Comments from RBC
June 1, 2021
Pembina Pipeline Corporation
The potential to go from good to great
Robert Kwan, CFA (Analyst)
Our view: While the industrial logic of a merger makes sense between
Pembina and Inter Pipeline (IPL), we were still surprised by Pembina's
involvement in the transaction given the company's focus on its existing
asset footprint and maintaining an increasingly conservative financial
structure. In our view, the market's response to the transaction will initially
hinge on the risk to the credit and other financial metrics (real and
perceived) and longer-term, the ability to capture synergies, develop new
high-return growth projects and optimize the capital allocation (particularly
through asset monetizations).
Key points:
The industrial logic is clear. Particularly looking at the NGL assets and
the Heartland Petrochemical Complex (HPC), the strategic fit of Inter
Pipeline's assets with Pembina's footprint has the ability to drive revenue/
commercial synergies. In particular, we see the potential to optimize flows
and capture additional customer volumes from the ability to offer multiple
services (e.g., access to HPC as part of the marketing pool).
On the surface, the numbers look good. We like the messaging on
immediate adjusted funds from operations (AFFO) per share accretion,
which we estimate at 7% in 2022E (first full year), achievable cost and
operational synergies and the ability for Pembina to stay within its financial
guardrails.
Digging into the details though is the important part and there are some
unknowns. Pembina did not disclose its assumptions around items like
commodity prices and EBITDA coming from HPC. We believe that the
sensitivity/potential volatility around the base figures will be important for
investors to fully assess the transaction.
We believe the focus will be on the credit and financial metrics... We think
that items such as the optics of Inter Pipeline's high current debt leverage
(i.e., prior to the commissioning of HPC) and uncertainty with respect to
potential credit rating actions will be an overhang on Pembina's shares in
the near-term. Over the medium-term, we believe the market will focus on
Pembina's ability to stay within its guardrails if commodity prices fall.
...however, we see asset sales as a way to take the transaction from
good to great. We believe the transaction provides Pembina with a suite
of asset monetization candidates that could have the multi-faceted benefit
of: (1) putting any concerns about credit to rest by reducing leverage;
(2) highlighting an attractive valuation marker for the remaining assets;
(3) improving the returns on capital employed; and (4) increasing the
growth rate by monetizing low growth, or declining, assets. Specifically, we
highlight the oil sands pipelines, which could be partially or fully monetized,
and in particular the high-leverage, low-return Corridor pipeline system.
The strategic rationale is obvious
· Expanding the “Pembina Store”: strong industrial logic for a merger. Particularly looking
at the NGL assets and the Heartland Petrochemical Complex (HPC), the strategic fit of Inter
Pipeline's assets with Pembina's footprint has the ability to drive revenue/commercial
synergies. In particular, we see the potential to optimize flows and capture additional
customer volumes from the ability to offer multiple services (e.g., access to HPC as part of
the marketing pool).
o An enhanced condensate system. The merger would combine Pembina’s existing
condensate gathering and transportation infrastructure (the Peace, Drayton Valley,
and Cochin pipelines) with Inter Pipeline’s systems that bring condensate to Alberta’s
oil sands (e.g., Polaris pipeline).
o Integrating the NGL footprint. There are numerous options for Pembina in the future
including interconnecting plants like Cochrane, optimizing the two Redwater assets,
moving propane from its terminals into HPC and using Pembina's logistics network to
move products to market from Inter Pipeline's facilities.
Near-term opportunities for high-return asset integration. Management sees $450
million of new project opportunities that are “readily actionable and uniquely available”
for the combined company, which could generate roughly $100 million of incremental
adjusted EBITDA (i.e., a very attractive EBITDA build multiple of roughly 4.5x). Specifically,
it sees an opportunity to connect Inter Pipeline’s Cochrane straddle plant to Pembina’s
Brazeau pipeline system, which would enable the propane-plus liquids stream to be
transported and processed with Pembina’s infrastructure, with a further connection to
HPC. Management also believes the combined company will have the required supply of
butane to support the development of a butane splitter in Fort Saskatchewan.
· Synergies appear to be very achievable. On a run-rate basis, the company expects $100-
150 million of annual synergies from lower G&A and operating costs that the company
expects to be realized in the first year after closing. We note that Inter Pipeline's G&A line
item in 2020 was almost $200 million (prior to the re-segmentation). Pembina expects the
remaining $50 million of synergies will come from commercial and product optimization.
