TNCAF - TC Energy: May Be A Value Trap

2024-01-11 01:25:55 ET

Summary

• TC Energy looks enticing with a high 7.00% dividend yield and 10-yr low valuations. But I believe it is a value trap.
• The company is an FCF bleeder, and this is expected to continue. Its dividends are funded by net debt issuances and its ROIC is below its cost of capital.
• TC Energy's debt portfolio is locked in at near all-time high interest rates heading into 2024 when rate cuts are expected. High debt servicing costs may be forcing asset sales.
• The company is pursuing asset sales as part of an aggressive deleveraging goal, but there may be some desperation in the selling, elevating value destruction risks.
• The value creation rationale for the spinoff of their Liquids business is unclear.

Thesis

I believe TC Energy ( TRP ) ( TRP:CA ) may be a value trap:

1. Valuations are near their 10-yr troughs
2. TC Energy's negative FCF generation record is expected to continue
3. TC Energy's debt portfolio does not directly benefit from rate cuts
4. Unclear rationale for the spinoff of the liquids business
5. Asset sales can lead to deleveraging but value destruction risks are there

Valuations are near their 10-yr troughs

TC Energy is trading near its 10-yr 1-yr fwd EV/EBITDA lows at 11.03x. This corresponds to a ~9% discount of the median multiple over 10 years of 12.11x. This may attract value and dividend investors, especially considering the 1-yr fwd 7.00% dividend yield . However, I will make my case for why I believe this is a value trap:

TC Energy's negative FCF generation record is expected to continue

Firstly, TC Energy has had a horrendous FCF generation record over the last decade. It has generated negative CAD 9.3 billion in FCF over the last 10.75 years:

The cash flow from operations has been CAD 62 billion in the same time period. However, most of that has been eaten away by capex spending, which totaled CAD 59 billion. This leads to a cumulative Capex/CFO ratio of 95% over the last 10.75 years. Going forward, this is not expected to decrease as management still expects to generate CAD 32 billion in operational cash flow and spend all the CAD 32 billion in future capex till 2026.

It has forked out CAD 22.8 billion in dividends in this time with a ~150% average payout ratio, with total dividends paid growing at 6.4% CAGR annually.

However, I contend that this high dividend payment record is not relevant as it is unsustainable; the dividends are funded largely by CAD 35.6 billion in net debt issuances:

The company is not using debt advantageously to make more than what even conservative estimates of the cost of capital would be (taking cost of capital to only equal the cost of debt of 5% . In practice, the cost of capital would be higher than that as cost of equity is higher than cost of debt, and the debt/assets ratio for TC Energy is 50%) either:

TC Energy's average return on invested capital ((ROIC)) has been 4.55%, below even the most conservative estimate of the cost of capital of 5%, which suggests value erosion. Note that more recent ROIC numbers are even worse at <3%, amplifying value erosion.

I don't think funding dividend payments via debt issuance for such an extended period of time without adding value on the additional capital is a characteristic of a good dividend-paying stock.

On the 2023 Investor Day, Wells Fargo Analyst Praneeth Satish noted that the company can get close to FCF-positive if capex is limited to CAD 5 billion and asked if management is vying for this goal:

So I guess when I look at the slide for committed projects in 2026, it's in the $5 billion range. If you add no new projects at this point, at least on our math, you'd be pretty close to being free cash flow positive. So I guess, how do you think about the desire to be free cash flow positive, fully self-funding at a philosophical level? And is this something that you would consider down the road in the '26 time frame?

- Author's bolded highlights

However, CEO Francois Poirier indicated that it is not their priority right now:

We have to balance some competing objectives. And so our approach -- and all of the work that went into devising a $6 billion to $7 billion range , with a bias to the downside to the down -- the bottom of that range at $6 billion, is to make sure that we can balance growth, a stable payout ratio as well as the strong balance sheet.

- Author's bolded highlights

Hence, I believe the negative FCF generation is likely to continue for a while longer.

