By: Jon Costello, HFIR Energy Income
Note: figures in this article are in Canadian dollars unless indicated otherwise.
When we first saw the news that Enbridge (ENB) would acquire Dominion Energy's (D) utility assets, which we discussed here, we suspected ENB may be pursuing a similar path as TC Energy (TRP). TRP recently announced that it would spin off its liquids pipeline business into a standalone publicly-owned entity. We believe the spinoff is likely to spur a higher stock price for TRP, and the announcement factored into our decision to buy TRP shares at USD$34.15—equal to CAD$44.40—during the selloff that occurred the following day.
On closer inspection, our analysis shows that ENB won’t benefit from a split into standalone liquids and non-liquids companies. In fact, it could cause the company to lose some of the valuation premium it enjoys from its stability and diversification. ENB’s former CEO, Al Monaco, believed that the market would pay a premium valuation for a company that possessed scale and breadth throughout the midstream value chain. At least in ENB’s case, our analysis indicates he was correct.
Over the past year, TRP’s shares sank as investors grew concerned about the company’s high leverage, lack of progress in deleveraging, and a series of operational setbacks that included massive cost overruns in its Coastal GasLink project and an oil spill from its Keystone Pipeline. TRP’s selloff caused its shares to trade significantly below our price target.
[img]https://substackcdn.com/image/fetch/f_auto,q_auto:good,fl_progressive:steep/https%3A%2F%2Fsubstack-post-media.s3.amazonaws.com%2Fpublic%2Fimages%2Fbf50e845-414b-4d48-9f2e-9c20bd39a3ac_640x398.png?utm_source=substack&utm_medium=email[/img]
On the evening of July 28, the company announced that it would sell its Columbia Gas and Columbia Gulf assets for $5.2 billion. Investors were disappointed by the low 10.5x EBITDA multiple that the Columbia assets fetched. The next day, TRP’s share price fell as much as 7.6%, to a 10.1x EV/EBITDA multiple, the lowest market valuation since 2005 and well below the shares’ long-term average multiple of 12.0x, as shown in the chart below.
[img]https://substackcdn.com/image/fetch/f_auto,q_auto:good,fl_progressive:steep/https%3A%2F%2Fsubstack-post-media.s3.amazonaws.com%2Fpublic%2Fimages%2Fce027c71-fddd-4319-89ee-cd6f5634a59e_640x396.png?utm_source=substack&utm_medium=email[/img]
As TRP shares sunk to historic lows, their long-term investment proposition became more attractive. A simple reversion of their trading multiple back to its historical average would spur a significant increase in the share price.
To get there, the company would have to show progress deleveraging and improving its operational track record. We believed that both were likely over the coming quarters. However, the spinoff announcement, which was made the same day as the Columbia asset sale was announced, added an interesting wrinkle to the TRP investment proposition. By separating its liquids segment from the rest of its business—which operates primarily in natural gas pipelines and utilities—TRP could eliminate a segment that acted as a drag on its stock’s trading multiple. Liquids-focused long-haul pipeline businesses trade at EV/EBITDA multiples below 10.0x. By contrast, a pure-play natural gas and utilities business would trade in line with publicly-listed peers at an EV/EBITDA multiple greater than 11.5x, well in excess of TRP’s 10.1x. Moreover, the two new standalone entities could benefit from greater operational focus and from management teams that are more strongly incentivized to expand in their respective markets.
Today, TRP shares trade at a 10.5x EV/EBITDA multiple. As such, they still offer significant upside if their multiple re-rates to 11.5x or above...