Investment Thesis

While the outcome of Enbridge’s (ENB) Line 3 replacement remains uncertain, the USD $2.9B capital expenditure on the U.S. portion of the pipeline is only a fraction of the USD $19B secured project portfolio Enbridge is currently advancing. Despite the opposition to the project, Line 3 still remains the most likely of the 3 large pipeline projects moving Canadian crude to be completed. TC Energy Corp.’s (TRP) Keystone XL and the Trans Mountain Expansion Pipeline recently bought by the Canadian government from Kinder Morgan (KMI) are also both facing ongoing court and regulatory challenges. Despite the headline concerns with Line 3, Enbridge is executing on its growth portfolio, creating visibility for long-term growth in distributable cash flow “DCF.” Investors should look beyond the noise of the Line 3 project and assess Enbridge on the firm’s investment merits.

Growing global energy demand underscores the importance and value of Enbridge’s world-class network of liquid and gas infrastructure in North America. Following its acquisition of Spectra Energy in 2016, Enbridge had a lot of work to do related to reducing its debt burden, streamlining its assets and reorganizing its structure to increase transparency for investors. Much of this work was accomplished in 2018 with the company simplifying its corporate structure by absorbing its sponsored vehicles, divesting $8B in core assets and fortifying its balance sheet.

Enbridge also ticks a lot of boxes for dividend-growth investors. The company has a 24-year record of dividend increases supported by growing EBITDA, ~98% of which is regulated, take or pay or fixed fee. Post 2020, Enbridge’s dividend growth is expected to slow from its current 10% annual increases to be in line with the company’s anticipated 5-7% growth in distributable cash flow. Combined with a current cheap valuation, Enbridge offers long-term investors an attractive total return supported by predictable cash flows and a low risk business model.

Company Profile

Enbridge, headquartered in Calgary, Alberta, has recently digested its 2016 Spectra takeover, making it North America’s largest midstream company with an enterprise value of USD $120B. With more than 17,000 miles (27,000 km) of pipelines, Enbridge operates the world’s longest and most complex crude oil and liquids transportation system. This system delivers more than 3M barrels of crude oil and liquids daily. The company is responsible for transporting one quarter of the crude produced in North America and accounts for more than one third of total U.S. crude oil imports.

Source: Enbridge

In addition to its crude and liquids transportation business which contributes 50% of EBITDA, Enbridge operates a massive natural gas pipeline, processing storage and distribution network. The company transports approximately one-fifth of the natural gas consumed in North America over its 26,000 miles (41,800 km) natural gas pipeline network. As a utility, Enbridge serves 3.7M retail customers in Ontario, Quebec, New Brunswick and New York State. Enbridge also operates a renewable energy portfolio with generation capacity 3,641 megawatts (MW) gross of zero-emission energy.

Line 3 Replacement

Enbridge’s Line 3 has been operating since the 1960s transporting Canadian crude from Hardisty, AB, to refineries in the U.S. Midwest. The old line has had issues with leaks and is due for replacement. Enbridge has planned to replace the existing 34″ line with a modern 36″ diameter pipe and nearly double the current capacity to 760,000 b/d. The pipeline covers approximately 665 miles (1,070 km) in Alberta, Saskatchewan and Manitoba before crossing the border where it covers 13 miles in North Dakota, 337 miles in Minnesota and 14 miles in Wisconsin. The replacement project also rerouted part of the existing line to avoid the Leech Lake Native American reservation and to avoid lakes and wetlands in the region.

Line 3 Replacement Project Summary

ENBRIDGE LINE 3 REPLACEMENT (L3RP) COST: CS5.3 billion (Canadian component) US$2.9 billion (American component) INITIAL CAPACITY: 760,000 b/d (replaces existing 390,000 b/d +370,000 b/d new) LENGTH: DIAMETER: 1 $59 kilometres 36 inch replacing 34 inch

Source: Canadian Association of Petroleum Producers

Building a new pipeline, even a replacement of an existing line takes years of permitting, regulatory approval and construction. Enbridge filed its initial applications in Canada with the Canadian Energy Regulator “CER” (formerly the National Energy Board) in November 2014 and filed its application with the Minnesota Public Utilities Commission (MPUC) in April 2015. Approval from the Government of Canada was completed in November 2016 while the MPUC approved Enbridge’s condition for work and rejects conditions for reconsideration in January 2019.

At a cost of CAD$ 5.3B, the Canadian portion of the Line 3 replacement will be operational by the end of 2019. Enbridge has reached an interim agreement with shippers for Q4 2019. On the U.S. side of the project, the Wisconsin segment is complete and in service while the regulatory approval and permitting is complete in North Dakota. Enbridge’s current challenges on Line 3 originate in Minnesota.

