Pipelines aren’t the cash cows many people think they are

A memo to the Liberal government, regarding Trans Mountain: Are you sure you want to buy this thing?

The owners of Canadian pipelines have discovered something in recent years: It takes an awful lot of money to build and maintain them, year after year, and they don’t generate as much cash as you’d think.

For a government that is buying control of the Trans Mountain pipeline for political reasons and hopes to flip it to a new owner soon, this may not matter. But for investors in the industry’s publicly traded companies, the cash-flow question is a critical one. The stocks of three of Canada’s biggest pipeline companies — Enbridge Inc., TransCanada Corp. and Pembina Pipeline Corp. — all touched 52-week lows in early April.

Pembina has rebounded sharply since, but Enbridge and TransCanada are still closer to that low than to their 52-week high. And those two have needed to put the best face on their results as credit-ratings agencies, concerned by their debt, have expressed concerns about their credit quality.

It wasn’t always so. Through a “golden era” of pipeline expansion, the Canadian players spent heavily on new projects, collected handsome fees from energy producers and maintained or boosted generous dividends. And investors applauded. In early 2015, for instance, Enbridge soared to new highs of about $66.

Today, it’s about $40, which reflects an increasingly dim view of companies with meaningful debt levels. Worldwide, the shares of more highly leveraged companies have underperformed those with healthier balance sheets.

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And there may be increasing concern about the cash-flow profile of the Canadian pipeline companies, specifically. Investment managers who are betting against Enbridge and TransCanada, the two biggest companies, say the combination of significant capital spending and frequent dividend increases is unsustainable. Either the capex has to slow down, or the dividend growth does. If the past several years were a golden era for the pipelines, they wonder, what would the bad times look like?

Many Canadians are already exposed to pipeline risk, because Enbridge, TransCanada and Pembina make up about 7 per cent of the S&P/TSX Composite Index, on which many mutual funds and exchange-traded funds are based. Now, the economics of the industry are also a matter for taxpayers, who need to understand that the picture often painted of a stable, cash-gushing domestic business has a darker side.

To see this, we turn to the companies’ financial statements, as presented in the Standard & Poor’s Global Market Intelligence database.

Cash from operations, as calculated according to International Financial Reporting Standards, is a measure of the cash the company produces from its day-to-day business. Capital expenditures are what the companies spend on long-lived assets — their pipeline projects.

The difference — operating cash flow minus capital expenditures, is considered by many investors to be “free cash flow,” the amount of money left over for the pipelines’ owners.

And what of the Canadian pipeline companies’ free cash flow, by this definition? It is an industry that has consistently, over the past decade, failed to generate cash from operations sufficient to fund both its capital spending and its dividends. In 30 fiscal years from 2008 to 2017 — 10 years for each of the three companies — they’ve produced just six years of positive free cash flow, by this strict definition. Pembina produced three of them, but only from 2008 to 2010. TransCanada’s two positive years were 2011 and 2012. Enbridge escaped negative territory only in 2016.

All told, over the 30 years surveyed, the three companies have generated just under $80-billion in cash from operations, but spent $113-billion on capital expenditures. Then, they’ve paid out nearly $25-billion in dividends.

Not coincidentally, they’ve issued almost $50-billion in net debt from 2008 to 2017.

This analysis varies wildly from the figures the companies present to investors, which are permissible under Canadian securities law and are widely accepted by the investment community, including the analysts who cover the companies. The companies point to their customized measures of profit, distributable earnings and dividend payout ratios. All exclude most of their tens of billions of dollars in capital expenditures over the past decade from these numbers; Enbridge and TransCanada designated a small portion of the capital expenditures as “maintenance capex” when arriving at their preferred cash-generations measures.

Contacted for comment, the companies emphasized the existing narrative, saying cash from operations should fund the annual dividends. Capital expenditures are long-term spending that expands the business and creates future profit. If the projected returns are compelling, that spending should be funded by selling debt or equity, rather than existing cash flow.

Enbridge CFO John Whelan tells The Globe and Mail his company has “stable, highly predictable cash flow. Our typical model is to pay out a fairly high portion, because of the reliability of the cash flow, as a dividend to shareholders. And then, periodically, raise capital as we need to, to invest in organic growth projects.”

In a statement, TransCanada spokesman Mark Cooper calls the company’s payout “a strong and growing dividend” and says it views its distribution as, generally, 40 per cent of “internally generated cash flow” with “the remaining 60 per cent available for reinvestment in accretive growth opportunities.” Mr. Cooper acknowledges the company does not always cover both its capital program and dividend, and says the company “has also accessed capital markets” to pay for projects “that are expected to generate significant growth in earnings, cash flow and dividends per share through 2020 and beyond.”

A Pembina spokesman, in a statement, says the former income trust has undertaken a large capital program since 2011 and “has funded this growth in a prudent manner which since 2011 has resulted in cash-flow-per-share growth of 79 per cent, dividend-per-share growth of 31 per cent and a reduction in its payout ratio from 85 per cent to 62 per cent, all while maintaining solid credit metrics and its investment grade rating.”

Pembina’s ratio of net debt — its debt, minus cash — to EBITDA, or earnings before interest, taxes, depreciation and amortization, averaged 4.8 in 2017, its highest level in the 10-year period, according to S&P. That’s better than Enbridge and TransCanada, however, whose ratios averaged 6.9 and 6.4 in 2017, respectively.

For Enbridge, that’s better than the long-term average, but concerns remain. Moody’s Investors Service downgraded the company in December, saying “the large, ongoing capital program and leveraged financial structure continues to put pressure on the company’s financial metrics.” The company is now moving to simplify its complex structure by reacquiring multiple publicly traded spinoffs and continuing asset sales that are raising billions of dollars.

One of the company’s many bond issues (it had $65-billion in outstanding debt at year-end) is a 10-year note convertible into preferred stock. In the company’s capital structure, the notes are senior only to equity, and representative of sophisticated investors’ views of Enbridge’s credit prospects. And in May, the notes’ price continued a long-term slide into an area that suggested junk-bond territory.

It may indeed be the end of an era for one of Canada’s most-favoured sectors, at least in the eyes of investors. For taxpayers, a new era of risk is beginning.