Description

“An investment you can trust.   In a turbulent environment, Enbridge’s conservative approach, proven business model and compelling value proposition set us apart as a solid investment.” – Enbridge Investor Relations Portal, March 2018.

I will walk through why this claim is far from reality.

Recommendation

• Short ENB CN common stock with target of <$20 CAD
• Short ENB US common stock with target of <$15 USD
• Purchase put options expiring in July 2018, January 2019, and March 2019

Summary Thesis

Enbridge is a levered business currently rated by Moody’s as Baa3 (one level above junk) that is reliant on the capital markets to fund its dividend.  ENB’s non-GAAP definition of maintenance capex (in their bridge to “Distributable Cash Flow”) allows them to perpetually understate their maintenance capex costs and consequently overstate their dividend coverage.  A number of pinch points exist over the next 12 months – each of which could stop the music on the capital markets funded “growth” capex game, revealing the true economics of the business, forcing a dividend cut, and further equity issuance.

Business Overview

Liquid Petroleum Pipelines

ENB is primarily a liquid petroleum and natural gas pipeline owner/operator whose “crown jewel” assets are the Canadian Mainline, the oil pipelines that transport ~2.6 million barrels of crude per day from Alberta to the United States.  At first glance, this mainline asset has all the attributes of a superior business model. For example, there is a seemingly insatiable demand for this asset, Alberta energy producers lack scale alternatives to get their products to refineries, and building a pipeline to compete with the Mainline is very hard to do (as evidenced by the current stalemate between the British Columbia and Alberta governments regarding the TransMountain Pipeline).  While these points remain true, the fundamentals of the mainline business are actually fairly ugly. Pricing along the mainline is fixed until 2021 (through the Competitive Tolling Settlement), volumes are already at capacity (no incremental EBITDA), and a significant portion of the assets have aged to the point where they require significant maintenance costs and/or replacement. This becomes a problem because when one uses a realistic maintenance capex number, ENB’s FCF doesn’t cover the declared dividend, meaning the dividend is funded through the capital markets.  The maintenance capex number is increasing, the Mainline cash flows remain fixed, and management has promised a 10% annual dividend increase through 2020.

Gas Pipelines

In 2017 Enbridge acquired Spectra Energy, a U.S. based pipeline company primarily focused on natural gas pipelines.  This acquisition significantly bolstered their Gas Pipeline Segment. Including the assumption of Spectra debt, ENB paid close to 20x trailing twelve months EBITDA for the business, when comparable transactions were priced at just over 13x.  Granted, there were a number of Spectra projects that were coming online, and ENB’s purchase premium partially reflected that. It was an all-stock deal that closed in February of 2017, with ENB issuing ~680 million shares to purchase Spectra.  This increased the annual declared dividend cost to Enbridge by over $1.5B CAD. This deal also increased their Net Debt to Adjusted EBITDA to 6.3x at year end 2017, just as ENB embarks on their largest maintenance capex program ever.

In 2017, these two primary segments accounted for 85% of Adj EBITDA (Liquids 53%, and Gas 32%).

Capital Structure Overview

The capital structure of ENB is fairly complex, with the parent entity (Enbridge Inc.) being domiciled in Canada and dual listed in Canada and the U.S.  ENB also owns three Sponsored Vehicles (which historically have been used for cheap access to the capital markets). The Fund Group (Enbridge Income Fund Holding, ENF CN), a Canada based sponsored vehicle whose assets primarily consists of the Canadian portion of the Mainline liquid petroleum pipelines, Enbridge Energy Partners (EEP), a U.S. based MLP whose assets consist of the U.S. portion of the Mainline liquid petroleum pipelines, and Spectra Energy Partners (SEP), a U.S. based MLP whose assets primarily consist of U.S. based Natural Gas pipelines.  Enbridge economic interests in the sponsored vehicles at year end 2017 are: ENF – 82.5%, EEP – 34.6%, SEP – 83%.

Of note is the economic interest in EEP.  While EEP debt is consolidated in the annual report, for the purposes of a credit rating, the rating agencies weight the debt proportionally to the economic interest.  There is currently $6.9B USD of debt at the EEP level – which may only “count” as $2.4B USD of debt at the parent level from a rating agency perspective. I revisit this later.