· Longer-term growth opportunities look robust. Including the near-term $450 million of
opportunities noted above, Pembina expects the combined company will have visible
unsanctioned investment opportunities in excess of $6 billion. Management also expects
a better probability of project success and increased capital efficiency through a
combination of the two companies’ portfolios. Pembina also noted that the success of
HPC could pave the way for Pembina to evaluate the polypropylene project it previously
mothballed.
· HPC requires approximately $800 million to complete. As of Q1/21 reporting, Inter
Pipeline had spent approximately $3.4 billion on HPC, compared to a final cost estimate
for the project of $4.2 billion, meaning roughly $800 million of spending is required
through the project’s expected start-up date of early 2022. Approximately 90% of on-site
construction for the PDH and PP units and central utility block was complete as of May
2021.
On the surface, the numbers look good
· We estimate an EV/EBITDA transaction multiple of approximately 9-10x pro forma HPC.
We estimate that the transaction's EV/EBITDA is in the range of 9-10x using Inter Pipeline's
$450-500 million long-term annualized EBITDA guidance for HPC with the lower-end of
the range assuming Pembina's guidance for synergy capture.
· On a preliminary basis, we expect AFFO/share accretion of 7% in 2022; could be closer
to 15% using the long-term run-rate for HPC and synergy capture. As shown in Exhibit 4,
we estimate that the transaction could be roughly 7% accretive to AFFO/share in 2022
using the low-end of Pembina's year one guidance for synergies. We have also set out our
initial expectations for the run-rate accretion in the range of 15% assuming a full ramp-up
for HPC as well as Pembina's guidance for year two synergies at the mid-point.
· Pembina poised to increase dividends on the back of the transaction. The company
announced that it expects to increase its dividend post the close of the transaction to an
annualized rate of $2.64/share (up 4.8% from current levels) with a further increase to an
annualized rate of $2.76/share following the successful commissioning and in-service of
HPC, which is targeted for 2022.
· Some management assumptions remain undisclosed. Pembina did not disclose its
assumptions around items like commodity price expectations and EBITDA coming from
HPC. We believe that the sensitivity/potential volatility around the base figures will be
important for investors to fully assess the transaction.
Pembina expects to remain within its financial guardrails
While pro forma metrics slip slightly versus Pembina’s current positon, the company expects
to remain well within its financial guardrails on fee-based contribution, dividend payout,
counterparty credit exposure, and expected credit rating based on FFO/debt coverage.
· Credit metrics should improve as HPC ramps up. Management expects pro forma
adjusted funds from operations-to-adjusted debt (rating agency methodology) of
approximately 17-19% over the next three years, with improvement in the metric as HPC
comes into service and ramps into its long-term run rate contribution range.
· We expect HPC to be less than 10% of pro forma adjusted EBITDA. Inter Pipeline has
previously outlined that it expects HPC to generate $400-450 million of EBITDA in its first
full year of operations (2023), and $450-500 million of annual EBITDA as a long-term run
rate. Of note, the 2023 EBITDA figure incorporates a grant of roughly $136 million under
the Alberta Petrochemicals Incentive Program (APIP) and a polypropylene to Edmonton
propane spread of approximately US$1,200 per tonne. The long-term run rate represents
a 10-year average (excluding the 2022 stub year), higher polypropylene spreads, lower
operating costs, higher production rates, and a debottlenecking project in the 2025 time
frame that could increase capacity by roughly 10%. For additional details with the latest
update on Inter Pipeline’s HPC project, please click here to access our note from Q1/21
reporting in early May.
We would view material asset monetizations very favourably
We believe the transaction provides Pembina with a suite of asset monetization candidates
that could have the multi-faceted benefit of: (1) putting any concerns about credit to rest by
reducing leverage; (2) highlighting an attractive valuation marker for the remaining assets; (3)
improving the returns on capital employed; and (4) increasing the growth rate by monetizing
low growth, or declining, assets.
· Will they or won't they? We believe it is appropriate to take a wait and see approach to
asset sales. While Pembina noted the potential for asset sales on its conference call, we note
that material asset monetizations would mark a significant departure from Pembina's
historical strategy, partly as Pembina's asset footprint has been strategically linked and a
sale of a material asset could have negative implications for the remaining assets.
