Past Comments – Trans-Mountain Pipeline

From my July 1, 2018 post:

Trans-Mountain Pipeline

This is a political disaster for the Liberals. It will be an even bigger political disaster when they try to tender the contracts to build the pipeline. It is a recipe for over budget, behind schedule politics, especially since the protestors know that any construction will be fueled by even more political pressure than it being built by a corporate entity. I do not believe this pipeline will be built even after the federal government bailed out Kinder Morgan Canada (TSX: KML).

Just remember, the government that can’t even build a gun registry or payroll system for themselves without spending more than a billion dollars of taxpayers’ money are trying to build an energy pipeline. Best of luck!

Obsession with dividend investing does not prevent capital losses

There are quite a few financial websites out there dedicated towards investing in dividend-bearing securities.

Some give the impression that it is nearly guaranteed to produce returns superior to the overall market.

In addition, a lot of them convey that the production of income through dividends is somehow “safer” than investing in major index ETFs.

In general, I do not have issues with dividend-bearing equities. In a lot of instances companies do not have proper places to re-allocate capital and giving it to shareholders is the right decision – especially if their stock price is high and the cost of their debt is low.

Where I have issues with dividend investing is in companies that have suspicious cash flow profiles or give cause to believe that their earnings profiles are going to be less than what is implied by their market pricing.

I’ll give an explicit example. Cineplex (TSX: CGX) I have written about in the past. Specifically in a May 2014 article (when the stock was trading at around $41), I was puzzled why the stock was doing so well given the “dinosaur” aspect of their business.

A lot of people though will take a look at their current 5.4% dividend yield (currently trading at $32/share) and blindly buy on the basis of that number alone. What will not be asked is whether this can be sustained or whether the business is fundamentally sound to generate sufficient cash flows in the future. Maybe it will, but there is an awful amount of risk for that 5.4%, much more than I could justify for my own (cowardly) risk profile. The 5.4% doesn’t compensate for the risk of future potential losses.

Another example that I have not written about in the past is Laurentian Bank (TSX: LB). This got on my radar back in June when their CMHC securitization issues hit the headlines. After doing some deep-dive research, while I believe the financial institution in general will continue to generate cash, I determined that better prices in the future could probably be had. Their last quarterly report was a prime example of mediocrity that one would expect from a centuries-old financial institution and their stock got hit 5% on the day after the report. Dividend investors were screaming “buy, buy, buy!”, looking at the juicy 6% yield and apparent value (then trading around 17% under book value). How can you lose? Today, it is down another 5% from the day after they reported earnings. It would take a year of dividends and a flat stock price to “catch up” to even.

The real test of the veracity of dividend investors is what happens when the capital value of their investments go south, and I am not talking 5-10% – when they start seeing 20-30% capital losses across their portfolios, will these dividends be nearly as important?

Just note this is not a prediction on the future outcome of CGX or LB or the market in general. It is simply a commentary that dividend investing is not risk-free magic and it requires just as much financial rigour as other types of investing. For common share investments, I’m agnostic towards companies that either give out or do not give out dividends or distributions. It factors little in my investment decision-making. I’m much more concerned about what management does with the capital they have.

Trans-Mountain Pipeline / Enbridge / TransCanada

Nobody is laughing out louder today than the management of Kinder Morgan (NYSE: KMI) who have sold their $5 billion pipeline (TSX: KML) to the government of Canada, when a federal court effectively ruled the trans-mountain expansion project to a halt (the reasons of which are not too relevant to the analysis in this post).

(Update, August 31, 2018: See Kinder Morgan’s “laughing to the bank” announcement here)

I’m ignoring the fact that the original Trans-Mountain pipeline still exists and still operates and pumps oil down to the old Chevron Burnaby refinery now owned by Parkland Fuels (TSX: PKI). There is enough pipeline capacity to supply the refinery, but not enough for any meaningful export quantities. This doesn’t make it a complete disaster for Canada, but they sure paid a lot more for it what it is worth.

There are two big economic winners with this court ruling, and it is not Kinder Morgan (they had their victory back in May when the Government of Canada agreed to the sale).

It is Enbridge (TSX: ENB) and TransCanada (TSX: TRP).