Enbridge Line 3 Replacement lowering in

Source: Pipeline News

The Minnesota Court of Appeals ruling in June 2019 determined that the environmental review was inadequate as it failed to consider the effects of an oil spill in the Lake Superior watershed zone. While the ruling ensures more back and forth between Enbridge and the regulator, a Minnesota Supreme Court ruling in September confirmed that no further appeals will be heard by the court.

In addition to the delays from the MPUC, Enbridge was also recently denied a key water permit from The Minnesota Pollution Control Agency requiring the company to satisfy additional requirements before it can reapply for the permit. While the state environmental permitting work is ongoing, the route in Minnesota is approved and permitting is underway.

For a full project timeline see CAPP

The firm lists the anticipated completion date for the Line 3 replacement project to be in the second half of 2020; however, analysts at Morningstar expect additional delays. In the latest investor presentation, Enbridge notes that the in-service date is subject to state permitting timing and MPUC process determination. Analysts with GMP FirstEnergy continue to use a start date of January 1, 2021, in their modelling for the full project, according to a September 2019 research note. It is difficult to know how long the latest delay will postpone the in-service date by.

Line 3 Opposition

Pipelines are tangible symbols of climate change that are lighting rods for environmental activists. Enbridge’s Line 3 is not alone in facing environmental opposition, TC Energy’s Keystone XL and the TransMountain Pipeline Expansion in Canada have faced similar challenges. The Line 3 replacement will carry more crude and heavier crude than the current pipeline does. Opposition in Minnesota stems from a history of oil spills in the state including the 1991 pipeline rupture near Grand Rapids. That spill released more than 1.7 million gallons of oil creating the largest inland spill in the U.S. history.

Enbridge hasn’t had any spills on its new pipelines over the last decade and the company’s safety record is good and improving. Nonetheless, Line 3 has failed to gain social license and the construction process in Minnesota will be rocky.

The Standing Rock tribe opposed the pipeline

Source: Climate News

Enbridge can expect Line 3 opposition from environmental groups, Native American communities and lake-loving Minnesotans. Enbridge has already moved the original pipeline route in response to requests from Native American Bands. While the new pipeline route doesn’t go through Native American reserves, it will transit traditional ancestral lands. This route will likely attract challenges from Native American Communities from Minnesota and beyond.

In 2016, thousands of protesters converged on the Energy Transfer Partners’ (ET) pipeline project at Standing Rock, North Dakota. Protesters chained themselves to equipment, disrupted construction work and sparred with security and law enforcement. At the Standing Rock protests, law enforcement costs amounted to USD $40M and construction costs soared as the delays wore on. According to a study on the impact of the protests by Colorado State Boulder, the protests at the Dakota Access Pipeline (DAPL) sites accounted for direct costs to Energy Transfer Partners of USD $1.364B. These costs included lost revenue, over USD $300M in construction schedule and remobilization costs as well as USD $70M to renew easements. The study concludes:

The project was originally slated to cost USD $3.8B But, the total cost of DAPL is likely closer to USD $7.5B. As noted before, this case study suggests that the delay is directly correlated with the cumulative social pressure opposing DAPL that began in April of 2016

The response to the completion of the permitting process in Minnesota will likely attract serious protests and disruption to construction. Drawing on the experience of Energy Transfer Partners with the Dakota Access Pipeline, Enbridge can certainly expect added costs and a truncated timeline for the Minnesota portion of the project.

Line 3 Next Steps

Following the MPUC’s October 1, 2019, request for a revised environmental impact statement from Enbridge to consider the impact an oil spill could have on the Lake Superior watershed, the company has 60 days to resubmit its review. Enbridge’s next submission will likely be approved. Despite the fierce opposition to the pipeline’s construction in Minnesota, the fact that the Line 3 project will replace an old leaky pipeline with new and safer infrastructure will likely ensure that the project is completed. The MPUC decision to advance the project initially was considered on these grounds. Despite opposition at that time, the MPUC did not have the option to stop the flow of crude in the existing Line 3; therefore, a replacement will likely be seen in the interest of the environment and should proceed.

Enbridge has proven itself to be effective in executing on its projects despite opposition. Between 2013 and 2017, the company added more than 1.1M b/d of additional capacity upstream of the Superior, Wisconsin, terminal and more than 1.65M b/d of additional capacity downstream of Superior. This track record suggests that Enbridge will be successful in completing Line 3, albeit later than planned.

Line 3’s Financial Impact

In the Q4 earnings call in February 2019, Chief Accounting Officer Allen Capps spoke about Line 3’s impact on Enbridge’s 2020 guidance.

