Pipeline companies are supposed to be about the least risky stocks an investor can own. Nearly all of their revenue is typically backed by long-term, fee-based contracts, which should provide cash flow stability amid any economic storm.
However, the risk profile of these companies has risen in recent years due to increased opposition to new pipeline projects as well as tighter-than-expected capital markets. That's causing investors to re-rate the risk level of a company like TransCanada (NYSE:TRP), which is starting to look riskier than its financial metrics would imply.
A very strong financial foundation
TransCanada has one of the strongest financial foundations in the pipeline sector, boasting an A rating from the major credit rating agencies. That implies it has a strong capacity to meet its financial commitments. As such, it's less risky than rivals such as Kinder Morgan (NYSE:KMI) or Energy Transfer Equity (NYSE:ETE), which only have BBB-/Baa3 and BB/Ba2 ratings, respectively.
Kinder Morgan's rating implies just adequate capacity to meet its financial commitments, while Energy Transfer Equity's sub-investment grade rating suggests that it's a bit more vulnerable and faces major uncertainties should industry conditions deteriorate any further.
In addition to a stronger balance sheet, TransCanada's dividend is also built on a strong foundation. Not only is the bulk of the company's income derived from fee-based assets, but it boasted having a 2.2 times coverage ratio for 2015. Also, that ratio is expected to remain above 2.0 times through 2020 even as the company grows the payout by 8% to 10% per year. Compare that to Energy Transfer Equity and its weaker 1.16 times coverage ratio in 2015 or Kinder Morgan, which only had a roughly 1.0 times ratio last year before it was forced to slash its dividend 75% in order to maintain its investment grade credit rating. Because of its much stronger coverage ratio, and credit rating for that matter, it suggests that there is minimal risk that TransCanada's dividend will be reduced even if industry conditions worsen.
Where the risks grow wild
Where TransCanada's risk starts to elevate is when you look at future growth, given that it has had problems getting growth projects off the ground in the past. Currently, the company has over $45 billion long-term capital projects in its growth pipeline. However, these projects include the controversial $12 billion Energy East pipeline and billions of dollars' worth of natural gas pipeline projects in Western Canada that are currently up in the air due to delays to virtually all of Canada's proposed LNG export projects. That's in addition to the problems with its Keystone XL pipeline, which was rejected by the U.S. government.
Given the issues the company is having with organic growth, it recently turned to acquisitions to juice its growth pipeline. In doing so, it agreed to pay roughly $13 billion in cash to acquire Columbia Pipeline Group (UNKNOWN:CPGX.DL). That acquisition, however, opens up additional risks, including sourcing the cash needed to pay for the deal. The company is turning to asset sales to fund more than half of the acquisition price and is looking to unload its U.S. northeast power assets and minority interest in a Mexican natural gas pipeline business. That said, selling assets at a time when energy asset prices are depressed by the current market conditions is an added risk because these sales might not fetch as much as it is hoping.
TransCanada needs these growth initiatives to pay off because it has guided to grow its dividend by 8% to 10% annually through 2020. While it does currently have a bevy of smaller projects that are expected to support this growth, there's still a real risk it won't meet its lofty target. That's exactly what happened to Kinder Morgan, which had been guiding for 10% annual dividend growth through 2020 only to slash its dividend when market conditions abruptly shifted forcing it to protect its access to the credit markets over the dividend. Other weaker midstream companies like Energy Transfer Equity are at risk of doing the same if conditions worsen. While cutting the dividend isn't something we'll likely see at TransCanada, slashing its dividend growth outlook is a growing risk given the challenges it is currently facing.
On the surface, TransCanada would appear to be one of the least risky pipeline stocks given its strong credit rating and robust coverage ratio. However, its risk level elevates a bit when it comes to growth judging on its recent struggles. It needs to execute on closing the Columbia Pipeline Group acquisition while also fetching fair values for its asset sales. Furthermore, the rest of its growth projects need to move forward on time and on budget so that it can meet its robust dividend growth targets. That's easier said than done, which is why TransCanada is riskier than it would seem at first glance.
Matt DiLallo owns shares of Kinder Morgan and has the following options: short Jan. 2018 $30 puts on Kinder Morgan and long Jan. 2018 $30 calls on Kinder Morgan. The Motley Fool owns shares of and recommends Kinder Morgan. The Motley Fool has the following options: short June 2016 $12 puts on Kinder Morgan. 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.