ENB consolidates the debt from these sponsored vehicles in their Annual report, which totaled $65.2B CAD of debt at year end 2017, preferred issuance totaled $19.4B CAD at year end 2017, Cash of $0.5B CAD at year end 2017, and a current market capitalization of $67.0 CAD for a total EV of $151.1B.  There are 1.7B shares outstanding with dividend obligation of $2.684 CAD annually per share for a total cost of $4.6B CAD annually. For perspective, total Cash from Operations in 2017 minus Distribution to NCI (before any maintenance capex preferred dividends) was $5.5B CAD.

Maintenance Capex

The crux of thesis is that ENB understates their maintenance capex in their non-GAAP bridge to Distributable Cash Flows.  In the ENB Q42017 Earning Release (February 16, 2018), ENB offers the following definition for Maintenance Capex (bolded emphasis mine):

Maintenance capital expenditures are expenditures that are required for the ongoing support and maintenance of the existing pipeline system or that are necessary to maintain the service capability of the existing assets (including the replacement of components that are worn, obsolete or completing their useful lives). For the purpose of DCF, maintenance capital excludes expenditures that extend asset useful lives, increase capacities from existing levels or reduce costs to enhance revenues or provide enhancements to the service capability of the existing assets.

As one can imagine, a definition like this provides significant wiggle room in what the stated maintenance capex number is.  For example, it could be argued that almost any cost incurred could “extend asset useful lives.” Given that management compensation relies heavily on this Non-GAAP Distributable Cash Flow metric, the incentives are certainly aligned to drive this maintenance capex number as low as possible.  While the ENB proxy is an exercise in obfuscation, I estimate that 50% of the CEO Al Monaco’s 2017 compensation (excluding change in pension and nonqualified deferred compensation earnings) is directly tied to this Distributable Cash Flow number.

Luckily for us, we can rely on FERC filings to better understand what the real maintenance capex number is, at least on the U.S. part of ENB’s mainline system.  In the FERC Form 6 filing for the Lakehead System for 2015 (the ENB U.S. Mainline System; controlled by the sponsored vehicle EEP), on page 51 we can see that ENB lists capital expenditures during the year of $1.69B USD (https://elibrary.ferc.gov/IDMWS/common/opennat.asp?fileID=14206963).  This $1.69B USD number includes all CAPEX, both growth and maintenance.  ENB lists out their growth CAPEX projects in their Annual Reports, as well as offers some details in the Form 6 Filing.  From these documents (with some variation for rounding) we can estimate that ENB’s growth CAPEX projects and costs for 2015 in the Lakehead system were: Lakehead System Mainline Expansion – $0.9B USD, U.S. Line 3 Expansion Program - $0.1B USD, and Eastern Access - $0.31B USD.  The total of these growth capex projects (for just one portion of their liquid pipeline system) is $1.31B USD. Subtracting this number from the total capex number in the FERC Form 6 filing yields $0.381B USD.  That represents dollars spent on the Lakehead System (again, only a portion of the mainline pipeline) excluding growth projects.  This represents the true costs of running the pipelines, or in other words, maintenance capex.  Going to ENB’s Distributable Cash Flow Bridge, ENB lists their Maintenance Capex cost for their entire liquid pipeline assets as only $278MM CAD.  Converting that number to USD, at an average exchange rate of 0.78 is $217MM USD or $0.217B USD.  This would indicate that on only a portion of their liquid pipelines, ENB’s true maintenance capex was 175% of what they state was the ENTIRE STYSTEMWIDE liquid pipeline maintenance capex in their non-GAAP Distributable Cash Flow Metric.  Clearly there is a problem.  Repeating the exercise for 2016 (the most recent year for which the FERC Form 6 is available) yields similar findings, although the results are not quite as egregious.   See below for details on 2015 Capex Reconciliation with FERC Form 6.

FERC Form 6 2015 CAPEX Reconciliation

ENB has been able to obscure these true maintenance costs through aggressive, capital markets funded growth projects.  For example, FCF (defined as CFO minus Total Capex) has averaged negative $3B CAD per year over the past 12 years.  With this type of capex spend, any company could easily conceal the true fundamental operating cost of the business.