The only way to get meaningful amounts of oil out of Alberta and Saskatchewan (other than by much more expensive rail) is now going through the Enbridge Line 3 project or the TransCanada Keystone Pipeline.

(Here’s a map of oil and gas pipelines in Canada)

The economic losers are the Government of Canada, and every major oil producer in Alberta or Saskatchewan: they still have to go through Enbridge or TransCanada pipelines and pay a very heavy differential to prevailing energy prices for a long, long time. Inevitably this will hurt the Canadian public as the purchasing power of their currency will be less than what it could be had we actually have a fully functioning economy, but these indirect effects are typically never measured nor felt as the absence of an effect is rarely lamented in the minds of most people.

Politically, there is one big winner: The BC Government. Premier John Horgan has a huge victory to show to the environmental activist wing of his political party (the BC NDP) and this will give him more clearance to operate in the province without internal opposition (which is historically how the BC NDP loses power).

I am somewhat surprised Enbridge and TransCanada are not doing better in trading today.

Canadian Dollar vs. US Dollar

This chart has grabbed my attention over the past couple weeks:

The market is trading CAD up presumably on hopes that Canada and the USA can iron out some sort of trade deal on the NAFTA front. I’d be skeptical. The politics does not work very well for both President and Prime Minister for a quick agreement.

The other drivers of the Canadian currency are interest rates and the state of the commodity markets, and relative to the USA, neither appear to be favouring the Canadian dollar at the moment.

That said I do not pretend to understand all the nuances of Canadian dollar trading, so perhaps some other enlightened individuals can chime in.

Spectra Energy Partners / Enbridge

Enbridge has sweetened its offer for Spectra Energy Partners (NYSE: SEP) from the initially proposed 1.0123 shares of Enbridge per SEP to 1.1 shares of Enbridge (a 9.8% increase).

Enbridge common shares are down 2% as a result, but SEP is up 3% as a result of the increased consideration. It appears the market baked in about half of the expected appreciation over the prevailing 1.0123 share ratio:

A factor quoted in the press release was the July 18, 2018 FERC Order – and you can also see this implied increase in value on the SEP:ENB chart above.

I will note that this is a fait accompli as the salient sentence in the press release is the following:

As the majority SEP unitholder (83% of total SEP common units outstanding), Enbridge’s approval by consent will constitute the requisite SEP unitholder vote required to approve the transaction.

Unitholders were more or less in it for the ride and short of a minority shareholder oppression lawsuit, it was going to get done at any “reasonable” price.

What is interesting is that Enbridge is concurrently attempting to consolidate its other master limited partnership, Enbridge Enterprise Partners (NYSE: EEP) and related entity (NYSE: EEQ). I have written about EEP in a previous analysis.

An argument by analogy (not air-tight by any means but does have merit) is that if SEP receives a 10% boost in consideration, EEP should be receiving the same, especially considering that EEP, in addition to the July 18, 2018 FERC ruling order, has under its belt a major positive ruling with the Line 3 expansion in Minnesota – one that was received after the initial proposal of 0.3083 shares of ENB per EEP unit. The other factor is that EEP unitholder approval is not guaranteed – EEP requires 2/3rds unitholder approval and Enbridge controls about a third of the vote.

A lot of Canadians are also invested in Enbridge Income Fund (TSX: ENF) which is also affected by this. However, Enbridge has an 82% interest in ENF so they will have to take whatever they are offered, within reason. ENF also does not have the benefit of having the July 18, 2018 partial reversal of the FERC ruling as it is mostly about Canadian operations (where the FERC doesn’t apply). I do not believe ENF holders that are waiting for a boost in the exchange ratio will end up with a happy outcome. Right now ENF:ENB is trading at 0.732 while the proposed exchange ratio was 0.7029.

My general expectation is that EEP unitholders will be offered 0.35 shares of Enbridge, or about a 14% boost-up from the existing offer. As Enbridge is likely to shade down in price as a result of the increased consideration for merging, I would expect the EEP price upon transaction announcement to settle around the $12.10 range. This is a relatively thin value play. I had a not inconsiderable amount of call options on EEP after the initial FERC announcement, but I added slightly to my position today – the downside risk is quite limited.