TC Energy's debt profile does not directly benefit from rate cuts

TC Energy is a CAD 55.7 billion market capitalization company with CAD 62.5 billion in net debt, denominated in mostly USD and CAD. 89% is fixed-rate debt at a weighted average rate of 5%. This debt profile does not directly benefit from the rate cuts expected sometime in 2024. Also, the average term of their debt is 18 years. Looking at the US 20-yr government bond yields, 5.00% means they have incurred a near-peak cost of debt funding:

Canadian bond yields also have peaked at 4.22% . So overall, the company has unfortunately locked in high interest costs, just when the rates situation seems to be getting a bit easier.

TC Energy's long-term debt is rated BBB+ ( lower-medium grade ). Previously, it used to be A-, but it was downgraded in March 2023 . Its preferred share class is rated BBB- , which is another downgrade from the earlier BBB. Debt maturities are spread over the next 3-4 years, but weighted toward the latter half, which means the company is locked into higher interest rates for longer, even though some $2.7 billion is callable (can be repaid earlier):

Their net interest expense as a % of their EBIT has been ballooning over the last 2 years. Over the last twelve months, net interest expense made up 61% of their overall EBIT. Even in prior years, debt costs have eaten away 30-40% of EBIT:

Perhaps this pressure is what is forcing them to undergo accelerated deleveraging via asset sales? (more on this later)

Overall, I believe TC Energy is a bit wrong-sided in terms of its debt profile positioning. And it highlights the critical need to fix their FCF and debt profile.

Unclear rationale for the spinoff of the liquids business

TC Energy's Liquids Pipelines business involves transport of Canadian crude oil from Alberta to refining and export markets in the US. They also provide storage services. Most of the contracts are long-term, but there is also some commodity price exposure here as they sell uncontracted capacity at monthly spot market prices.

This business has not been doing well. Over the last 3 years, its comparable EBITDA has de-grown at a CAGR of 1.4%. This segment used to make up 20% of the overall comparable EBITDA mix at the end of 2019. Now it makes up 15% of the overall mix:

The company intends to spin off this business into a separate entity called South Bow Corporation. Now I went through the company's presentations, transcripts, filings, and news reports. I couldn't find a clear rationale for spinning off this business and how exactly it would 'unlock value'. Only vague statements about being able to pursue more opportunities for growth were what I could gather. "Yes, but how?" would be my counter-question.

This lack of clarity casts further doubt on the company in my mind. The way I see it, the priority ought to be to fix their free cash flow and debt profile first. I shared before evidence that they are in no hurry to get to positive FCF. Regarding the deleveraging, management is trying something but I recognize other risks:

Asset sales can lead to deleveraging but value destruction risks are there

TC Energy has monetized CAD 5.3 billion of assets and plans on doing CAD 3 billion more:

We'll continue to optimize the use of asset sale proceeds to repay debt and accelerate our deleveraging going forward.

- CFO Joel Hunter at the 2023 Investor Day

This is part of their deleveraging goal toward 4.75x Net Debt/EBITDA in 2025. The current Net Debt/EBITDA stands at 5.9x (using LTM comparable EBITDA numbers). Management is very aggressively striving for this deleveraging goal (understandable given the insights we drew from the analysis of their debt profile earlier):

If we need to consider additional divestitures in order to maintain below the 4.75 in 2025, and we'll have visibility to that well in advance of that, we will consider that.

- CEO Francois Poirier in the 2023 Investor Day

I sense a bit of a desperate selling situation from management's tone. Especially when I consider the fact that 2023 asset sales may have occurred at lower prices than expected . This elevates the risks of value destruction in these asset sales.

Takeaway

TC Energy appears enticing with a high dividend yield and relatively cheaper valuations. However, digging further into the company, a host of issues are apparent; A perpetual FCF-negative profile with weak returns on capital, a large debt burden seemingly forcing a hurried sale of assets, overlayed by a lack of focus in a questionable spinoff project.

Overall, I rate the stock a "Neutral/Hold" for now instead of a 'Sell' due to the 10-yr valuation lows.

How to interpret Hunting Alpha's ratings:

Strong Buy: Expect the company to outperform the S&P500 on a total shareholder return basis, with higher-than-usual confidence

Buy: Expect the company to outperform the S&P500 on a total shareholder return basis

Neutral/hold: Expect the company to perform in line with the S&P500 on a total shareholder return basis

Sell: Expect the company to underperform the S&P500 on a total shareholder return basis

Strong Sell: Expect the company to underperform the S&P500 on a total shareholder return basis, with higher-than-usual confidence

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