Why This Matters

Without access to the capital markets, ENB cannot fund its current dividend, let alone grow it at 10% as management has promised.  The loudest bull thesis on the stock is, “the dividend yield is approaching 7%, ENB hasn’t cut their dividend before, the dividend coverage is ample, therefore the dividend is safe.”  The divided coverage is illusory and the dividend isn’t safe. In an episode of pure financial circularity, on November 29th, 2017 ENB announced a $1.5B CAD common equity issuance AND raised their dividend by 10% - in the same announcement.  The indicated dividend yield at the time was over 5%. It’s very clear that the sacrosanct nature of dividend increases is the price of admission to the equity capital markets – and a price which ENB can no longer afford.

Future Capital Expenditures

While the FERC filings demonstrate that ENB’s Non-GAAP historical maintenance CAPEX cannot be relied upon to understand the true operating costs of the business, what does the future hold? In December 2017, ENB laid out their “Conservative Funding Plan, 2018-2020” which provides a bridge to how ENB will fund $22B CAD of capex over 2018, 2019 and 2020.  Sources of cash net of dividends accounts for $14B CAD. The balance comes from $2B CAD of common equity issuance (already occurred), $4B CAD of hybrid securities (which ratings agencies give them ½ equity credit for; a portion has already occurred, most notably in April with an issuance of Hybrid Securities at a rate of 6 5/8th%), and $3B CAD of asset sales.  Assuming we want to believe management’s numbers in this instance, that would indicate $1B CAD of flexibility with funding.

There are, however, two fundamental problems with this bridge.  1) They mislead investors to believe that these are growth projects, yet the single largest project is at least partially a maintenance project (Line 3 Replacement), and 2) the change in FERC policy disallowing income tax recovery on cost-of-service rates for pipelines significantly impacts Sources of Cash.  Regarding the classification of these projects as “growth projects,” at the bottom of ENB’s Funding Plan Slide (“Annual Investment Community Conference” Presentation), it clearly states, “Secured growth plan readily financeable.” $9.5B CAD ($5.9B CAD and $2.9B USD) of the $22B CAD capex cost relates to Line 3 replacement.  While the project will increase capacity ~100% to the Line 3 original nameplate capacity, ½ of this cost is what is required to maintain the current level of EBITDA.  Regarding the new FERC policy, just under 50% of ENB/SEP’s gas pipeline assets are subject to cost of services rates, and hence will be impacted by the FERC decision.  ENB/SEP will attempt to negotiate additional offsets, so the exact impact of this policy change is hard to pin down, but in the worst-case scenario, the FERC decision could reduce total company EBITDA by almost 5.1% from adjustments to SEP alone.

It’s worth reiterating that this elaborate capital funding plan announcement occurred before the FERC ruling, and as Al Monaco the CEO said at the investor day in December, “We’re comfortable with, generally, the ratings categories that we have right now and so that’s what we would look to maintain.”  In other words, this proposed capital plan (including asset sales) only maintains their Moody’s Baa3 rating – it doesn’t improve it. Moody’s said in their downgrade of Enbridge credit the divestiture plan is, “insufficient to improve the financial profile of the company in

a timely manner.”  And the story only gets worse from here.

Catalysts

Line 3 Replacement

The largest capital project that ENB has ever undertaken is the replacement of Line 3 with a price tag of $9.5B CAD.  Line 3 is one of the mainline liquid petroleum pipes that runs from Alberta to the United States. It was built in the 1960s.  The materials that were used in its construction (steel and coatings) are not as resilient as other assets in the mainline, and ENB needs to replace it.  Currently it is operating at ~50% of its nameplate capacity because ENB has reduced the pressure at which Line 3 operates out of concern for environmental safety.  Of course, the residents of Minnesota clearly appreciate the environmental concern given ENB’s response to a pipeline oil spill in Kalamazoo Michigan of which Deborah Hersman the Chair of the NTSB stated, "Learning about Enbridge's poor handling of the rupture, you can't help but think of the Keystone Kops."

