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Morningstar | Despite Recent Rally, We Still See 20% Upside in TransCanada

After updating our model for TransCanada’s fourth-quarter results, we are lowering our fair value estimate to $53 (CAD 70) from $54 (CAD 72). We are maintaining our narrow moat rating. Our lower fair value estimate is driven by our increased forecast in cash taxes. Even with the valuation decrease, we still see 20% upside in the stock, which is trading near $44 (CAD 58).  TransCanada’s stock has fared well in 2019, up 19% year to date compared with 11% for the S&P 500. Despite the rally, we still think the market is underestimating the company.

With pipeline expansion expected to add 1.8 million barrels a day of new capacity in the near term, there is some uncertainty regarding the utilization of the Keystone system. But investors should rest assured that the Keystone system will be fully utilized in the long term, with only a few quarters of minor underutilization. TransCanada was successful in securing commitments from 90% of the capacity but will move 200 thousand bbl/d of commitments from the legacy Keystone system. However, that leaves more open spot capacity on the legacy system that serves the more attractively priced Midwest market. Eventually, the entire pipeline system will operate near full targeted capacity when Canada ramps its supply to our forecast levels and maximize returns on the project.

The market also continues to overlook the positive impact the CAD 47 billion growth portfolio will have on cash flows and the balance sheet. We think investors have placed too much emphasis on less important outside factors such as the widening of the heavy oil discount, the Federal Energy Regulatory Commission's proposed tax regulations, and rising interest rates. Once the Keystone XL is placed into service, we expect that coupled with various natural gas growth projects will generate CAD 3.5 billion in incremental EBITDA, which will support dividend growth and improve the balance sheet.

TransCanada increased its annual dividend by 9% to CAD 3 per share from CAD 2.76. While this lags peers, it's still attractive at a 5.3% yield and offers superior growth to Enbridge's dividend. We expect TransCanada to increase its dividend at 9% annually over the next five years while maintaining a comfortable coverage ratio that approaches 1.7 times and improving the balance sheet.

TransCanada generated comparable earnings of CAD 946 million, or CAD 1.03 per share, in the fourth quarter compared with CAD 719 million, or CAD 0.82 per share, in the year-ago period. Comparable earnings surprised to the upside compared with our expectations, driven by better-than-expected performance in the U.S. natural gas pipelines business, increased volumes on the Keystone pipeline driven by excess Canadian crude supply, and lower U.S. income tax rates. The company reported distributable cash flow of CAD 1.7 billion, also above our expectations. Higher distributable cash flow is attributed to the improvement in comparable earnings.

The Keystone XL remains in the legal system’s hands. The South Dakota Supreme Court dismissed an appeal against the pipeline, but outstanding challenges remain in Nebraska and Montana. TransCanada continues to work with the U.S. Department of Justice to defend the legal challenges to the presidential permit and the environmental assessments. We think there is still time for the project to begin construction during the first half of 2019, and we still expect the Keystone XL to be placed into service by the end of 2021.

For a detailed look into Canadian crude market and pipeline trends, please refer to our January Energy Observer, "Pipelines Are Canada’s Lifelines."

For a deeper dive into TransCanada and what the market is missing about the stock, see our April Select report, "What the Market Is Missing on Keystone's Impact on TransCanada."