Enbridge (NYSE:ENB) has a massive collection of midstream assets constantly throwing off cash. That's great for investors, which benefit from the Canadian giant's well-covered 6.8% dividend yield, but it is about to create a quandary for management. How will this company deal with the extra $2 billion in cash flow it expects to generate in 2022?
Enbridge's business is fairly simple to understand. It operates as a toll taker, collecting fees for the use of its infrastructure assets. Roughly 54% of its adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) comes from oil pipelines, 29% from natural gas pipes, 14% from a natural gas utility operation, and 3% from its renewable power business. It is a big player in each area, sporting a huge $80 billion or so market cap. In fact, when it comes to the midstream company's oil and natural gas assets, it is an indispensable part of the energy transportation system.
The fees it charges are either set by regulators or long-term contracts and are largely independent of the price of the commodities flowing through its system. Thus, demand is more important to Enbridge's financial results than commodity prices. It is a very consistent business.
Historically, the company has grown by investing in its operations, including ground-up construction of new assets. However, Enbridge is just about done with a big spending program and because of the global push toward lower carbon energy sources, there's less opportunity for new investment right now. The upshot of this is that the company is still generating tons of cash, but it has fewer places to put it to work. In 2022, management expects to have around $2 billion in cash above what it needs to fund its capital investment program and dividends.
That's a nice problem
On the one hand, it's a pretty good "problem" to have excess cash just burning a hole in management's pocket. On the other hand, that's a lot of money that needs to be put to work in some fashion.
The most logical thing to do, simplistically speaking, would be to give it to the company's owners -- Enbridge shareholders. There's only one problem: As CFO Vern Yu noted during Enbridge's third quarter 2021 earnings conference, "we don't believe the market's fully valuing the level of the dividend that we provide today." He made sure to point out that dividend growth was important to the company, but if the stock isn't responding to dividend increases the way management would like (by appreciating in value), it's not likely that management will push too far in this direction. That leaves new capital investment, acquisitions, debt reduction, and stock buybacks.
The current situation in the midstream space is a bit uncertain, as carbon-related businesses are facing ESG headwinds. Thus, finding meaningful new projects outside of the clean energy sector could be difficult. What's more likely is Enbridge seeking out additional acquisition targets. In fact, it has been active lately on this front, recently completing its $3 billion acquisition of the Ingleside Energy Center, an oil export facility in Texas. There's a triple benefit from such deals, as they increase the company's fee-generating assets, allow it to make good use of its cash, and provide future internal investment opportunities. However, acquisitions tend to be lumpy and unpredictable, so there's no way to be sure attractive deals will materialize.
Debt reduction and stock buybacks are the next-best options. Strengthening the balance sheet by reducing leverage is a good choice, but leverage also helps to maximize returns. Meanwhile, Enbridge's debt-to-EBITDA ratio isn't out of line with its closest peers and is actually toward the lower side of its recent historical range. It's not clear that this is the best use of excess cash. And that leaves stock buybacks, which are also problematic because they don't really do much to benefit future performance. Sure, a reduced share count means less being paid out in dividends, but it doesn't bring in new cash flows.
All of the above?
At the end of the day, the key takeaway is that Enbridge is in a great position as it heads into 2022, with a material amount of excess cash that needs to be put to work. What it does with that cash will probably be a combination of things, including a dividend increase, some stock buybacks, and investment either in its own business or the bolt-on acquisition of external assets. As an investor, you should watch for the company's decision on this in 2022 because the excess cash situation could be a long-term "problem."