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Morningstar | Best Idea Enbridge Pays 10% Premium for Spectra; Stock Still Deeply Undervalued

Best idea Enbridge has entered into a definitive agreement to acquire all public shares of Spectra Energy Partners in a stock deal valued at $3.3 billion (CAD 4.3 billion). Enbridge raised its offer to 1.111 of the company’s common shares for each unit of Spectra, a 10% increase from its initial 1.0123 proposed exchange rate. The deal represents an additional premium to our expectations, which included a 5% premium to the initial exchange rate.

The stock is down 2% on the news, but we see this as an overreaction. Despite the increase in purchase price, we don’t think the additional premium paid is material enough to change our valuation. Accordingly, we are maintaining our $49 (CAD 64) fair value estimate.

We like the move, as it simplifies the Enbridge family into a single holding. After the Federal Energy Regulatory Commission issued its tax disallowance proposal in March, the master limited partnerships no longer serve the purpose they were created for: capital-raising vehicles for Enbridge.

We consider Enbridge a rare triple threat, boasting a wide moat, an attractive 5.8% dividend yield, and a cheap valuation. While the market continues to place too much emphasis on the dividend and overlook the impact that the growth portfolio will have on future cash flows and the balance sheet, 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 mb/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 4-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.