WPC - TC Energy: Preferreds Offer Big Yields With Large Premium Over Debt

2023-12-08 01:06:45 ET

Summary

• TC Energy's plan to spin off its liquids division and focus on natural gas transportation has not exactly been well received.
• We examine the plan of action to see if they can make the required debt metrics.
• We tell which preferred shares offer a big yield in our outlook.

TC Energy Corporation ( TRP ) ( TRP:CA ) has had a difficult 2023. The company has been in the crosshairs of the credit rating agencies as it has multiple delays in achieving its debt to EBITDA targets. To make matters worse, project delays and cost overruns have put it on the backfoot several times. Its plan to spin-off its liquids division was greeted with an ice-cold capital market.

Shares of TC Energy fell nearly 5% on Friday after the Keystone pipeline operator said it would spin off its liquids business to focus on transporting natural gas.

The spinoff, combined with TC's announcement on Monday that it will sell a 40% stake in its Columbia Gas Transmission and Columbia Gulf Transmission pipelines, will help TC reduce its high debt levels.

But TD Securities downgraded TC to "hold" from "buy", saying it was skeptical the spinoff would create value.

"We see execution risk introducing uncertainty and potentially distracting from its existing strategic priorities," TD analyst Linda Ezergailis said in a note. Shares in Toronto plunged 4.4% to C$45.21, touching a seven-year low.

"There's blood in the water, the stock has already been going down on the back of the Columbia transaction, so I think there's some (selling) piling on," said Ryan Bushell, president of Newhaven Asset Management, a TC shareholder. TC CEO Francois Poirier said TC needed to sell another C$3 billion in assets during the next 18 months to reach its 4.75 times debt to EBITDA target. TC had 5.4 times debt to EBITDA last year and is aiming to reduce that to 5 times this year.

The TC share sell-off reflects a re-rating after the company made the Columbia deal at a lower price than some expected, and now plans a spinoff carrying more debt compared to EBITDA than some U.S. peers.

Source: Reuters

Downgrade from TD Securities to a hold is about as rare as you can get in the pipeline space. They have historically held the most unabashed positive view on these companies in general and TRP in particular. The entire sell-side community is confused as to why TRP cannot get its acts together and instead in foundering around with moves that are not value creating. But there are some signs that TRP is getting at least some of the message. Let's look at their investor day thoughts and move from there to why the preferred shares represent a compelling value.

Investor Day

TRP highlighted the smoking hot EBITDA for 2023 (8% growth) and their ability to meet their monetization targets.

Next they spoke about the separation of the two companies.

This is of course the confusing part as they are both utility-like assets and they both should perform in a similar manner. TRP of course feels that it can waive a magic wand and reverse engineer a better valuation despite having two sets of G&A expenses on top of an incoherent strategy. Some of this was obviously driven by the ESG aspect where the liquids are "bad" and gas is well, "good." So throw the liquids into a separate business and then add a few green slides down the line to show how TRP is now taking better care of the planet. Cause you know, those assets are polluting in a different company name. Next came the timeline, which as expected is long and arduous.

But the real key here is the capex outlook. TRP's drunken sailor days are done and the slowdown will be palpable.

Even this reduction basically gets them to cash-flow neutrality in 2024. But the expected projects being placed online should allow further deleveraging.

Finally, while the spin-off is value destructive to some extent, it will likely appease the credit rating agencies as the liquids side company will take the additional leverage with it.

Preferreds

With the liquids spin-off, this is what TRP will look like.

The low-risk, model coupled with 4.75X debt to EBITDA is likely to be viewed superior to the standard utility. The exact dividend make up of this company is a bit unknown, but TRP has promised to not pull a W. P. Carey Inc. ( WPC ) on us.

While the common shares with their 7.22% dividend yield remain attractive, we will be focusing on the preferred shares today.

TRP has two types of preferred shares currently quoted on the TSX.

1) The 5 year resetting ones which change their dividend payout based on the Government Of Canada (GOC-5) yields.

2) The ones tied to 3 month floating rates.

Now options 1 and 2 are interchangeable on the reset dates. So for example, TRP has TC Energy Corporation cumulative redeemable first preferred shares series 1 ( TRP.PR.A:CA ) which is GOC-5 plus 1.92%. It also has C Energy Corporation cumulative redeemable first preferred shares series 2 ( TRP.PR.F:CA ) which is the 3 month Bank Of Canada rate plus 1.92%. These are exchangeable for each other on the next reset date, which is December 31, 2024. We will focus though on the first type (tied to GOC-5), which is what most investors are interested in. In that area, TRP has 6 preferred shares resetting between April 2024 and January 2026. There are two here that are really interesting are the ones about to reset.

1) TC Energy Corporation cumulative redeemable first preferred shares series 7 ( TRP.PR.D:CA ) ( OTC:TRPPF ), which resets on April 2024 at GOC-5 plus 2.38%. At the current GOC-5 yields this will get to 5.82% on par ($25) and thus a 9% yield on the current $16.20 price. This is a solid yield for a company with TRP's credit ratings. TRP's 2030 bonds which are a close proxy for the 5 year duration on these preferreds, yield 4.79513%.

So you are likely to get a 4.2% higher yield and a tax-advantaged one relative to what the bonds are paying.

2) TC Energy Corporation cumulative redeemable first preferred shares series 3 ( TRP.PR.B:CA ) are a more interesting one for those believing in the higher for longer thesis. These reset on June 30, 2025 at GOC-5 plus just 1.28%. The very low spread makes them yoyo around with GOC-5 yields quite a lot. At the current price of $10.90, these would yield to close to 11%, based on where GOC-5 is currently at. Of course if the yield rises into this environment, then we could be looking at very high numbers for the reset. It is important to note that the current yield on these, thanks to the last reset being in the heart of COVID-19, is very low. They yield just 3.85% but that will get a big upgrade down the line.

Verdict

TRP's move to split the company is another example of poor corporate governance. The move likely reduces value for stockholders and we are neutral in the name at present. In the sector our favorite is still Pembina Pipeline ( PBA ), ( PPL:CA ), as that continues to show the most discipline.

TRP preferred shares though, are underrated relative to their potential. That logic still applies even after the latest misstep by management. We like the ones noted above. The risk of a recession hangs over both their heads, but is more notable for TRP.PR.B. We think the interest rate cuts being visualized today won't happen and hence these resets will likely prove very strong.

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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