Future Dividend Champions – Enbridge

If you are from Canada then you are familiar with this large company. If you are not from Canada then you will become familiar with seeing it in the list of Dividend Champions. Simply looking at this company’s numbers can be deceiving as to whether or not it should be included in your portfolio, so we will investigate the aspect of those numbers that normally remove Enbridge’s ability to pass many screens for safe dividend companies.

If you have participated in the Dividend Investing for Canadian Investors forum, then you know that Enbridge is a company that has been referenced many times. It is probably the most requested company in the Stock Exchange section, with over 1,700 mentions.

Based in Calgary, Alberta, Enbridge (NYSE:ENB, TSE:ENB.TO) is an energy generation, distribution, and transportation company in the U.S. and Canada. It operates the longest crude oil and liquid hydrocarbon transportation system in North America. It is also Canada’s largest natural gas distribution company, which also generates renewable and alternative energy.

The energy sector has sensitivities to the business cycle, which is currently not performing well due to the pandemic. Although the shutdowns feel like they will last forever, certainly that is not the case, so this may be a good time to consider looking at dominant players of the sector while their prices are low.

Enbridge shows its dominance through its infrastructure. A quarter of all crude oil in North America flows through its pipelines, as well as 20% of the natural gas that comes into the United States. Their cash flows are highly predictable, as nearly all of its EBITA is regulated, cost-of-service, or contracted. Additionally, nearly all of their customers are investment-grade companies.

The company has spent almost $8 billion over the past two decades in renewable energy and power transmission projects, which is a drop in the bucket compared to the whole of the company. Like many other energy companies, however, Enbridge sees oil and gas going away in the distant future and is working to find an impact in alternative energy sources

Enbridge’s share price has been unimpressive over the past five years, actually sitting about 13% lower over that period of time. During the same timeframe, the S&P 500 gained almost 75%. This is not a growth company to purchase in the hopes that the market pushes it to new highs, it is a company to purchase primarily for the dividend.

And oh, what a dividend it is.

Enbridge’s current dividend yield clocks in over 8.5%, which is monstrous. Were the company not on the cusp of being one quarterly dividend offering away from 25 consecutive years of dividend increases, then such a high dividend would have red flags waving in front of it. A yield of this sort normally will not make it through many of my screens because the yield is in the “if it looks too good to be true…” category.

However, its history demands that we at least give it a serious look.

There is no question that Enbridge’s dividend growth is impressive. Their 10-year growth rate is an impressive 14.4%. This is not a company that offers a token dividend increase to maintain a consecutive streak, as has been the case with too many companies I have examined. Each increase is meaningful and aggressive.

The company’s sentiment is that they take their dividend very seriously. Their website touts, “We have a consistent track record of delivering annual dividend increases, and our continuing goal is to deliver superior shareholder returns through capital appreciation and dividends.”

They follow this by noting that they have paid dividends for over 65 years, and “our dividend growth has not come at the expense of our financial strength as our dividend payout remained very strong in 2019, at approximately 65 percent of our Distributable Cash Flow (DCF).”

Keep this quote in mind, as it is key to understanding an essential part of the consideration process of this company – whether or not Enbridge has the means to continue offering its dividend well into the future. After all, a great dividend that is not there for us in the future is not helpful to our financial well-being.

According to MarketBeat, their payout ratio currently lies at 329% of trailing 12 months of earnings. This is the point where I normally walk away and look for other investing opportunities. I typically seek out companies with a payout ratio of around 40-60%. This range tells me that the company feels that it is important to give a significant portion of the profits back to its shareholders and that the amount is affordable to the company.

Even if cut in half, their payout ratio would still make anyone uncomfortable. Looking into their payout ratio history shows that this number has always been high.

I will ignore the 2015 amount, as it is not necessary to understand what happened that year, but it is not. The high payout ratio has been a staple for eight of the past nine years. Normally, this would not be a sustainable situation, so something must be going on.

The “something going on” is linked to the wording in the paragraph above I flagged to be remembered, which referenced, “65 percent of our Distributable Cash Flow (DCF)”. That is the key point to be understood in this article.

Pipeline companies like Enbridge are not well analyzed by just looking at GAAP earnings because of their high depreciation/amortization charges.

For such companies, we should be comparing the dividend amount to the distributed cash flow, which takes depreciation and capital maintenance into consideration, as opposed to the earnings.

DCF is not a GAAP term, so there is no codified definition for the term. However, the generally accepted meaning is:

DCF = Net Income + Depreciation and Amortization – Capital maintenance 

Depreciation allows the cost of large ticket items to be spread out over the course of its useful life. Net income is a real thing, as is Capital maintenance. However, Depreciation is an accounting item that does not indicate cash leaving the business, so it is not an actual cash expense.

Increasing the denominator in the formula (Total Dividends / Distributable Cash Flow) dramatically decreases the percentage. While this may initially sound like an accounting trick to make something appear artificially better, it is actually a better and more complete means of understanding the pipeline company’s ability to retain its dividend.

This is the reason that Enbridge has appeared to be somehow sustaining something that would appear to be unsustainable. For most companies we examine the payout ratio to ensure that the company has the ability to sustain the dividend. However, this is a case where using distributable cash flow as a metric makes more sense, so the 65% they reference falls close to the 40-60% I noted as my general target.

Enbridge is not a company without risk. Their ability to execute capital programs on time and within their budget has been challenging, especially with large projects. This has shown itself in the form of increasing debt.

The increasing debt, however, has been offset by increasing equity, and Enbridge has moved significantly toward the lower end of their debt-to-EBITA ratio target. This has given them positive ratings with major credit agencies, resulting in favorable interest rates.

Finishing Up

Enbridge has a long history of dividend increases. Their dividend yield is very high, but that appears to be sustainable. The company is large and a leader in its industry. On the cusp of joining the elite Dividend Champions, it is certainly a company to consider if seeking an energy company for one’s portfolio.

Disclosure: I started a position in Enbridge in October and will build it over time with numerous small purchases.