Politics, Oil Prices Create Opportunity in TransCanada (TRP)

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Dec 15, 2014

TransCanada (TRP, Financial) shares have fallen nearly 20 percent over the past three months. Concerns such as the most recent Keystone pipeline bill being shot down by the Senate, falling oil prices, and critics' arguments that even if approved by Congress, the Keystone pipeline is no longer economically feasible due to recent trends in lower oil prices have caused the stock to plummet.

The recent negative trend in oil is undeniable, as is the correlation between oil and TransCanada’s stock (as shown below). However, the charts have been less correlated in the past few months, mostly due to the hope that the Keystone pipeline bill would be approved by Congress, followed by the subsequent market reaction to the “no” vote by the Senate on November 18.

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The Senate’s vote and falling oil prices have caused an overreaction in the stock’s price. Although TransCanada hoped that the bill would pass on November 18, it is by no means the last time that the bill will be presented to Congress. With all Republicans historically voting party-line in favor of the pipeline and a growing number of Democrats supporting the bill, combined with the power shift in the Senate in this following year, it seems clear that the Republicans will be able to get the 60 votes necessary to pass the bill.

"This will be an early item on the agenda in the next Congress, and I'm very confident we will be able to get it to succeed," said soon-to-be Senate Majority Leader Mitch McConnell following the Senate’s decision (Foran).

One critic’s argument is that President Obama would veto Congress’ bill. However, many others argue that the president will use the pipeline as political leverage, using it to get other spending power such as large investments in infrastructure in an effort to promote bipartisanship in the now Republican-controlled Congress. Even if the president does not play this political game, there is a possibility that the Republicans could get the 67 votes necessary to override the president’s veto in wake of a growing number of Senate Democrats in favor of the pipeline.

Another argument made against TransCanada is that, even if the pipeline does get approved, it will no longer be feasible for the company to undertake the project. The bears are correct in asserting that slumping oil prices may have a short-term impact on profitability. The company’s projected cost of the project that will carry roughly 830,000 barrels per day (TransCanada) has risen from $5.4B to $8B due to the lengthy political debate and increased costs.

Although some of these arguments are valid in the short term, the company seems undeterred. In response to falling oil prices and questions about whether the Keystone pipeline would still be economically viable, TransCanada spokesman Shawn Howard said “We don’t build projects like this on short-term prices; it’s with a long-term view in mind.” (Snyder)

Although smaller players in the business may be forced to halt projects due to short-term price fluctuations, huge players such as TransCanada, with $53.9B in assets and $3.3B in annual operating income, tend to look at the longer view of the industry and do not base long-term projects on today’s oil prices. Thus, it is assumed that Congress will inevitably approve the pipeline sometime in 2015 and that TransCanada will decide to undertake the project.

Due to how the market reacted when the 2014 bill had a chance of passing, these two assumptions are potential catalysts for a rally in 2015.

However, I believe that the market has overreacted on both positive and negative news regarding the Keystone pipeline. It seems that the market has become too caught up in this $8B project and fails to remember that the Keystone pipeline is a relatively small portion of the total projects that TransCanada is undertaking. For instance, TransCanada has also launched a $10B Energy East project, a $2B Merrick Mainline project, and a $600M Tamazuncale pipeline in Mexico. Although an $8B project cannot be written off as “nothing”, I certainly believe that the significance of the project has caused overreaction by U.S. investors due to the political spotlight the debate has created.

Because the success and failure of the stock doesn’t solely depend on the success or failure of the final leg of the Keystone pipeline, it is also very important to consider other factors that influence the price of the stock.

The company anticipates EBITDA to grow from $4.8B (2013) to $10B in 2020. TransCanada expects 8% growth in the next 3 years followed by 3 years of 16% growth, according to the CEO in last year’s annual report. TransCanada expects to achieve this growth by $46B in new projects, making the $8B Keystone pipeline only about 20% of expected projects.

The company has a dividend that yields about 4% and the company has noted that they will grow the dividend at 8% per year for at least the next 3 years. Although this seems like an attractive yield for many normal U.S. investors, it is actually a lower yield than average (United States) MLPs. Many investors have pushed TransCanada to raise their dividend in previous years, citing that a rise in dividend and an 80% cash flow payout could cause U.S. investors to value the stock between $70-$85 (USD).

However, TransCanada doesn’t seem likely to significantly increase dividend yield in the short term, noting that their conservative structure has worked well for them throughout their history. As already discussed, the company has undertaken significant projects that are capital-intensive, so a large change in dividend is likely unlikely, although it would be a huge catalyst for the stock if a dividend increase were to occur.

Another potential catalyst for a move is for activist investor group Sandell Asset Management to become more involved with the company. Sandell is pushing TransCanada to spin off TransCanada’s power business, claiming that shares could be valued as much as $75 if the spinoff occurred. (Krugel)

Sandell claims that there is no need for TransCanada’s oil and pipeline business to be in the same corporation as its nuclear power operations. Sandell also believes that separating the two businesses would help reduce volatility that results from the power and energy markets. The company rejected Sandell’s proposal, calling the proposal “flawed” but not elaborating on the substance of his points. Although this spinoff doesn’t seem like it will happen in the short-run, its implications should be a consideration before purchasing the stock.

Regardless of whether or not the Keystone line gets approved or if Sandell’s complaints get any attention, the company’s underlying financials are strong. Gross margins have improved from 43.5% in 2007 to 64.5% in 2013, while net margins have increased from 13.8% in 2007 to 21.7% in 2013. Although margin volatility can be expected due to oil prices, the company has historically done quite well in increasing operational efficiency to maintain relatively stable margins even as the price of oil fluctuates, as shown below (Data from Town, Phil site). Note that net margins remained stable even during 2008 while the price of oil plummeted. Thus, I think some of the market’s reaction and focus on how harmful oil’s drop will be to TransCanada is over-exaggerated.

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Further, the company has an exceptional record of keeping return on equity consistent, as shown below. The company has achieved an average of over 10% ROE over the past 10 years, navigating successfully through many different oil prices and market conditions.

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From a technical standpoint, it seems that the current levels are close to a buying opportunity. If the stock falls about another 4% to $43, there is a significant floor that has held since the beginning of last year. I would consider buying my first tranche at that level, and another tranche between $39-$40, which is a previous floor (illustrated below).

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I believe that due to potential 2015 catalysts, a recent market overreaction, and solid fundamentals, TransCanada is a buy at $43. I will likely be writing a follow-up article with an investment idea that could hedge this position due to potential price volatility as a result of short-term changes in the price of oil

References

Foran, Clare, and Ben Geman. "Here's What's Next for the Keystone Pipeline." The National Journal. 8 Nov. 2014. Web. 12 Dec. 2014. .

Krugel, Lauren. The Financial Post. 17 Nov. 2014. Web. 12 Dec. 2014. .

Snyder, Jim. "Keystone Pipeline Foes Energized as Tumbling Crude Prices Pinch Oil Sands." The Financial Post. 24 Oct. 2014. Web. 10 Nov. 2014. http://business.financialpost.com/2014/10/27/keystone-pipeline-foes-energized-as-tumbling-crude-prices-pinch-oil-sands/?__lsa=8e63-8214

TransCanada. "Keystone Project Overview." TransCanada, 1 Jan. 2014. Web

Town, Phil. "TransCanada: Numbers View." Rule #1 Investing. Web. 12 Dec. 2014.