2023-08-07 17:41:15 ET
Summary
- Enbridge Inc. reported solid second quarter 2023 earnings results, with year-over-year growth in most financial measures.
- The company's business model, which relies on long-term contracts for transportation services, provides stability and insulation against commodity price fluctuations.
- Enbridge's growth prospects include a focus on natural gas transmission and distribution projects, with secured contracts in place for future projects.
- The company continues to maintain high leverage relative to its peers, but the dividend is well covered and likely to be stable.
- The company should prove to be a solid core holding for income-focused investors going forward.
On Friday, August 4, 2023, Canadian midstream giant Enbridge Inc. ( ENB ) announced its second quarter 2023 earnings results. At first glance, these results were quite reasonable, as the Canadian energy giant posted year-over-year growth in most measures of financial performance. This was quite impressive, especially considering that energy prices were lower during the second quarter of this year than they were during the corresponding quarter of 2022. The market seemed to have a mixed reaction to the news, though. Enbridge's stock did surge in the morning of August 4 following the earnings release, but later gave up its gains:
Overall, Enbridge closed slightly down on the day. A closer look at the earnings report reveals that there was no good reason for this, though, as the results were quite solid. Enbridge has long been quite well known for delivering relatively consistent financial performance regardless of economic conditions or energy prices and we do certainly see that here, along with a moderate amount of growth. The company also agreed to relocate its Line 5 pipeline in Minnesota, which should put an end to the court battles that have been waging over this project for the past several years. Overall, there was a lot to like in this report and investors should be quite pleased with the company's performance.
Earnings Results Analysis
As regular readers are likely well aware, it is my usual practice to share the highlights from a company's earnings report before delving into an analysis of its results. This is because these highlights provide a background for the remainder of the article as well as serve as a framework for the resultant analysis. As such, here are the highlights from Enbridge's second quarter 2023 earnings results:
- Enbridge reported total revenue of C$10.4320 billion in the second quarter of 2023. This represents a 21.06% decline over the C$13.2150 billion that the company reported in the prior-year quarter.
- The company reported an operating income of C$2.3840 billion in the most recent quarter. This represents a 50.98% increase over the C$1.5790 billion that the company reported in the year-ago quarter.
- Enbridge transported an average of 2.991 million barrels of liquid hydrocarbons per day during the reporting period. This represents a substantial increase over the 2.782 million barrels of liquid hydrocarbons per day that the company transported on average during the equivalent period of last year.
- The company announced that it is relocating the Line 5 pipeline out of Bad River Band tribal property in Minnesota. This ends a multi-year-long court dispute over the location of the pipeline.
- Enbridge reported a net income of C$1.9350 billion in the second quarter of 2023. This represents a 225.21% increase over the C$595.0 million that the company reported in the second quarter of 2022.
It seems essentially certain that the first thing that anyone reviewing these highlights will notice is that Enbridge generally reported stronger financial results than it did in the prior-year quarter. This comes despite the fact that crude oil prices were lower on average than they were a year ago. We can see this quite clearly in this chart showing Brent crude oil prices from April 1, 2022, to June 30, 2023:
We have seen the impact of lower second-quarter 2023 energy prices on those companies that have reported their second-quarter results so far. For the most part, financial performance across the energy sector is down compared to the prior-year quarter. With the exception of revenue, Enbridge is clearly an exception to that. In fact, even its revenue is not down by as much as might be expected given the steep decline in crude oil and especially natural gas prices. The biggest reason for this is Enbridge's business model. In short, the company enters into long-term contracts with its customers under which it provides transportation for crude oil, natural gas, and related products owned by its customers using its huge network of pipelines. In exchange, the customers compensate Enbridge based on the volume of resources that the company transports, not on their value. This provides the company with a substantial amount of insulation against fluctuations in commodity prices. It also provides the company with a great deal of cash flow stability over time since 98% of its adjusted EBITDA in the second quarter came from these volume-based contracts:
Enbridge
As the above chart implies, this makes Enbridge something like a utility that can deliver reasonably consistent results regardless of conditions in the broader economy. This is exactly the kind of thing that we like to see in an income investment. After all, stable cash flows provide a great deal of support for the dividend that the company pays out. It is quite similar to our personal lives, as evidenced by the fact that it is much easier to carry a mortgage if you are a salaried employee than if you are working a job that has variable income (like commission sales).
