(Published by Nick McCullum on July 4)
The energy industry is known for housing exceptional dividend stocks.
When we think of dividend energy stocks, however, the heavyweights – Exxon Mobil Corp. (XOM, Financial), Chevron Corp. (CVX, Financial) and Royal Dutch Shell (RDS.B, Financial) – tend to come to mind. We generally do not immediately think of smaller, regional energy players.
Smaller energy companies can be a surprisingly good source of dividend income. Inter Pipeline Ltd. (IPPLF, Financial) (TSX:IPL, Financial) is one example of this.
On the surface, there is a lot to like about Inter Pipeline. The company has increased its dividend for 14 consecutive years. This shows the company is clearly committed to long-term dividend growth.
Along with its strong dividend history, the company has a high dividend yield of 6.4%. In addition, Inter Pipeline pays its dividendmonthly, making it ideal for retirees or other investors who need to budget their dividend payments.
The company’s strong dividend history, very high dividend yield and monthly dividend payments are three reasons why the company appeals to dividend growth investors.
Business overview
Inter Pipeline is an energy infrastructure company engaged in the transportation, storage and processing of energy products in Western Canada and Europe.
The company is headquartered in Calgary, Alberta and has a market capitalization of 9.4 billion Canadian dollars ($7.2 billion). The company is divided into four distinct segments for reporting purposes:
- Oil sands transportation (49% of EBITDA)
- NGL processing (26% of EBITDA)
- Conventional oil pipelines (17% of EBITDA)
- Bulk liquid storage (8% of EBITDA)
More details about each of the company’s operating segments can be seen below.
Source: Inter Pipeline June 2017 Investor Presentation, slide 3
As mentioned, Inter Pipeline operates in two geographies: Western Canada and Europe.
In Canada, the company owns assets in two provinces: Alberta and Saskatchewan.
In Europe, the company's operations can be found in Ireland, England, Germany, Denmark and Sweden.
A map showing the geographic distribution of Inter Pipeline’s operations is below.
Source: Inter Pipeline June 2017 Investor Presentation, slide 4
The vast majority (92% of EBITDA) of Inter Pipeline’s business lies in its home country of Canada.
Growth prospects
Inter Pipeline’s growth strategy is quite simple: issue new shares and use the proceeds to acquire high-quality energy infrastructure assets that generate revenue through long-term, risk-insulated contract agreements.
There are certainly benefits to this strategy.
By being a chronic issuer of shares, the company has a readily accessible pool of capital it can leverage to acquire additional assets.
The growth strategy also has downsides, however.
Namely, the company’s share count has nearly doubled over the past decade.
Source: YCharts
Normally, this would be a very bad sign. Shareholder dilution can have a tangible negative effect on the intrinsic value of a business.
There are two situations where issuing shares to buy new assets can be beneficial for a business’ existing shareholders.
The first is when the company’s stock is overvalued. To put it simply, selling overvalued stock is a good idea whether you are a investor or an employee in the treasury management department.
The second is when the assets being acquired are accretive to a company’s earnings per share.
For instance, if Inter Pipeline is trading at a price-earnings ratio of 25 and is acquiring a company with a price-earnings ratio of 10, then every dollar of stock the company issues to fund the transaction will result in an increase in pro forma EPS once the transaction closes.
This is because the company being acquired is trading at a lower price-earnings ratio than the stock that is issued to fund the transaction. For Inter Pipeline, the relevant metric is likely funds from operations (not EPS), but the principles underlying the concept of EPS accretion remain the same.
So how do we measure the performance of Inter Pipeline’s potentially dilutive growth strategy?
We can look at the company’s per-share performance, shown below.
Source: YCharts
Aside form some lean times in 2013-14, Inter Pipeline’s FFO per share has more than doubled over the past decade.
This shows its company-wide funds from operations have grown at a much faster pace than its share count, indicating its growth strategy is working. It is either issuing overvalued stock, engaging in accretive acquisition deals or some combination of the two (most likely).