The big driver of the 14% EBITDA growth over 2019 ($4.85 to $5.15 per share) is the impact of the full year’s contribution from the Line 3 Replacement project, in addition to contributions from other projects coming in the service and ongoing strong performance from the base business.

The delay on Line 3 equated to CAD $0.08 per share in DCF for Q2 2019, or approximately 6% of annual DCF. According to the CER, the average toll on the mainline for heavy crude from Alberta to Superior Wisconsin is USD $3.62/ per barrel. With the additional of 370,000 b/d on the U.S. portion of the mainline, Enbridge can expect roughly USD $490M in toll revenue from Line 3 (Canadian and U.S. portions). While this is material, it represents a small fraction of the company’s CAD $13B EBITDA forecast.

3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 2011 2012 2013 2014 201S 2016 2017 2018 3.62 SUS per barrel 3.27 $US per barrel / SLIS per barrel r barrel r barrel 2019

Source: Canadian Energy Regulator

There are two ways to look at the challenges associated with building new pipelines: firstly, that the barriers to expansion and replacement projects will drive higher costs and limit future expansion; or secondly, that the incumbents in the midstream space own infrastructure that is essentially irreplaceable, extremely valuable and cannot be easily substituted. I would tend to emphasize the latter point. The assets that Enbridge owns, particularly the Main Line is infrastructure that would probably never be built today. The high barriers to entry and the limited availability of substitute or alternative transportation options give Enbridge an incredibly wide moat. In terms of valuing the challenges associated with projects like Line 3, it is worth considering that the same factors act to increase the value of the company’s existing assets. With global demand for oil forecast to grow into the 2030’s and beyond, the value of Enbridge’s system should only increase.

World oil demand in the economic growth sensitivities 2016 2020 2028 2032 GOP GDP gmth 2036

Source: OPEC

Growth Opportunities

As SA Author Scott Wilkie mentions in his recent discussion of TC Energy, the company has found success in focusing its development strategy on smaller attainable projects rather than solely on its larger projects with greater regulatory scrutiny such as Keystone XL. Enbridge is advancing a number of smaller scale projects that have not crowded the headlines. Of the projects listed in Enbridge’s secured growth portfolio, more than CAD $10B in projects are unrelated to Line 3.

u Segments: Project AOC Lateral Acquisition Stratton Ridge Generation Pipeline Acquisition Hohe See Wind & Expansion — Germany Gray Oak Pipeline Line 3 Replacement — Canadian Portion Utility Growth Capital Line 3 Replacement — U.S. Portion Southern Access to 1 ,200 kbpd PennEast Utility Reinforcement — Windsor & Owen Sound Utility Growth Capital Atlantic Bridge (Phased ISD) Spruce Ridge T-South Expansion Other expansions East-West Tie-Line Dawn-parkway Expansion Saint-Nazaire Offshore Wind - France Expected ISD In-service In-service 2H19 2H19 4Q19 4019 2019 2019 TOTAL 2H201 2H20 2020 2020 2020 21-119/2020 2021 2021 2020/23 2021 2021 2022 Capital ($8) 0.3 CAD 0.2 USD 0.1 USD 1.1 CAD 0.7 USD 5.3 CAD 0.7 CAD 2.9 USD 0.4 USD 0.2 USD 0.2 CAD 0.7 CAD 0.2 USD 0.5 CAD 1.0 CAD 0.6 USD 0.2 CAD 0.2 CAD 1.8 CAD2 Liquid

Source: Enbridge Investor Presentation

In the firm’s core liquids business, Enbridge is advancing a strategic goal of expanding its U.S. Gulf Coast exposure with the development of the Gray Oak pipeline and the Texas COLT Offshore Loading Facility. These two projects support market access for the growing production in the Permian basin. In addition to these, Enbridge sees opportunities for CAD $3B in projects that would further optimize the mainline. In western Canada, Enbridge has identified CAD $4-6B in gas and NGL pipeline opportunities and CAD $5-10B in LNG specific opportunities, getting gas from the Duvernay and Montney formations to market.

Additional renewable options include further expansion into wind turbines, especially offshore wind projects where costs per KWH are projected to decline significantly in coming years. After opening Rampion in Q2 2018, Enbridge has 3 more offshore wind projects under construction in the North Sea and English Channel with 3 more in development. Enbridge likes these offshore wind projects for their attractive low risk returns and minimal commodity price risk. The most significant of these is the Saint Nazaire Offshore Wind project at a cost of CAD $1.8B.