The reason why ENB needs Line 3 to be replaced isn’t just about the environmental liability – it is also about cost.  As Laura Kennett, a Supervisor, Pipeline Asset Integrity Projects at ENB, testified to the Minnesota Public Utilities Commission on January 31, 2017, "...In the U.S. alone, approximately 4,000 integrity digs were forecast during the following 15 years to maintain Line 3 at its reduced level of operation. Dig and repair costs were forecasted to exceed $6 billion through the year 2026…"  The quick math is $600MM USD per year of maintenance costs for 1 section of 1 part of the mainline pipeline system. For perspective, in 2016, the last year that ENB broke out “Maintenance Capex” by segment, they claimed to have spent only $207MM CAD on maintenance capex for the entire liquids system.  At a minimum the cost to maintain the current level of EBITDA on Line 3 is 50% of the total project capex, or $4.75B spread out over 2-3 years – easily swallowing any purported dividend coverage.  I am reminded of what Warren Buffet said at the 2003 Berkshire shareholder meeting, "Not thinking of depreciation as an expense is crazy. I can think of a few businesses where one could ignore depreciation charges, but not many.  Even with our gas pipelines, depreciation is real — you have to maintain them and eventually they become worthless (though this may be 100 years)." In the case of Line 3, worthless seems much closer to 50 years rather than 100.

ENB’s proposed replacement partially follows a new route through the state of Minnesota.  ENB has stated they have proposed a new route for environmental sensitivity. The real reasons why ENB proposed a new route are: 1) Cost.  They plan to leave the original Line 3 in the ground, thus saving on removal costs, 2) They don’t lose the EBITDA from Line 3 if they don’t have to shut the line down to replace it, and 3) The current route runs through the Leech Lake Indian Reservation, and Enbridge’s easement on that land expires in 2029.  Having a new route through the state eliminates the hard (/expensive) negotiating for a new easement with the Leech Lake Band that ENB faces in 2029. With a new route, their negotiating hand strengthens significantly because they would have the newly created option of moving the other lines in the mainline system to the new route.

The process for ENB to receive a permit for a new route Minnesota has already begun.  This process has taken years, during which testimony from related/affected parties has been gathered and environmental impact studies created.  On April 23rd an Administrative Law Judge (ALJ), after hearing all of the evidence, issued her recommendation on the Line 3 replacement.  To summarize, she stated that ENB should replace the Line 3 pipeline, but only if they dig up the old one, and use the existing route.  This recommendation is near fatal given ENB’s capital structure. While the recommendation isn’t final, the Minnesota Public Utilities Commission (a group of 5 people appointed by Governor Mark Dayton, Democratic-Farmer-Labor Party) which will be making the final decision in June 2018 is supposed to strongly consider the recommendation.  Their decision will likely end up in court no matter what they decide.

If the Commission endorses the Administrative Law Judge’s recommendation, the dividend will need to be cut.  As CEO Al Monaco said last year, “I don't want to say what we would do or whether there's a Plan B because we're focused on executing the plan right now.”  I will elaborate on what the consequences look like. Financially, they must complete the project, because the actual future maintenance capex charges of Line 3 are too large ($6B USD over 10 years in MN alone).  Completing the project the way the ALJ recommended increases costs (~$2B USD to remove the old pipeline), decreases EBITDA (~5% of total company EBITDA for 12-24 months while the project is completed, elongates the timeline for completion and receipt of incremental cash flows (Sources of Cash goes down), and sets up ENB for a very financially punitive negotiation with the Leech Lake Band.  Each of these events alone could trigger a credit downgrade, and take together, they certainly will.

Line 5

While the Line 3 replacement has dominated the headlines recently, another component of the mainline, Line 5, has its own set of issues on the horizon.  Line 5 was built in the 1950s, is one of the largest mainline pipelines, and a portion of the pipeline sits on the lakebed in the Straits of Mackinac, between Lake Michigan and Lake Huron.  This pipeline was recently struck by a ship anchor. ENB has been caught misrepresenting the condition of the coating of the underwater section of the pipeline numerous times and it seems like residents of Wisconsin have had enough.  There is a gubernatorial election this Fall. The primaries are August 7th, and the Election is November 6th.  As we have seen, expect the unexpected in politics, but the three leading candidates and their positions on Line 5 are:

Bill Schuette – Leading GOP candidate

Comments on Line 5: The pipeline's days "are numbered," said Bill Schuette, state attorney general.

