Looking at Pipelines

March 3rd, 2011 by Potato

The pipelines have long been a core part of my portfolio: with nearly no income, I pay no income tax, so the tax treatment of the distributions never affected me, allowing for a bit of tax arbitrage (for most investors, outside of a taxable account, the yield on a pipeline would have been less after-tax than an eligible dividend, so their yields were high). They’re stable, long-term businesses, with very acceptable returns (esp. given the, IMHO, low risk involved). For full disclosure, I own both Fort Chicago (now Veresen) and Inter Pipeline, and have for years. So when Wayfare was looking for a safe investment in the midst of the chaos of 2008/2009, we turned towards pipelines, and settled on Enbridge Income Fund. After roughly doubling, she was wondering if it was perhaps wise to sell it (or sell half and invest in something else). Here’s a few of the things I looked at when making that decision:

First of, it’s important to recognize that pipelines are not exactly growth industries: it’s a capital-intensive business, and it’s hard to build out some fraction of a pipeline per year. So I don’t generally plan on much, if any, growth, which may be a little pessimistic (if nothing else, the transport tariffs may increase with inflation, and they do have other business lines, and hook up new producers to the pipeline over time in small segments).

There are parts that are hard to analyze, and hard to talk about analyzing. The companies often have other businesses (e.g., Fort Chicago/Veresen has both power generation and NGL extraction businesses). Some of these may be commodity-price sensitive, but I think I can safely say that generally most of the income from the pipelines is independent of what natural gas/oil does. The contracts vary (this is one of the hard parts to research), but are often take-or-pay, which means that the pipeline gets paid even if the producer gets shut down for some reason and doesn’t use the capacity. The pipeline itself may have different characteristics (e.g.: Inter Pipeline is all up in the oil sands, so it has a bit more growth as it hooks up the growing extractors in that region to its system). Enbridge and Veresen split the main Alliance pipeline that stretches across half the continent, but Enbridge has been more active in trying to grow in Saskatchewan. The corporate structure shouldn’t matter, but I find it much easier to read Fort Chicago/Veresen’s statements than I do Enbridge, since firstly the Enbridge name applies to several different companies (Enbridge Inc., Enbridge Energy Partners, Enbridge Income Fund) which have various relationships, and secondly because even just Enbridge Income Fund itself has various subsidiaries and holding company structures. Figuring out how to value these differences is a bit of a challenge to me.

Nonetheless, the first thing I look for is yield: after all, unless there is an expectation for growth somewhere, the yield is going to be where most of the return comes from in the pipelines. ENF right now yields about 6.1%, vs. it’s brother VSN at 7.6%.

Yield however is fairly meaningless if there isn’t cash flow* to back it up, so I next look there: what’s the payout ratio? The payout ratio represents the size of the distribution vs. the amount of cash or earnings the company is making: for an income trust (now just a high yielding corporation), I expect a high payout ratio, but one that still leaves room for growth, debt repayment, margin of error, etc. It’s pretty subjective and depends on the industry, but for REITs and pipelines, I look for a roughly 80% payout — much higher, and I start worrying about a future cut in the yield (or at least no/low growth); a lower payout may indicate a forthcoming increase to the distribution. For the payout ratio, I tend to look to cash flow rather than net earnings due to the very high depreciation line item that’s usually found — this tends to make the P/E ratio look crazy for pipelines (and other trusts/REITs). I have gone through the statements myself at some point in the distant past to get a handle on cash flow, and how it meshes up with net earnings, but lately I’ve been lazy and have just been accepting what the statements say at face value, or what the broker report has down for cash flow. For the latest quarter, ENF reported $100M of cash available for distribution [full year], and paid out $84M in distributions [full year], for an 84% payout ratio. VSN will report their full year results tomorrow I believe, but for the last 9 months had $134M of cash flow, compared to $107M in distributions [9 mos], for an 80% payout ratio. Due to the income trust conversion, these companies will have to pay income taxes going forward (but on net income, and it will also make the distributions eligible dividends), so I would expect the payout ratios to be squeezed for a few years.

What’s the debt look like? One big question will be the total amount of it, which is usually easily found (ENF: $1.1B, VSN: $1.7B), and that can be compared to earnings or cashflow/EBITA to look at debt coverage. Those measures are very sector-dependent: I’d be running for the hills if a restaurant had debt of 10X cashflow, but it seems appropriate for a pipeline. The various maturities can be important, as was brutally learned by Priszm and H&R — if credit conditions tighten, it can sometimes be difficult to “roll” the debt, so ideally the debt maturing in each year should be within a range where at least a large part of it could be paid off from earnings (with suspended distributions) if it came to it. ENF has this chart on page 17 of the Q4 report, I haven’t found it for VSN, but will likely be in the full annual report. That debt actually gets paid off can be important, depending on your view of leverage, but I think it is important for long-life assets to have the debt paid off before the asset is fully depreciated, and that is indeed how the debt is structured for the Alliance pipeline. VSN’s debt situation is a little more opaque as they paid down some long-term debt related to the pipeline, but then issued more debt in recent years for other acquisitions and capital spending. Anyway, both companies look very similar from a debt perspective (which should be expected).

For growth, I think ENF might have the edge over VSN due to its Saskatchewan system of pipelines. Otherwise they’re very similar, each owning part of the same Alliance pipeline (which makes up the majority of their businesses) and even sharing some power generation assets.

So at the end of the day, I looked at these two and couldn’t figure out why ENF had run up so much (119% for ENF vs 81% for VSN since March 2009) and was now yielding so much less than VSN (6.1 vs 7.6%), and that’s how we came to decide that Wayfare should sell ENF.

* – also called AFFO – adjusted funds from operations.

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