Investment Thesis

As a dividend growth investor who looks for long-term buy and hold opportunities, TC Energy Corporation (TRP) ticks a lot of boxes for me. The company owns and operates critical energy infrastructure across North America, where it is positioned to benefit from growing global demand for natural gas and liquids. TC Energy operates a capital intensive business that has high barriers to entry and few viable substitutes for the massive quantities of energy the company transports and generates.

This simple business that combines high quality assets with a low-risk business model has produced very positive results for long-term investors. TC Energy shareholders have enjoyed a 14% average annual total return over the last 20 years. As a result of the company’s growth profile and low-volatility revenues, TC Energy has also delivered an impressive 19 consecutive years of dividend increases. This commitment to dividend growth, averaging 7% CAGR since 2000 is a clear demonstration of the firm’s commitment and ability to consistently return a growing stream of profits to shareholders. With a current capital program of CAD $30B TC Energy is executing on growth projects that will continue to create shareholder value and fuel dividend growth for decades to come.

A Top Performing Holding

In 2014, when crude global crude prices collapsed, I pivoted some of my positions in energy exploration & production companies into pipelines as a way to avoid volatility. This strategy has proven to be beneficial and has allowed me to “buy the racetrack instead of trying to pick horses” so to speak. I still own some high quality oil names that have performed well despite weakness in crude prices in recent years, however I have largely limited my energy exposure to high quality midstream companies such as TC Energy and Enbridge Inc (ENB). On November 6th, 2015 the Obama Administration announced that the permit for the Keystone XL Pipeline project, TC Energy’s signature infrastructure project, had been denied. On that day, as the share price tumbled, I loaded up on the stock. Since that time, the dividend has grown from CAD $2.08 annually to CAD $3.00 today; a 44% dividend increase. With a strong record of dividend growth and value creation for shareholders, I have reinvested quarterly dividends for long-term growth. This strategy has resulted in a total return of over 91% in a little over 4 years.

Source: TC Energy Investor Presentation

While I happened to take advantage of some negative headlines to buy TC Energy on a down day, the timing of my purchase has had little to do with the positive total return on this investment. TC Energy has grown into my single largest holding because of the company’s sound business model and strong cash flow generation that have led to share price appreciation and have supported consistent dividend growth.

I am happy to let my winners run, but my personal preference is not to have any single stock exceed 5% of my portfolio in order to limit the downside of any single company events. With my comfort and risk tolerance, I am comfortable to have midstream firms account for some of the top holdings in my portfolio. TC Energy has maintained stable revenue and continued to raise its dividend throughout all stages of the economic cycle including during the commodity price downturn in 2014 and the global financial crisis in 2008.

TC Energy is a very low-risk, low-beta utility with highly stable cash flows. The company has a 60-month Beta of 0.71 and a 24-month Beta of 0.53 reflecting the low volatility in the share price. Despite having “Energy” in the name, midstream energy companies like TC Energy operate more like utilities than energy firms with limited exposure to commodity price volatility. With the majority of the company’s revenues underpinned by long-term contracts, or regulated rates, TC Energy has stable and predictable annuity-like revenues. These characteristics ensure that the company will continue to generate a growing stream of sustainable and stable revenue for decades to come.

Company Profile

Headquartered in Calgary, Alberta TC Energy has approximately CAD $100B in assets and employs 7,000 people in its key markets of Canada, the U.S. and Mexico. The company trades on the Toronto Stock Exchange and the New York Stock Exchange under the ticker “TRP” where it has a market capitalization of CAD $64B (USD $49B). TC Energy was founded in 1951 to develop the Canadian Mainline to transport natural gas out of Western Canada. Over the last 69 years, TC Energy has built one of the largest energy infrastructure networks in North America with 92,000 km (57,500 miles) of natural gas pipeline; 4,900 km (3,000 miles) of oil and liquids pipeline as well as 6,000 megawatts of energy generation capacity and more than 650 billion cubic feet of natural gas storage. TC Energy is responsible for the transportation of approximately 25% of the natural gas and 20% of oil moved in North America. The company plays a vital role in the North American economy supplying critical fuels for residential heating and industry use.

