The story of Icarus and Daedalus is supposed to remind us that overambition and hubris can lead to the direst of punishments. Perhaps I'm being a little histrionic, but I can't think of a more succinct way of describing the pipeline, processing, and logistics business in North America. It is an industry that rewards modesty, and companies that try to fly too high with overambitious growth numbers tend to get punished by the market.
Pipeline giant Enbridge (NYSE:ENB) has arguably the most ambitious growth plans in the industry. The sheer amount of money it expects to spend on new infrastructure investments over the next decade is hard to contemplate, and management intends to richly reward its investors with dividend increases in the double-digit range.
While it's easy to imagine the piles of money you could be sitting on in time as Enbridge's stock builds wealth for you, Enbridge's way of achieving that audacious plan is quite similar to that of another pipeline company in recent years -- a plan that didn't turn out that great for investors.
So let's take a look at why it's so easy to become enamored with Enbridge's plans and whether it will be able to pull off a feat that didn't turn out so well the last time a company tried to do it.
There's a lot to like in its investor presentation
Enbridge's portfolio of assets is one of the most impressive in the oil and gas infrastructure business. Its footprint of crude pipelines provides Canada with industry-essential arteries to move its product to demand centers. Its acquisition of Spectra Energy gives it an immense platform to deliver natural gas from the Marcellus and Utica shale gas formations. Its natural gas distribution business across Quebec and Ontario provide incredibly reliable sources of cash year in, year out. To top it all off, it has a portfolio of renewable power assets across North America and Europe.
Equally impressive is Enbridge's ability to invest in this portfolio of assets to grow the business and its payout to investors over the next several years. It currently has 22 billion Canadian dollars in new assets either put into service this year or that will be completed by 2020. On top of that, management says it has identified CA$20 billion to CA$35 billion in additional investments after 2020 that should fuel growth for years.
To gear up for all of this growth, Enbridge is doing a considerable restructuring of its business by acquiring all outstanding stakes in its subsidiary partnerships Enbridge Energy Partners, Spectra Energy Partners, Enbridge Energy Management, and Enbridge Income Fund Holdings. The deal, which was agreed upon just recently, will bring all of Enbridge's assets under one roof and will likely lower the cost of capital to build all of those assets.
That's a lot to get excited about if you are an investor. It looks like the company is going to have an easier time developing its billions in capital projects thanks to a lower cost of capital, and it should improve returns for the business that can translate into higher dividend payments.
I feel like I've heard this song before
For all of the positives that Enbridge has, there is one thing that should probably give investors a slight moment of hesitation. We have seen a company recently try to do the exact same thing, and the results didn't turn out great for investors.
Let's travel back to the halcyon days of 2014. At that time, another incredibly large and diverse pipeline company was touting plans to invest gaudy amounts of money in new assets that would fuel incredible growth. It, too, had several subsidiary master limited partnerships, which was a drag on its cost of capital. So it planned a massive roll-up transaction of its subsidiaries to make it easier to grow the business.
That company was Kinder Morgan (NYSE:KMI), and that roll-up transaction was one of the first ominous signs that all was not well in the state of Kinder. All of that growth spending was straining its debt load, and credit rating agencies were starting to question its investment-grade creditworthiness. To address those debt issues, the company elected to slash its dividend payment by 75% and use more internal cash flow to pay for growth and trim its debt load. While it was the right decision in the long run, it doesn't change the fact that investors got hosed by the fateful decision.
The situations at Enbridge and Kinder Morgan aren't exactly the same, but there are enough similarities to raise a few caution flags for investors. Like Kinder Morgan, Enbridge's credit rating was downgraded by Moody's in the past year to one level above junk status. So there are some risks to the company's creditworthiness in the eyes of the rating agencies.
Also, Enbridge is relying heavily on the equity market right now for its funding, which can get very expensive. To complete the roll-up of its subsidiaries, it will have to issue about 295 million shares -- 17% of all shares outstanding. Also, as part of its 2018-2020, management intends to issue another CA$6 billion in stock and hybrid securities as well as complete CA$7.5 billion in asset sales to fund growth as well as pay down debt. So now, we have a situation where the company is eroding its current earnings power and significantly diluting shareholders at the same time.
It's hard enough for a company in this business to fund ambitious growth plans and maintain promises to investors about sizable dividend increases. Enbridge is trying to do this while also reducing debt. To achieve all three simultaneously is a monumental task that few companies have been able to pull off. If something were to give in this situation, the dividend is likely the first one to go.
Chance of a blowup is enough to keep me away
Enbridge's current situation and business plan don't sound like a tribute band playing Kinder Morgan's hits, but it sure does sound like it is sampling a lot of its tracks for its own album. The pursuit of rapid business growth and payout increases requires immense capital obligations that can stretch the financial fortitude of a company to the point of breaking.
One thing that Enbridge certainly has going for it over Kinder Morgan is that it probably won't have to deal with an epic crash in oil and gas prices during the early phases of this transition. Producers are desperate for pipeline space these days, so there is little worry of declining revenue from existing assets. Also, management has already acknowledged that it needs to trim its debt load, so there is some reassurance there.
I could be wrong about this situation, but there are enough signs that Enbridge is headed down the same path Kinder Morgan walked just a few years ago. Until I see a significant improvement in the company's balance sheet and proof that it doesn't have to rely so heavily on debt or equity to fund this massive capital program, I'm going to stay on the sidelines for this one.