ENBA - Enbridge Preferred Shares: 7.5% Yields On The Horizon

Summary

• Enbridge promised a lot 5 years back and the plan looked unrealistic.
• It actually delivered better than what it promised and deleveraging has been completed.
• We look at the preferred shares that got reset to a 6.9% yield and those that will get reset at 7.5% assuming market conditions remain constant.

All amounts discussed are in Canadian dollars and refer to shares trading on the TSX.

While we have covered the Enbridge Inc. ( ENB ) common shares previously, today our focus will be exclusively on the Enbridge Preferred Shares and why they are extremely underrated. To start off. let's go back to 2017. Enbridge investor day showed the following slide with debt to EBITDA hovering near 6X.

Now it had come down from the near 7X levels in early 2015, but there was no question that a lot of work needed to be done. That same presentation showed that Enbridge planned to execute $22 billion of capex (at least) over the next three years.

Only $14 billion of that $22 billion was supposed to be from internally generated cash flow after dividends.

The capex plan alongside plans of reducing net debt to EBITDA were extremely ambitious. Enbridge also guided to strong distribution and adjusted funds from operations (AFFO) growth in this same timeframe.

If we look back at the last five years, they were punctuated with multiple challenges for Enbridge that were likely not remotely anticipated by the company. From the 2018 heavy oil price crash, to negative prices in wake of COVID-19. From Michigan challenging Enbridge at every single turn to massive cost inflation in 2021 and 2022. Through it all, Enbridge has delivered.

Net debt to adjusted EBITDA is expected to be 4.3X this year and 4.1X next year.

The Preferred Share Perspective

Enbridge's adjusted EBITDA is likely to be in the $15.5 billion area this year. Post taxes and interest payments, the AFFO should be about $10.5 billion. The preferred share dividends are likely to be about $360 million, while common dividends close to $7.3 billion. That is a rather remarkable coverage ratio for these preferred shares, consuming just 3.5% of the pie that is left for equity holders. Put another way, the preferred share dividend coverage is close to 30X. Of course, the better and more conservative manner is to add back interest expenses to the AFFO and then divide that total by the sum of interest expense and preferred share dividends. By that measure we are dividing $13.7 billion by 3.6 billion. This fixed charge coverage comes close to 3.8X. While not as impressive as Pembina Pipeline's ( PBA ) coverage levels , it is still impressive for a company the size of Enbridge.

A Fixed Rate Choice

Enbridge has 18 classes of preferred shares and most of them are of the 5-year fixed reset variety.

That is, their yields reset every five years depending on where the Government of Canada's (GoC) 5-year bond is trading at the time. For those desiring just stability of income, Enbridge's ENB.PR.A trade at $23.00 and offer a stripped yield of 5.99%. If you believe interest rates in Canada are likely to peak in 2023, and then move lower, this is the issue for you.

Why The Resetting Yield Preferred Shares Are Undervalued

If you desire a higher yield today that is fixed for a long time and feel rates are likely to stay at or above current levels, then ENB.PR.B is for you. This one is trading near $19.00 a share and the yield was just reset in June 2022. The new dividend was $1.3005 (5.202% on par), which works out to a stripped yield of 6.9%.

The next reset will be June 2027 and it will be at the 5-Year GoC bond yield plus 2.4%. It is important to note here that this GoC yield was 2.802% at the time of the reset and is currently at 3.27% . That same yield gets to our undervalued aspect as well. The ENB.PR.B's are yielding 3.63% above the 5-Year GoC yield, a spread we think is largely unwarranted. Five years back, around the time of the last reset, ENB shares were trading at the same spot.

What is remarkable here is that these shares were reset to yield 3.415% on par vs the 5.202% on par today. Investors were ready to accept these at the same price with a yield of just 4.5%. So our pitch here is that ENB is on exceptionally firmer footing, debt to EBITDA has dropped two multiples, major projects were executed perfectly, roll-ups of subsidiaries were done, and the shares now have to yield 6.9%? In addition, we can likely argue that the GoC 5-year yield is close to peaking and this is a great chance to lock in a nice yield for five years.

You Think Yields Have Room To Go Up?

If you think yields are headed higher in the next 6-9 months, then we have a third choice for you. ENB.PR.D . That one has a reset date of March 2023 and GoC+2.37% spread. ENB.PR.D currently yields exactly 6% and is trading cheaper relative to ENB.PR.B. Investors are uncomfortable with the uncertainty of the rate reset but this could really deliver if rates stay around this ballpark.

If GoC stays at 3.27%, then the reset yield on par would be 5.64% (3.27%+2.37%). At the current price of $18.65 you lock in 7.55% for five years.

Verdict

Enbridge fixed reset preferred shares offer a strong income as long as you are comfortable with market based changes every five years. The shares appear undervalued to us relative to how much the credit quality has improved over the last five years. While not included in the US dividend aristocrats list, we will note that the company has delivered a 10% compounded dividend growth over 27 years in Canadian dollars.

We own three different classes of preferred shares and remain open to adding more.

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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