Since 2000, the company has diversified its business to include a larger portion of revenues derived from oil, liquids and power generation and storage. At the beginning of the century, natural gas pipelines accounted for 95% of EBITDA, today that business represents 69% of EBITDA. Similarly, 20 years ago, the company was almost entirely Canadian, over the last two decades, CAD $100B in infrastructure investment and strategic acquisitions has resulted in significant diversification away from Canada into the U.S. And Mexican energy markets where the company has encountered more favourable regulatory environments.

Source: TC Energy Corporate Profile

North American Footprint

In May, 2019 TransCanada Corporation changed its name to TC Energy to better reflect its growing businesses in the United States and Mexico. In 2016, TC Energy made a transformational acquisition of the Texas-based Columbia Pipeline Group. The USD $13B deal expanded the company’s reach to encompass a network spanning the two most important natural gas basins on the continent; the Western Canadian Sedimentary Basin and the Appalachian Basin. The deal linked TransCanada’s well established positions in the Montney and Duvernay in Alberta and British Columbia to the Marcellus and Utica formations in the North Eastern U.S. This acquisition marked a significant expansion outside of Canada and made TC Energy a truly continental infrastructure provider with access to the U.S. Gulf Coast enabling TC Energy to be a key provider of natural gas to North America’s LNG export facilities.

In the same year, TC Energy won a contract with Mexico’s Comisión de Federal Electricidad “CFE”, the country’s government utility commission, to expand natural gas pipelines in Northwestern Mexico. TC Energy made an initial CAD $800M investment in a project that included the construction of pipelines, storage and a marine terminal. This investment was the single largest investment in Mexico’s refined energy market since the energy industry was liberalized in 2016. Demand for natural gas consumption in Mexico is expected to increase by 75% by 2031. TC Energy now operates five revenue generating pipelines in Mexico, forming the backbone of the country’s gas transportation network. The firm is also advancing two other pipelines in Mexico, the Villa de Reyes, which is expected to be in service this year, and the Tula project which is anticipated to be complete in two years. These projects link U.S. natural gas to important power generation and industrial markets in Northwest and central Mexico where demand is expected to grow and where TC Energy enjoys long-term contracts with the Mexican government.

Strong Performance in 2019

2019 was an impressive year for TC Energy as the company advanced a number of important projects and delivered record financial performance in the first three quarters of the year. In the first 9 months of the year, the company achieved 10% growth in comparable earnings over the same period in 2018. Funds from operations topped CAD$5.3B for a 14% year over year increase. TC Energy advanced its CAD $30B capital program with approximately CAD $8B brought into service during the first three quarters of 2019. These new assets are now delivering cash flow and contributing to 2020 EBITDA growth.

For the quarters reported to date in 2019, TC Energy has been successful in raising CAD $7.8B to fund its operations, including through the divestment of CAD $6.3B in mature assets. The company completed the partial sale of its Northern Courier pipeline in Alberta as well as selected former Columbia assets in the Appalachian region. In July, 2019 TC Energy announced the sale of two of its natural gas fired power plants in Ontario as well as a 50% stake in a third to Ontario Power Generation Inc. This transaction alone has raised CAD $2.87B to be used towards advancing the company’s capital program and paying down debt.

Caption: Coastal Gas Link Terminal Location, Kitimat, BC; Source: CTV

In the final days of 2019, TC Energy announced that it had sold a 65% equity stake in the Coastal GasLink Pipeline Project to KKR & Co. Inc. (KKR) and the Alberta Investment Management Corporation. The company expects the transaction to close in the first half of 2020 and will record an after-tax gain of ~CAD $600M from the sale. This monetization helps to de-risk the project and allows TC Energy to prudently fund its capital program.

Self Funding Model

In 2019, the company announced that it is returning to its historic self funding model and will no longer need to issue equity to fund day to day business activities. This return to a self funding model included a Q3 2019 announcement that TC Energy would discontinue the 2% discount on its DRIP program, a signal that the firm is better able to self fund its capital program versus relying on DRIP proceeds. In the Q3 2019 earnings call, Don Marchand TC Energy’s CFO stated “what we see right now with our runway of projects, we think we’re in that spot where we can live with an internally generated cash flow debt capacity within those credit metrics”.

