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Morningstar | Another Strong Quarter for Enbridge; Stock Still Deeply Undervalued

Wide-moat Best Idea Enbridge reported its second consecutive strong quarter. The company reported second-quarter adjusted EBITDA of CAD 3.2 billion, or CAD 1.86 per share, compared with CAD 2.6 billion, or CAD 1.58 per share, in the year-ago quarter. Enbridge also reported distributable cash flow of CAD 1.9 billion, or CAD 1.09 per share, compared with CAD 1.3 billion, or CAD 0.81 per share, in the second quarter of 2017. The strong performance was more or less in line with our expectations. The improved results were driven by record volumes and increased tolls on the Mainline system, new projects placed into service, and the acquired Spectra assets.

Enbridge continues to improve its balance sheet, with adjusted leverage levels falling to 5.6 times, in line with our expectations. The company aims to decrease leverage below 5 times by the end of the year, and we fully expect it to do so. The company’s asset sales will aid in improving the balance sheet. Enbridge’s year-to-date asset sales stand at CAD 7.5 billion, with a potential for another CAD 2.5 billion in future dispositions previously identified by the company.

We are maintaining our $49 and CAD 64 fair value estimates and wide moat rating. The stock was up roughly 1.5% on the positive earnings report and over 10% since the news of Minnesota’s approval of the Line 3 replacement project. Despite the recent rally, we still see plenty of upside. We expect Enbridge to easily meet its 10% average annual dividend growth target through 2020 and maintain a healthy distributable cash flow ratio of 1.4 times the forward dividend. We consider Enbridge a rare triple threat, boasting a wide moat, an attractive 5.8% dividend yield, and a cheap valuation. We think the time is right for long-term investors to capitalize on the stock's considerable upside while collecting a steady stream of growing income.

Our September 2017 Energy Observer, "Don't Overlook Oil Sands: Falling Costs and More Infrastructure Will Make Canadian Production Globally Competitive," highlights our initial call that we expected Line 3 to obtain regulatory approval.

As a reminder, Enbridge's Line 3 replacement project would restore Line 3 to its initial capacity of 760 thousand barrels per day, adding 370 mbbl/d of new pipeline capacity. Similar to other mainline routes, the Line 3 replacement will be a common-carrier pipeline. The pipeline is expected to originate in Hardisty, Alberta, and connect to the United States in Minnesota, where it will connect to other U.S. pipelines. It will provide additional access to refineries in eastern Canada; Cushing, Oklahoma; the U.S. Midwest; and the U.S. Gulf Coast at an expected cost of $7.5 billion. Shipments on the expanded Line 3 can displace feedstock in eastern Canada, but most important, capitalize on the heavy oil refining capacity in the U.S. Gulf Coast while ensuring stability of crude receipts for Minnesota refineries. Construction has already begun on the Canadian portion of the pipeline expansion, while construction on the Minnesota portion is not expected to begin until early 2019.

As detailed in our May report, "Investors' Concerns Over Enbridge's Dividend Are Overblown," we think Enbridge can meet its targeted annual dividend growth of 10% through 2020. We expect the growth portfolio to generate almost CAD 4 billion in incremental EBITDA, which will support the dividend growth with a healthy distributable cash flow ratio of 1.4 times the forward dividend--more than enough buffer.

Best Idea and 5-star-rated Enbridge remains our top pick in the energy sector. With the shares trading at about $36 (CAD 46), we see 35% upside. We think investors are overlooking Enbridge’s big picture and are too narrowly focused on the company as a dividend stock. Because of this, we think they are overlooking cash flows from the growth portfolio, especially the Line 3 replacement project and the numerous natural gas projects. Combined, we expect these projects to generate CAD 4 billion in incremental EBITDA to fuel dividend growth while improving the balance sheet from current levels. Please refer to our January report, "Best Idea Enbridge Is a Triple Threat," for a deeper dive into the stock's upside.