You can’t call it a rally yet, but beaten-up Canadian pipeline stocks are stirring from recent lows. Perhaps investors are discovering that hefty dividends and low valuations are hard to ignore.
TransCanada Corp. has risen nearly 10 per cent since early April, after it had slumped toward a two-year low. Enbridge Inc. (full disclosure: I own this stock) is up more than 12 per cent after touching a six-year low in late April.
The best buying opportunities may have passed, but are the stocks still cheap? By most measures, they are.
The sector has struggled with rising bond yields. The yield on the Government of Canada 10-year bond rose from below 1 per cent in 2016 to above 2.4 per cent earlier this year, weighing on rate-sensitive pipelines.
It didn’t help matters that the Canadian energy sector had fallen out of favour because of environmental concerns, lacklustre oil prices and international energy companies retreating from the oil sands region.
TransCanada fell 20 per cent between November and April. Enbridge, digesting a $37-billion takeover of Spectra Energy amid plans for asset sales and debt reduction, fell 28 per cent over a similar period.
Robert Kwan, an analyst at RBC Dominion Securities, examined pipeline stocks from a number of perspectives and found that the stocks look inexpensive. Their low valuations imply that the downside risk is limited if turbulence returns – and investors can collect dividends while they await better days.
“We recognize that sector sentiment is poor, but we see an opportunity to buy into solid underlying businesses at attractive valuations along with the ability to get paid to patiently wait via relatively high dividend yields and expected annual growth in dividends per share,” Mr. Kwan said in a note.
Let’s look at price-to-earnings ratios first. Over the past decade, the average P/E ratio for TransCanada and Enbridge, based on consensus estimated earnings, have been above 20, according to Bloomberg. Today, P/E ratios are below 17. (Mr. Kwan’s forward P/E ratios, based on his own estimates, are between 15 and 16.)
More importantly, Mr. Kwan calculated that the historical valuation floor rests at a P/E ratio of 14, for data going back to 2005 .
For the shares to return to this floor, share prices would need to fall about 12 per cent from current levels. That doesn’t look particularly frightening, especially when Enbridge has an offsetting dividend yield of 6.4 per cent and TransCanada has a yield of 5 per cent.
There are other ways to look at valuations. And these, too, make the stocks look like compelling opportunities right now.
Mr. Kwan noted that the stocks are inexpensive when comparing their enterprise value to earnings before interest, taxes, depreciation and amortization (or EV/EBITDA, a ratio that compares a company’s theoretical takeover price with its profit potential.)
Price to distributable cash flow, another valuation measure, is also low relative to historical levels.
Meanwhile, the backdrop looks promising. Although the price of West Texas intermediate (WTI) crude oil has declined from recent highs above US$70 a barrel in May, it is more than 50 per cent higher than last year. Strong oil prices should ensure robust oil production – and the need for pipelines.
What’s more, the discount between the price of Western Canadian Select (an oil sands benchmark) and WTI has narrowed to about US$18 a barrel. That’s close to its 10-year average and well below the wider discount of about $30 seen in February.
Yes, challenges persist. There are pipeline bottlenecks and a tortuous route toward approving new lines in Canada and the United States. And no one really knows how high bond yields will rise.
But these uncertainties make the stocks cheap to buy – and the dividend yields hard to resist. Waiting for a true rally to kick in should be very profitable.
David Berman