Spectra Energy: Excellent Prospects for Future Growth

Spectra Energy has a strong track record of growth through accretive acquisitions and growing its dividend, and management has a goal to double current assets by investing $25 billion over the next decade.

Mar 26, 2014 at 3:19PM

Recently I came across an energy company that is blessed with strong growth prospects, a fast dividend growth rate, and a very strong balance sheet. It would make a fine addition to any income investor's portfolio.

Spectra Energy (NYSE:SE) began as a natural gas transportation and storage company. In 2013, the company transformed itself with $6 billion in acquisitions and investment in new projects. Today the company is a midstream gas distribution company as well as a diversified gas utility. It operates as a regulated utility and a general partner to two MLPs (master limited partnerships).

90% of  the company's revenues is fee-based, with 95% of revenue locked into contracts averaging nine years. This high predictability of cash flows allows the company to aggressively grow its asset base and its dividend.

A growth story
What makes Spectra Energy such an interesting energy dividend growth stock is management's aggressive plans for future expansion. According to its last investor presentation the company is currently pursuing $7 billion in acquisitions and organic investment opportunities. Management wants to complete $10 billion-$20 billion in total expansion through 2020, but maybe up to $25 billion in expansion could be undertaken within the next 10 years. This massive investment would result in the company doubling its assets.

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Source: Spectra Energy

There are several factors to consider for a company that is planning on an aggressive expansion effort. The most important are opportunities for lucrative investment and financing. 

Spectra Energy has a strong presence in all the key locations of increasing oil and gas production. Its Texas Eastern system serves the Marcellus and Utica shale areas. Marcellus Shale production is projected to increase from 2.5 bcf/day to 13.5 bcf/day by 2020. Spectra Energy is also investing heavily in East Texas fields such as Barnett and Eagle Ford shale.

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Source: EIA

It's also present in the Haynesville shale and the Gulf Coast. The new Express-Platte system serves the Alberta Tar Sands and will be expanded to serve the Bakken formation in North Dakota. The Alberta Tar Sands possess 174 billion barrels of recoverable crude. This is the third largest oil reserve on earth. Meanwhile there is potential for Bakken to double 2012 production of 662,000 barrels/day to 1.2 million barrels before beginning a gradual taper in 2020-2025.

Who's paying?
If Spectra's goal is $25 billion in new projects and acquisitions over the next 10 years, then the company will need access to cheap capital. Luckily the company has a very solid balance sheet and credit ratings. For example S&P rates Spectra Energy BBB+, which is investment grade, while Morningstar gives the company a credit grade of A-.

Management is very responsible with its borrowing. Despite access to cheap debt, the company's debt/EBITDA ratio (a measure of total debt/operating cash flow) is 24% lower than the industry average. 
The company generates strong and consistent cash flows that cover its interest payments 4.6 times. Thus Spectra Energy can afford to aggressively invest in growth yet also increase its dividend. 

The MLPs
The biggest competitive advantage Spectra Energy has is the ability to finance its activities by dropping down assets to its MLPs. This means it sells assets such as pipelines to its subsidiaries in exchange for cash, additional ownership rights and the subsidiary taking on Spectra's debt. For example, in 2013 Spectra Energy announced it would drop down all of its domestic transmission and storage assets to Spectra Energy Partners. Spectra Energy received $2.7 billion in cash, 178 million in new units, and an assumption of $2.4 billion of its debt. The deal improves Spectra Energy's balance sheet and grants it 82% ownership in Spectra Energy Partners.

A benefit of being a general partner to an MLP is that above a certain distribution level (MLPs pay distributions not dividends) the general partner receives 50% of all income. What Spectra Energy is now apparently doing is turning itself into a holding company for MLP assets. It will become a financier for its MLPs and use its solid credit rating and access to cheap debt to purchase assets. It will then drop down these assets to its MLPs in exchange for cash, more units (MLPs have units not shares), and an assumption of its debt.

Spectra's MLPs will end up investing in the growth and expansion of dropped down assets while Spectra Energy reaps distributions and growing general partner fees, which can be substantial. As an example, DCM Midstream is a joint venture with Phillips 66. Spectra Energy owns 50% of the general partnership rights. DCM Midstream funds its own growth yet pays Spectra Energy $400 million in annual distributions. In addition, as 50% general partner Spectra is anticipating fees from DCM to increase from $53 million in 2013 to $200 million in 2015. Spectra Energy Partners is also expected to greatly increase its fees to Spectra Energy. By 2015 it's likely that this MLP will provide its general partner with $800 million in income. Combined with DCM Midstream, Spectra Energy will likely receive $1.415 billion in fees and distributions from its MLPs.

Bottom line
The bottom line is that Spectra Energy represents an excellent long-term dividend growth play in the burgeoning energy sector. Management has a strong track record of well-executed acquisitions and an ambitious plan to grow the company for decades to come. By focusing on becoming a banker to its highly profitable MLP subsidiaries, Spectra Energy will be able to cheaply and efficiently finance its massive expansion plans while also quickly growing its dividend. With a 3.7% yield and potential long-term 10% annual dividend growth rate Spectra Energy deserves consideration as part of a diversified dividend growth portfolio. 

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Adam Galas has no position in any stocks mentioned. The Motley Fool recommends Spectra Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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