As we can see in the highlights, Enbridge's transported volumes increased year-over-year. The company's management made note of this in its earnings press release :
"During the first half of the year, we reached a win-win-win settlement with our customers on the Mainline, which further enhances the utility-like profile of our cash flow. We've seen record Mainline volumes and strong uptake on the Flanagan South open season and sanctioned the Enbridge Houston Oil Terminal, which will further strengthen the competitive position of the Mainline."
We see this high volume reflected in the highlights above, as Enbridge's hydrocarbon liquid volumes increased significantly relative to the prior-year quarter. Curiously, Enbridge did not provide a figure for its transported volume of natural gas during the quarter, although the business unit's adjusted EBITDA went down by C$51 million year-over-year. However, for now, at least, the company's liquid transportation is much more important for the overall business. As we can see here, Enbridge currently expects that its liquids business will account for more than half of its full-year 2023 adjusted EBITDA:
Enbridge
Thus, the strong performance here more than offsets any weakness that is seen in the company's natural gas transmission business.
Growth Prospects
There are some reasons to believe that the liquids transportation business will not be the largest business in the company forever. This is because Enbridge is currently devoting much more of its capital expenditures and resources towards developing its natural gas transmission and distribution businesses. We can see this by looking at the company's current projects in development and their budgeted costs:
As we can clearly see, only C$390 million (converted using Enbridge's long-term estimated exchange rate of US$1 = C$1.30) of the company's C$19 billion spending plan is devoted to its liquids pipeline business. The remainder is natural gas and renewables projects. This is hardly surprising, considering that natural gas has significantly stronger growth projects. I have pointed this out in numerous previous articles. In short, it comes from the fact that natural gas is being used as an energy source in turbines meant to supplement unreliable renewable electricity generation.
One of the nicest things about all of these projects is that Enbridge has already secured contracts from its customers for their use. This is nice because it ensures that the company is not spending a great deal of money to construct infrastructure that nobody wants to use. It also means that Enbridge knows in advance how profitable a given project will be before work on that project begins. As such, it can be reasonably certain that it will generate a sufficient return to justify the investment. The company did not state exactly what the expected return on any of these projects is in either its earnings press release or in the conference call. However, it is common for a midstream project to pay for itself after about four to six years. That would be a reasonable estimate for the payback period on these projects as well.
The company unveiled a new addition to its growth pipeline recently, the Rio Bravo Pipeline. This is a massive natural gas pipeline project that is intended to transport an average of 4.5 billion cubic feet of natural gas per day from the hub in Agua Dulce, Texas to NextDecade's Rio Grande natural gas liquefaction plant in Brownsville, Texas. At its planned capacity, this will be one of the biggest natural gas pipelines that have been constructed over the past decade, although it will not be very long (it is 144 miles from Agua Dulce to Brownsville, although Enbridge did not provide an exact length for the pipeline). As might be expected considering the scale of this project, Enbridge will be constructing the pipeline in multiple phases. The first phase only has a planned capacity of 2.6 billion cubic feet of natural gas per day and is expected to come online sometime in 2026. As such, we should not expect it to have a positive impact on the company's revenues or cash flows until that date. Fortunately, though, Enbridge does have a number of other projects under development that it can bring online during the interim period. Overall, the company is positioned to deliver steady growth over the next few years.
Financial Considerations
It is always important to investigate the way that a company finances its operations before making an investment in it. This is because debt is a riskier way to finance a company than equity because debt must be repaid at maturity. That is typically accomplished by issuing new debt and using the proceeds to repay the existing debt since very few companies are capable of completely paying off their debt with cash as it matures. As newly-issued debt will carry an interest rate that corresponds with the market rate as of the time of issuance, this process can cause a company's interest expenses to increase following the rollover in certain market conditions. As of the time of writing, interest rates in the United States are at the highest levels that have been seen since 2007. In Canada, rates are at higher levels than have been seen since the early 2000s:
As such, Enbridge's interest expenses will almost certainly increase if the company has to roll over debt today. In addition to interest-rate risk, a company must make regular payments on its debt if it is to remain solvent. As such, an event that causes the company's cash flows to decline could push it into financial distress if it has too much debt. While midstream companies like Enbridge tend to enjoy remarkably stable cash flows over time, this is still a risk that should not be ignored.