Gretchen Whitmer – Leading Democratic candidate

Comments on Line 5: “…That is why as Governor, I will immediately file to enjoin the easement and begin the legal process to decommission Line 5, and anything short of that is insincere.”

Abdul El-Sayed – Democratic candidate

From his Platform: “Fight for clean water for all and shut down Enbridge’s Line 5”

If ENB miraculously gets approval for their preferred Line 3 route, they will need to repeat the exercise (and find the dollars for the additional replacement capex cost) with Line 5.

2019 Guidance

As mentioned previously, the FERC policy change is very material to ENB.  Immediately after the decision, ENB issued a statement that said, “SEP anticipates no immediate impact to its current gas pipeline cost of service rates as a result of the revised policy, and therefore, no impact is expected to its previously provided 2018 financial guidance.”  This statement is true, but it omits a rather large qualifier. One of the mechanisms FERC uses for cost of service rates is an adjustment each year for overcharging/undercharging on the rates. For example, if a company like SEP charges $1, but the new FERC rate should be $0.65, they are able to continue to charge that $1 for the entire period (usually one year).  However, when the next rate is set, there is an offset for overcharging. In this example, the rate for the next year would be $0.65 minus the overcharge of $0.35 for a rate of $0.30 in Year 2. Year 3 would go back to $0.65. A number of the rates that SEP charges haven’t been negotiated for a while, so there is the opportunity for ENB/SEP to lobby for offsets – however it is very unlikely that they will completely offset the Income Tax Disallowance policy.  In short, for every dollar of EBITDA that SEP derives from overcharging its customers in 2018, there will be an offset that occurs 2019. The worst-case scenario for ENB is a 5.1% reduction in total company EBITDA from SEP times two for 2019, for total 2019 reduction of EBITDA of 10.2%. This reverts back to a reduction of 5.1% in 2020. Sources of cash are reduced, and leverage is increased.

Sponsored Vehicles and a Credit Rating Downgrade

At some point, ENB will have to address their Sponsored Vehicle problem.  From a high-level perspective, ENB created these entities to access the capital markets and juice returns from IDRs.  Currently, these vehicles are broken as a funding mechanism (Cost of equity is too high), and in the U.S., EEP and SEP will have distribution coverage issues once the FERC Tax Disallowance Policy flows through.  Eventually this will lead to a roll-up of their sponsored vehicles. The biggest problem here lies with EEP, which has $6.9B of debt, and ENB has an economic interest of 34.6%. While rating agencies are a bit of a black box, there is some “ring-fencing” of this debt relative to a GP’s economic interest in the MLP.  Depending on the rating agency model, rolling up EEP could add an additional $4.5B USD, or $5.6B CAD of debt to ENB. This would certainly trigger a downgrade to junk. Granted, the ratings agencies generally like simplifications, so there is some positive offset to an EEP roll-up, but likely not enough to avoid a downgrade.

ENB Bridge to Distributable Cash Flow

While I believe that a real, normalized maintenance capex number is somewhere around 2.5x the number that ENB presents in their Non-GAAP financials, it’s worth examining the other adjustments that they make in their bridge to “Distributable Cash Flow.” There are two notable add-backs, changes in Adjusted Working Capital, and Project Development Transaction Costs.  Both of these add-backs are one way. Firstly, regarding increase in working capital, it is a cost. If ENB needs to increase working capital to drive Cash From Operations, it is a real cost incurred and not Distributable Cash Flow. Secondly, the same principle applies to Project Development Transaction costs. If these costs drive future Cash Flows, then they need to be deducted when the asset begins producing Cash Flows.  It is unclear if there is ever a deduction. Removing these two very simple add-backs shows that ENB is only covering their declared dividend by 1.32x (again, ignoring the elephant in the room that is Maintenance Capex).  Additionally, in ENB’s bridge, the stated number for “Distribution to non-controlling interests” does not tie to the Cash Flow Statement.  There is an unexplained adjustment there, simply footnoted as “Presented net of adjusting terms.”