Source: TC Energy Investor Presentation

Growth Profile

TC Energy is advancing CAD $30B in commercially secured through 2023 including the Keystone XL Project, Coastal Gas Link and the Bruce Power Plant Life Extension project. TC Energy has been focusing its growth portfolio on advancing projects that are low risk and have long-term contracted or regulated cash flows. On TC Energy’s Q3 2019 earnings call, CEO Russ Girling (with whom I happen to share a barber) spoke to the company’s growth trajectory:

Looking forward, we have five significant platforms for growth, Canadian, U.S. and Mexican natural gas pipelines, our liquids pipeline business and power and storage. Just as we’ve done since 2000, as we advanced our $30 billion secured capital program, we expect to deliver growth in earnings, cash flow and dividends per share.

An example of TC Energy’s growth portfolio successful advancement is the Unit 6 Major Component Replacement underway at the Bruce Nuclear Power Plant in Ontario. This CAD $2.2B investment expected to be complete in 2023 is part of a larger refurbishment of the Bruce Power Facility. In April of 2019, to reflect the investment made into this facility as well as normal course annual inflation adjustments,the regulated power price from this facility increased to ~78 per MWh. In the first 3 quarters of 2019, TC Energy’s Power and Storage EBITDA increased by CAD $45M as a result of the higher realized sale price of power from the Bruce plant.

Source: TC Energy Investor Presentation

Growing Demand for Natural Gas

McKinsey & Company listed natural gas as the fasted growing fossil fuel globally in a September 2019 report. According to the International Energy Agency “IEA” consumption of natural gas increased by 4.6% in 2018 with North American appetite for gas accounting for nearly half of the increase in global energy demand. In addition to growing demand in North America, key growth for natural gas comes from greater industrial demand in Asia. Growing industrial capacity in Asia, especially in China has led demand growth with increasing production from the U.S. addressing these needs.

Source: IEA 2018

This growth in global consumption has led to a booming liquefied natural gas “LNG” market in North America and Australia where producers have been busy building export terminals to address demand from Asia. LNG demand is expected to increase by 3.5% annually to 2025; in 2018 alone, demand for LNG grew by 8.6%. The U.S. and China together accounted for 60% of overall demand growth in LNG in 2018. The IEA forecasts that the LNG market will tighten over the next few years as spare capacity is utilized. With more than one third of LNG supply capacity currently under construction and expected to come online in phases by 2025, strong global demand could lead to higher prices for LNG. By advancing egress projects like the Coastal Gas Link and the NGTL in the Western Canadian Sedimentary Basin, TC Energy is well positioned to capitalize on demand growth.

Dividend Growth

Stable cash flows underpinned by long-term contracts have allowed TC Energy to increase its dividend for 19 consecutive years. After 15 years of 7% CAGR, TC Energy boosted the dividend increase range from 8-10% CAGR from 2015 to 2021. After 2021 dividend growth is expected to moderate to match the company’s anticipated organic growth rate of 5-7% annually. Following an 8.7% increase in 2019, TC Energy currently pays a quarterly dividend of CAD $0.75 for CAD $3.00 annually, per common share. Future dividend growth will be supported by the company’s vast secured growth program of high quality long-term assets. The company’s trailing 12-month dividend payout ratio is 68.53%, its lowest level in the last 5 years. This stable payout ratio is a clear sign that growth in earnings per share has kept pace with dividend growth over the last long term.

Source: TC Energy Investor Fact Sheet

In 2019, 35% of investors participated in the DRIP program including myself. Reinvesting shares each quarter has boosted my share count allowing for my total annual cash payout to grow through the powerful combination of consistent dividend increases and quarterly share accumulation. Even with dividend growth expected to slow from current levels to 5-7% going forward, investors can anticipate powerful compound dividend growth. Taking the lowest end of guidance (8% to 2021 and 5% thereafter) investors can expect TC Energy to reach CAD $5.43 annually by 2030. This works out to an 7.8% yield on cost for buyers of TC Energy at today’s levels. While there are no certainties in investing, cash flows of regulated utilities are among the more predictable variables in any forward looking analysis.

Source: Author

Valuation

TC Energy has achieved a total return of 55% since I last recommended the company in October 2018. This run up has lifted the share price much closer to the company’s fair value than the deep discount available in the Fall of 2018. Based on an Enterprise Value/EBITDA multiple of 12X, Morningstar Senior Equity Analyst, Joe Gemino maintains a fair value estimate is $54USD ($71 CAD). TC Energy is currently trading at an Enterprise Value/EBITDA ratio of 12.23X, above Morningstar’s fair value estimate but below the company’s 5-year average of 22.1X. The current dividend yield of 4.34% is slightly above the firm’s 5-year average yield of 4.21%. Similarly, the Price/Cash Flow ratio of 8.77X is slightly below the company’s 5-year average of 9.08X.