Source: Enbridge

Returning Capital to Shareholders

In 2019, Enbridge has foretasted a record EBITDA of CAD $13B, of which CAD $7.6B is available as distributable cash flow. On a per share basis, this amounts to CAD $4.42 in DCF, a 20% increase year over year. Enbridge targets a payout ratio to 60-65% of DCF post 2020. The company’s current annual dividend payout of CAD $2.92 per share puts it at the higher end of its payout ratio. Therefore, Enbridge will need to grow its dividend in line with its DCF going forward to maintain its target payout range.

24 consecutive years of dividend increases CENBRIDGE 10% 3 Year CAGR (2018-2020) 11% 24 Year CAGR (1996-2019) 1996 2018 2019 2020e

Source: Enbridge AGM Presentation

Enbridge’s shareholders have enjoyed an 11% CAGR in the firm’s dividend since 1996 and 10% from 2018 onwards. In Enbridge’s Annual General Meeting in May, 2019 CEO Al Monaco confirmed the company’s commitment to extend dividend increases at 10% annually to the end of 2020. Beyond 2020, Monaco offered guidance that dividend increases will follow growth in distributable cash flow which the firm targets at 5-7% annually. While some investors may see this as slowing growth, shareholders should applaud this prudence as a more modest dividend growth target will allow Enbridge to protect its balance sheet and invest capital in growth projects.

Valuation is Attractive

Enbridge was featured on the Morningstar Core Canada Pick List for Aug 2019 with a 4 Star rating, an indicator that puts the company firm in the top 8% of stocks in Morningstar’s 15,000+ stock universe. The ratings agency ascribes a fair value estimate of USD $47 or CAD $62 per share, suggesting a 32% upside from current levels. Of the 19 analysts who cover Enbridge, the average one-year price target is CAD $54.11 for a more modest 15% upside.

Analyst Price Targets (19) 00 Current 47.42 Амегаде 54.11 НО БОСО

Source: Yahoo Finance

According to Jeremy Rosenfield of IA Securities, Enbridge is an attractive investment that offers stable earnings and cash flows, visible, low-risk organic growth, attractive income characteristics and upside potential. His firm maintains a buy rating with a target price of CAD $60 per share. The analyst note from IA Securities concludes:

We continue to see longer-term potential upside from additional growth initiatives, which could support an extension of the existing DCF/share growth rate, without the need for external equity.

Enbridge is currently trading at an Enterprise Value/EBITDA ratio of 13.11X, well below the company’s 5-year average of 21.09X. The current dividend yield of 6.08% is 53.8% above the firm’s 5-year average dividend yield, suggesting the firm is undervalued. Reuters lists the mean analyst rating as 2.15, emphasizing the positive sentiment for the stock in the analyst community. I see the current price as very attractive and expect that prices will return to pre-Spectra levels in the high CAD $50s-low $60s.

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Source: Reuters

Balance Sheet & Risk Analysis

Following Spectra acquisition, shareholders were concerned over Enbridge’s high debt load. In 2016, consolidated Debt/ EBITDA reached over 6X. Over the last 3 years, Enbridge executed on accelerated deleveraging initiatives, including CAD $8B in non-core asset sales and through the suspension of the company’s DRIP program. The company has brought Debt/EBITDA back to 4.6X, comfortably within the target range of 4.5X to 5X. As a result of this balance sheet strengthening, Enbridge was upgraded by Moody’s in January 2019 and has maintained its investment grade credit rating.

Source: Enbridge Investor Presentation

Execution risk on the major projects in the company’s growth portfolio is the most substantial short-term risk for Enbridge. The company will inevitably face challenges on all of its planned and future major pipeline projects. The firm will certainly see delays and added costs as a result of an increasingly challenging regulatory environment.

Beyond the challenges associated with expanding its pipeline projects, Enbridge is relatively a low risk investment. Over 98% of 2019 revenue is derived from stable regulated earnings on take or pay or fixed pay contracts. Enbridge has limited exposure to commodity pricing and has shown remarkable resilience in DCF growth through business cycles. The company has low counter party risk as it ships for hundreds of investment grade clients. While Enbridge may be exposed to significant reputational risk, its business model offers highly stable and predictable cash flows.

Investor Takeaways

The Line 3 replacement project will likely continue to face long, protracted, regulatory and permitting processes. Despite the headlines that will continue highlighting the delays in major pipeline expansion projects, Enbridge remains a solid long-term investment. The firm has valuable infrastructure with strong demand tailwinds. Enbridge is advancing a number of smaller growth projects that will fuel EBITDA growth and support future dividend increases. The model of regulated earnings coupled with limited exposure to commodity price fluctuations makes this a business that can continue to grow in all economic conditions. Enbridge offers investors good value, predictable dividend growth and irreplaceable infrastructure assets. Enbridge is one of my largest positions due to its strong cash flows and 24-year record of dividend growth.

Disclosure: I am/we are long ENB, TRP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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2019-10-20