One metric that is usually used to measure the ability of a midstream company to carry its debt is the leverage ratio, which is also known as the net debt-to-adjusted EBITDA ratio. This ratio essentially tells us how many years it would take the company to completely repay its debt if it were to devote all of its pre-tax cash flow to that purpose. As of June 30, 2023, Enbridge had a net debt of C$78.1820 billion. The company's adjusted EBITDA during the second quarter was C$4.008 billion. That works out to C$16.032 billion annualized, which gives the company a leverage ratio of 4.88x based on its annualized twelve-month adjusted EBITDA. That is better than the 5.0x ratio that Wall Street analysts usually consider to be acceptable, but it is still one of the highest ratios in the industry. Following the events of 2020, most midstream companies have devoted a great deal of attention to reducing their leverage ratios down under 4.0x in an effort to insulate themselves from the moods of the market. Enbridge has not even been making an effort to do that, as the company's target range remains 4.5x to 5.0x.
While it can certainly carry its leverage at the present level, the problem here is that the company's interest expenses will start to ramp up very quickly if interest rates remain at their present levels. There are reasons to believe that this will be the case, especially since rising energy prices could cause inflation to start ticking up once again.
Dividend Analysis
One of the biggest reasons why investors purchase shares of Enbridge is the very high dividend yield that the company's stock historically possesses. Indeed, Enbridge is a core holding for many income-focused investors for exactly this reason. As of the time of writing, Enbridge boasts a 7.32% yield, which easily beats the 1.46% yield of the S&P 500 Index (SP500), although it is well below the 8.41% yield of the Alerian MLP Index (AMLP). Enbridge has also increased its dividend in each of the past 28 years:
With that said, this trend of consistent dividend increases is only present when we measure the dividend in the company's native Canadian currency. American investors, who will typically purchase the NYSE-traded shares and receive their dividends in U.S. dollars, experience a bit more fluctuation:
Overall, the general trend here is still positive but there is considerable fluctuation from quarter to quarter. This is due to the movement of the U.S. dollar against the Canadian dollar, however. Enbridge is a Canadian company that pays its dividend in Canadian dollars, so for American investors, the dividend is converted into U.S. dollars at the time of payment. The variation from quarter to quarter is thus not Enbridge's fault.
It is nice to see a company increase its dividends over time, especially during inflationary periods such as the one that we are experiencing today. This is because inflation is constantly reducing the number of goods and services that we can purchase with the dividend that the company pays out. This can make it feel as though we are getting poorer and poorer with the passage of time, which is an especially big problem for retirees and others that are depending on the incomes from their portfolios to cover their living expenses. The fact that the company increases the amount of money that it pays out on a regular basis helps to offset this effect and ensures that the dividend maintains its purchasing power over time.
However, it is still important to ensure that the company can actually afford the dividend that it pays out. After all, we do not want to be the victims if it is forced to reverse course and cut the dividend. This is because such a scenario will reduce our incomes and almost certainly cause the company's stock price to decline.
The usual way that we judge a midstream company's ability to pay its dividend is by looking at its distributable cash flow. Distributable cash flow is a non-GAAP metric that theoretically tells us the amount of cash that was generated by a company's ordinary operations and is available to be paid out to the common stockholders. In the second quarter of 2023, Enbridge reported a distributable cash flow of C$2.783 billion, which works out to C$1.375 per common share. The dividend is only C$0.8875 per share, so the company had sufficient cash flow to cover its dividends 1.55 times over. This is quite reasonable, as Wall Street analysts usually consider anything over 1.20x to represent a sustainable long-term dividend. I am more conservative though, and like to see this figure be over 1.30x in order to add a margin of safety to the investment. As we can very quickly see, Enbridge clearly meets even this stricter criterion. As such, we can conclude that the dividend is likely to be quite safe today.
Conclusion
In conclusion, Enbridge's latest results showed the general stability that we have come to expect from this company over the years. This stability is one of the reasons, along with its high yield, that the company has long been a core holding in the portfolios of many income-focused investors. As has always been the case, the biggest problem with Enbridge is that its leverage is significantly higher than many of its peers. That could present very real risks to its investors if rates remain elevated for an extended period of time. There are reasons to believe that this may be the case, especially since rising energy prices will put upward pressure on the inflation numbers.
There is still a good argument for including the company in your portfolio, though, as Enbridge Inc. does have a very respectable yield that appears to be sustainable along with some significant growth prospects. Overall, it may be worth considering adding to your portfolio today.
For further details see:
Enbridge: Q2 Results Give Us Much Of The Same, But That Is Not A Bad Thing