· The big opportunity from our perspective is to potentially monetize a portion of the oil
sands pipelines. Whether it be the high-leverage, low-return Corridor pipeline system on
a stand alone basis, or a partial sale of the collective oil sands pipelines (with Pembina
retaining operational control), we believe these assets represent an attractive potential
opportunity for Pembina to drive meaningful value while improving investor sentiment.
We estimate the combined oil sands pipelines business will generate roughly $1 billion of
annual EBITDA.
· The sale of the remaining European storage would make sense to clean up the portfolio,
but this would not move the needle (numbers or sentiment wise). While the sale of Inter
Pipeline's remaining bulk liquid storage terminals in Europe would help clean up the asset
portfolio, these assets are fairly small in size (roughly $60 million of estimated annual
EBITDA) and would likely attract a relatively low valuation, particularly given the
significant indirect commodity exposure (contango and volumes) for the Gulfhavn
terminal in Denmark.
Thoughts on a potential Brookfield response
· We think BIP will remain disciplined. We continue to expect that BIP would have minimal
support from its unitholders for a headline bid above $20.00/share, which leaves minimal
room for an increase to its offer above the $19.45/share implied in Inter Pipeline’s
agreement with Pembina (based on the exchange ratio of 0.5 shares of Pembina for each
share of Inter Pipeline and Pembina's current share price). We also note BIP's history of
walking away from publicly disclosed transaction processes when the valuation gets out
of hand (e.g., Cincinnati Bell, Invepar) and given BIP's toe-hold position, walking away
should also net a tidy profit.
· BIP has the toe-hold while the synergies favour Pembina. Given Pembina's strategic
footprint and the ability to capture integration and optimization synergies, we believe that
Pembina has a much greater ability to generate cost and revenue/commercial synergies
from an acquisition of Inter Pipeline.
· We think additional parties entering the fray is unlikely. Given the transaction with a
strategic party like Pembina, the associated break fee and deal protection, and the added
complication of BIP and its toe-hold position, we believe it is unlikely that another party
will get involved at this stage.
· BIP’s offer expires June 7. We think BIP will announce its intentions in relatively short
order and before the expiration of its bid on June 7, 2021, assuming it does not extend
and/or increase its offer.
Investment summary
We expect Pembina’s shares to outperform its peers for the
following key reasons:
• The Inter Pipeline transaction makes sense from an
industrial logic and numbers perspective. Particularly
looking at the NGL assets and the Heartland Petrochemical
Complex (HPC), the strategic fit of Inter Pipeline's assets
with Pembina's footprint has the ability to drive revenue/
commercial synergies. In particular, we see the potential to
optimize flows and capture additional customer volumes
from the ability to offer multiple services (e.g., access to HPC
as part of the marketing pool). From a numbers perspective,
the transaction keeps Pembina within its financial guardrails
and we also estimate that the transaction will be
immediately accretive to AFFO/share.
• We see asset sales as a way to take the Inter Pipeline
transaction from good to great. We believe the transaction
provides Pembina with a suite of asset monetization
candidates that could have the multi-faceted benefit of:
(1) putting any concerns about credit to rest by reducing
leverage; (2) highlighting an attractive valuation marker for
the remaining assets; (3) improving the returns on capital
employed; and (4) increasing the growth rate by monetizing
low growth, or declining, assets. Specifically, we highlight
the oil sands pipelines, which could be partially or fully
monetized, and in particular the high-leverage, low-return
Corridor pipeline system.
• Potential catalysts. Clarity on the process to close the Inter
Pipeline transaction; improved investor sentiment towards
energy and midstream stocks; additional volumes for the
conventional pipeline system; government programs that
strengthen oil and gas producing customers; increased
Montney producer activity on the back of the sanctioning of
the third-party LNG Canada project.
Risks to rating and price target
Risks to our price target and rating include: (1) actual
economics for the Inter Pipeline transaction being materially
different from our forecast, (2) the impact of COVID-19
and a weak market for energy including lower-thanexpected
throughput on the pipeline systems, (3) regulatory
intervention, (4) the ability to complete new projects on time
and on budget, (5) operational issues, (6) reduced margins in
the midstream and marketing segment, and (7) acquisitions,
investments and/or projects that fail to gain the confidence of
investors.