Regarding the gap between the declared dividend and the cash outlay for ENB dividend, that is explained by their Dividend Reinvestment Program, or DRIP.  ENB’s DRIP program offers shares (at a slight discount to market) in lieu of cash a shareholder would receive in the form of a dividend. Steady use of the DRIP conserves cash for ENB in the short term, while diluting equity.  As the dividend has continued to grow, a smaller and smaller portion of the declared dividend costs have been redeemed as shares. A table below illustrates the dwindling effectiveness of ENB’s DRIP, with a record low participation of 19% in Q4 2017.

While determining a specific number for what Enbridge’s real maintenance capex costs are is close to impossible, we know that they are understating it on the DCF bridge (as shown with the FERC filing example), and we know that in the future either maintenance capex costs on just one section of Line 3 will average $600MM USD per year or ½ of the total Line 3 replacement project cost should be accounted for as maintenance capex ($4.75B spread out over two to three years).  Using a (very rough) multiplier of 2.5x, we can see that ENB cannot fund it’s declared divided.  On a dollar basis, this 2.5x multiplier takes 2017 maintenance capex from $1.26B CAD to $3.15 CAD, or an increase of $1.89B CAD.  Given that ENB spent ~$1.2B CAD on line 3 replacement in 2017, we can assume that ½ is maintenance capex, or $0.6B. That leaves approximately $1.29B of extra maintenance capex – which is roughly double management’s number, a fair estimation given the gross understatement of maintenance capex as shown by the FERC filings.

Valuation

I believe that the fair value of the Canadian listed equity is somewhere below $20 CAD per share and the fair value of the U.S. listed equity is somewhere below $15 per share, or greater than a 50% downside.

On a 2019 EV/EBITDA basis, a peer group of Kinder Morgan, Transcanada Corp, and the Williams Cos Inc trade at an average multiple of 10.1x.  I believe that given the huge replacement capex cycle Enbridge is embarking on, the credit issues, and the unresolved MLP issues, ENB should trade over a full turn lower, or 9.0x.  This implies an equity price of $13.35 (for the Canadian listing) off of my 2019 EBITDA of $11.875B, or approximately a 66% downside.

Given the large proportion of dividend oriented investors in ENB’s shareholder base, I’ll include math around that as well.  I believe the prudent thing for ENB to do would be to cut the dividend to zero and use that cash to fund their replacement capex as well as reduce debt.  However, I believe a 75% divided cut is the most likely outcome (similar to what Kinder Morgan did in 2015). If ENB cuts the dividend by 75%, and the shares trade on a dividend yield basis similarly to Kinder Morgan (3.6%), the fair price of the equity is $18.6 per share (for the Canadian listing), or 53% downside.

Recommendation

• Short ENB CN common stock with a target price of < $20 CAD
• Short ENB US common stock with a target price of < $15 USD
• Purchase put options expiring in July 2018, January 2019, and March 2019
  • July 2018 options provide exposure to Minnesota Public Utilities Commission decision
  • January 2019 options provide exposure to FY2019 Guidance (if given at analyst day in December)
  • March 2019 options provide exposure to FY2019 Guidance (if given with Q42018 release)

Risks

• ENB has continually demonstrated that they have unlimited access to the capital markets.  While I believe this blind faith is weaning (as evidenced by the 6 5/8th % issue – a much higher spread than they are accustomed to), it is always possible that it continues.
• If Line 3 is replaced as they have proposed (unlikely), other pipelines aren’t built (Trans Mountain Pipeline and Keystone XL), they don’t blow up before 2021, and then they receive a significant rate increase from a new Competitive Tolling Settlement in 2021 (the producers wouldn’t be happy), then the equity will be worth much more.
• ENB pays a $2.68 dividend which can make shorting the stock expensive
• Despite being the 6th largest TSX listed constituent, borrow could become tight

Catalyst

• ENB can't fund current dividend load without utilizing the capital markets, let alone increases
• Minnesota Public Utilities Commission decision on Line 3 Replacement in June 2018
• 2019 Guide given FERC tax dis-allowance policy, or SEP announcement
• Credit rating downgrade
• Upcoming political issue with Line 5
• Capital markets tightening