CA - Enbridge: Market Lacking In Confidence Over The Dominion Gas Utilities Deals (Rating Downgrade)

2023-09-10 08:30:00 ET

Summary

• Enbridge announced a blockbuster deal to acquire three deals with Dominion Energy, expanding its natural gas utilities business.
• The acquisition will make Enbridge the largest gas utility franchise but comes at a high cost of US$14 billion, including debt and a share sale.
• The market has quickly priced in near-term downside for ENB, with concerns about the acquisition's potentially dilutive effect on shareholders and additional debt burden.
• I assessed that ENB's price action had weakened over the past month before the deals were announced. Investors are likely seeking more substantive evidence on the deals' supposed earnings accretion.
• While ENB's valuation remains well-balanced, buyers are surprisingly lacking in confidence. While a long-term bottoming remains possible, it's better to let the market action play out first.

What a week for Enbridge Inc. ( ENB ) investors as the company unleashed a blockbuster deal , completing three deals with Dominion Energy ( D ) over the past week. As such, the acquisition is expected to significantly expand the company's natural gas utilities business, with the acquisition expected to close in 2024 (pending regulatory approvals).

Enbridge's acquisition would help create " North America's largest gas utility franchise." Of course, it doesn't come cheap, as Enbridge needs to cough up about US$14B or C$19B in total deal value, including $4.6B in debt. The company also anticipates raising up to C$4.6B in a share sale to fund the acquisition. As such, it is expected to lift the company's adjusted EBITDA leverage ratio further, adding more burden on its financing costs, which could crimp its ability to undertake more aggressive capital returns for shareholders.

Given the potential dilutive effect and additional debt burden, the market has already quickly priced in near-term downside (even though the deal has not closed). Accordingly, ENB fell nearly 7% from the previous week's close through its lows in the recently concluded week. As such, investors are likely concerned about how accretive the deal will be for Enbridge despite management's assurances.

I gleaned that buying sentiments in ENB over the past month didn't look constructive, as I had anticipated in my previous update in July. Notwithstanding the company's solid August earnings release , investors are likely pricing in a slowdown in its adjusted EBITDA growth, even though it resolved its Mainline contracts. Notably, the company's cautionary statements that accompanied its financial outlook in early August stressed that "a lower toll on the Mainline is anticipated to impact financial performance." In addition, Enbridge also indicated that "higher financing costs are expected due to increased interest rates."

As such, I find it interesting that while Enbridge highlighted the acquisition is expected to bolster the company's utility business earnings profile, it didn't raise its earnings growth guidance despite the increase in debt burden and potential share dilution.

Management updated in a conference call discussing the acquisition that Enbridge is confident of hitting an adjusted EBITDA leverage ratio of 4.5 to 5x. However, Wells Fargo presented estimates suggesting the acquisition could cause Enbridge's EBITDA leverage ratio to surge to 5.4x.

As such, I believe investors are still assessing the possibility that Enbridge needs the acquisition to maintain its medium-term EBITDA growth profile of above 5%. Moreover, management updated that "share repurchases will be paused" as Enbridge assessed opportunities to capitalize on its growth backlog.

Despite that, Enbridge remains committed to maintaining its dividend profile, as ENB's forward yield surged to 7.9%, well above its 10Y average of 5.5%. ENB's valuation seems pretty well-balanced. Seeking Alpha Quant assigned ENB with a valuation grade of "C-." Despite that, midstream companies like ENB are usually valued at a relatively higher level than their broad oil and gas peers, given the predictability of their earnings profile and solid distribution characteristics.

Despite that, I believe the marked weakening in ENB's price action over the past month necessitates a more cautious approach to assess whether buyers could return with conviction over the next two months.

As seen above, ENB lost its critical 200-week moving average or MA (purple line) in August, even before the recent selloff this week, as the market attempted to price in the acquisition.

While ENB finished above its week's lows, there wasn't a bullish reversal price action. Moreover, I didn't glean any bear trap or false downside break opportunity at the current levels, undergirding more robust buying sentiments.

Investor psychology in ENB is assessed to remain cautious, but ENB's long-term chart indicates a bottoming process is possible. However, I need buyers to return aggressively over the next two months and hold ENB above the $35 level decisively (October 2022 lows) for the thesis to play out convincingly.

As such, I believe it's time to return to the sidelines, even though I think ENB's valuation remains reasonable (fairly valued). I will continue to observe ENB's buying sentiments over the next two months to assess a more robust buying opportunity moving ahead.

Rating: Downgraded to Hold. Please note that a Hold rating is equivalent to a Neutral or Market Perform rating.

Important note: Investors are reminded to do their due diligence and not rely on the information provided as financial advice. Please always apply independent thinking and note that the rating is not intended to time a specific entry/exit at the point of writing unless otherwise specified.

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