All these indicators suggest that despite the run up in share price in 2019, TC Energy still has some upside. Reuters lists the mean analyst rating as 2.37, emphasizing the positive sentiment for the stock in the analyst community. Of the 19 analysts who maintain a target price for TC Energy, the mean price target is CAD $70.58, suggesting a ~3% upside for a total return of 7.2% in 2020. Long-term investors can continue to buy TC Energy for its dividend growth or wait for a pull back to capture a better price.

Source: Yahoo Finance

ESG Considerations & Risk

The risks associated with TC Energy fall into two main categories, ESG risk and project execution risk; specifically those related to the Keystone XL project. In November, 2019 TC Energy reopened the Keystone pipeline in North Dakota after the pipeline had leaked 9,120 barrels of oil (1.4 million litres) in late October. This volume represents 1.4% of the daily volume transported through this line. While TC Energy has a good track record of environmental safety, its pipes do occasionally have leaks. These spills are not especially costly to clean and repair, but damage to the reputation of the firm can be significant.

Poor environmental performance can lead to regulatory delays for future project approvals and can add costs through work disruptions. Cost escalations resulting from opposition to pipeline projects was most notable during the 2016 construction of Energy Transfer LP’s (ET) Dakota Access Pipeline, a topic I explored in a previous article. While TC Energy still has room to improve, its track record of pipeline integrity is positive. The Canadian Energy Pipeline Association “CEPA” reports that incidents for both gas and liquids pipelines have decreased in Canada since their high in 2013.

Source: Canadian Energy Pipeline Association

Disruptions and delays to pipeline projects will continue to grab headlines especially if there are spills or other incidents on existing lines. Despite these challenges, on a volumetric basis, transporting gas and crude is safer via pipeline than by other alternatives such as truck or rail. Similarly shipping crude via a pipeline has a better carbon profile than alternative shipping methods such as crude by rail. There is also a strong argument that North American LNG exports will help to offset coal use in Asian markets. LNG employed to offset the burning of coal for heat or electricity generation would lead to lower green house gas emissions.

Project Execution Risk – Keystone XL

In terms of project execution, few industries experience more public scrutiny on their projects than pipeline operators. Climate change and other environmental considerations have made pipeline operators the target of environmental groups. Challenges from these groups as well as Native American communities and other land owners have added to delays for controversial projects such as the Keystone XL pipeline. Despite these challenges and the headlines associated with them, with 96,000 km of oil and gas pipelines built and operating, TC Energy has proven itself to be effective in advancing complex projects.

In August, 2019 the project received removed one of the last major regulatory barriers with the State Supreme Court of Nebraska upholding the prior approval of the project through the state. The CAD $10.85B project that would add 890,000 b/d of capacity is currently held up in Montana where a judge is hearing concerns from local Indian communities about spill protection and the need for further consultation with local tribes.

I am confident that Keystone will ultimately be completed as it enjoys broad commercial support from shippers and will benefit many producers by providing a more attractive energy export market with higher netbacks. When completed, Keystone XL will move Canadian crude to the U.S. Gulf Coast where 93% of the projects’ capacity has already been contracted. Analysts at Morningstar expect the project will be operational in 2H 2022. If the project is delayed further or ultimately cancelled, there could be share price volatility as occurred in 2015, however TC Energy will continue to enjoy stable revenues. With this project first proposed in 2008, additional delays cannot be ruled out which could add to the overall cost of the project.

Investor Takeaways

There is no greater demonstration of management’s confidence in a firm’s future earnings growth than a consistent record of dividend increases. TC Energy is my top holding as it provides a growing stream of income and operates a low risk business model underpinned by contracted and regulated earnings. As a company, TC Energy operates infrastructure that is essential to the North American economy making its services difficult to substitute. The firm is advancing a portfolio of growth projects that will continue to fund dividend growth for decades to come. Investors can expect dividend growth of 8-10% to 2021 and 5-7% after that. While there will be headlines with Keystone XL and the Coastal Gas Link projects, TC Energy has proven that it can grow its cash flow and increase its dividend in all economic conditions. TC Energy is a core holding for investors seeking high-quality, low-risk dividend growth for the long-term.

Disclosure: I am/we are long TRP, ENB. 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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2020-01-11