on Enbridge if the company is unable to successfully raise additional funds through asset sales or other means such that adjusted debt to EBITDA is at or above 5x for a prolonged period.

We could revise the outlook to stable if the company is able to raise a substantial portion of the remainder of the capital to fund the acquisition and reduce debt to EBITDA closer to 4.75x during the next 12-18 months.

Source: S&P Global

Now, ENB had a pretty strong Q3-2023. It was possibly lost in the mayhem of the deal announced just prior to the quarter completion, but the results were impressive. Adjusted EPS came in at 62 cents, well ahead of consensus at 57 cents a share. The company maintained its guidance of distributable cash flow of $5.25-$5.65 per share.

Investors should keep in mind that Enbridge had pre-funded the Dominion acquisition via equity issuance. So there were more shares outstanding, without corresponding assets. So there was reason to suspect that they would downgrade their numbers on a per share basis. The fact that they did not, certainly added some confidence in the setup. Their debt to EBITDA was at 4.5X, which is the low end of where they need to be. Even that number is adjusting for the pre-funding. In other words they are subtracting out the equity issued for the future purchase. If you did not do that, debt to EBITDA was at 4.1x.

ENB confirmed this on their conference call.

Adjusted for pre-funding of the acquisitions, our debt to EBITDA for the quarter is right at the bottom of our stated 4.5x to 5x range. On an unadjusted basis, you will note debt-to-EBITDA at 4.1x.

Source: ENB Q3-2023 Conference Call Transcript

While the threat that they would get downgraded is real, ENB can negate that over the next 5 quarterly results. They had some cushion when they started out on September 7, 2023 and the first set of results expanded the cushion just a bit. We think they will hold their ratings (BBB+ S&P and Fitch) and the preferred shares will hold the BBB- mark.

Enbridge Inc. PFD SER A 5.5% ( ENB.PR.A:CA )

It is hard to consider something yielding 6.8% on a stripped basis when we are getting 14% yields on longer dated covered calls. Nonetheless, we think that preferred shares offer a different risk-reward versus covered calls on common shares and they should form part of an income oriented portfolio. ENB.PR.A:CA has been around for a long time and investors today are certainly paying less than almost any other time in history.

In fact, the only time ENB.PR.A traded lower was during October 2023. Nonetheless, the yield leaves a bit to be desired relative to alternatives. We believe investors are paying a lot of premium for the fixed nature of this yield. We can show that by comparing a preferred share that just reset.

Enbridge Inc. CUM RED PF S N ( ENB.PR.N:CA )

This preferred share class just got reset and the dividend for the next 5 years will be as follows.

The new annual dividend rate applicable to the Series N Shares for the five-year period commencing on December 1, 2023 to, but excluding, December 1, 2028 will be 6.696 percent, being equal to the five-year Government of Canada bond yield of 4.046 percent determined as of today plus 2.65 percent in accordance with the terms of the Series N Shares.

Source: Enbridge

That is of course on par. So the annual dividend will be $1.674. On a price of $19.50, the yield is 8.58%. So both these shares will have fixed dividends for the next 5 years, after which, ENB.PR.N will be reset. They key question you have to ask is whether the 1.78% extra per year compensates you for the resetting feature. We think it does and unless you expect a complete return to ZIRP (zero interest rate policy) in Canada, the resets offer an advantage. One way to give yourself a line in the sand, is to ask at what Government of Canada (GOC-5) yield would both ENB.PR.N and ENB.PR.A, provide the same yield 5 years down the line. The answer at the current price, is 2.66%. If the next reset is at GOC-5 2.66%, then ENB.PR.N would yield 5.33% (2.65%+2.66%) on par. That would work out to about 6.82% on the current price, which is the same as the ENB.PR.A fixed yield.

Verdict

You don't always get paid for risk, but here you are getting plenty of compensation for going the reset route. If you are ready to wait a little more, then the some like Enbridge Inc. PREF SER P 4% ( ENB.PR.P:CA ) make even more sense. At current rates, the reset will be around 9.0% and will be announced beginning of February 2024. These are all Canadian dollar listed options, but US Dollar ones also offer interesting yields. Enbridge Inc. Cumulative Redeemable Reset Rate Preference Shares, Series L ( OTCPK:EBBNF ) ( ENB.PF.U:CA ) is a US dollar traded one that yields 7.86% today and will float in September 2027 at five-year United States Government treasury bond yield plus 3.15%. At the current 5 year treasury rate of 4.49%, the reset would be at 7.64% on par and that would work to 10.24% on the current price. In fact, the 5-year treasury would have to drop below 2.70790% on reset for you to get a lower yield from September 2027. Again a fair bet in our view. We like and own a lot of these and trade around them as opportunities arise.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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