Looking ahead, Inter Pipeline’s growth strategy will likely remain the same: issue company stock and use the proceeds to buy high-quality energy infrastructure assets.
Prospective investors should keep in mind that if Inter Pipeline purchases some less-than-stellar assets, it will be hit with the two-sided effect of poor absolute financial performance and dilution for existing shareholders.
Competitive advantage and recession performance
Inter Pipeline’s main competitive advantage comes from its low-risk business model.
The company typically buys assets and sells their use to a creditworthy counterparty under long-term, inflation-adjusted, commodity-insulated contracts.
Most of Inter Pipeline’s contracts are with highly creditworthy counterparties, with more than 80% of the company’s revenues being derived from investment-grade counterparties.
Source: Inter Pipeline June 2017 Investor Presentation, slide 33
The company also has a very attractive debt maturity profile.
Inter Pipeline only has one tranche of debt expiring in 2017 to 2019, and its debt thereafter is well-laddered, with a weighted average maturity of approximately nine years.
The company also has an average cost of debt of approximately 3.6%, which shows the financial markets view this company as a reasonably low-risk enterprise. Inter Pipeline has a BBB+ credit rating from S&P.
Source: Inter Pipeline June 2017 Investor Presentation, slide 34
I would expect Inter Pipeline to perform relatively well during a recession because of its low-risk business model. The company’s performance during the 2007-2009 financial crisis validates this claim:
Source: YCharts
Inter Pipeline’s FFO per share declined by about 50% during the recession, although much of this was a retracement after a significant run-up starting in 2007. Further, the company recovered its previous level of profitability shortly thereafter.
The company’s low-risk business model and strong historical recession performance make it an attractive high-yield dividend stock for investors building energy exposure in their portfolio.
Valuation and expected total returns
Inter Pipeline’s future shareholder returns will be composed of valuation changes, dividend yield and growth in FFO per share.
The company owns and operates long-lived energy assets like pipelines and storage tanks.
Accordingly, this company incurs significant non-cash depreciation and amortization charges, which impair our ability to analyze its valuation using the traditional price-earnings ratio.
One straightforward alternative is to compare the company’s current dividend yield to its long-term historical average dividend yield.
Inter Pipeline currently pays a monthly dividend of 13.5 cents, which yields 6.4% on the company’s current stock price of $25.40.
The following diagram compares Inter Pipeline’s current dividend to its long-term historical average.
Source: YCharts
Inter Pipeline’s current dividend yield of 6.4% is meaningfully elevated above its five-year average of 4.9% and slightly above its 10-year average of 6.3%. The company is likely trading slightly under its fair value (relative to historical norms).
As with any high-yield dividend stock, we should take a moment to assess the safety of Inter Pipeline’s dividend before blindly purchasing this security. The following diagram shows the company’s dividend payments have been more than covered by its FFO since (at least) 2011.
Source: Inter Pipeline June 2017 Investor Presentation, slide 7
Looking at Inter Pipeline’s most recent quarter, the company reported per-share funds from operations of 67 cents and paid dividends of 40.5 cents, giving it a payout ratio of approximately 60% in the most recent quarter.
All said, the company’s dividend appears safe right now and for the foreseeable future.
The remainder of the company’s shareholder returns will be composed of FFO growth. Looking back historically, Inter Pipeline has grown its FFO at around 10% per year over the past decade.
I believe growth will be slower going forward and investors can conservatively expect FFO growth of 4% to 6% over full economic cycles.
Thus, Inter Pipeline’s total returns will be composed of:
- 6.4% dividend yield.
- 4% to 6% FFO growth.
For expected total returns of 10.4% to 12.4% over full economic cycles.
Final thoughts
Inter Pipeline has a number of characteristics that help it stand out to dividend investors, including 14 years of consecutive dividend increases, a 6.4% dividend yield and monthly dividend payments.
Further due diligence reveals this company appears to be a well-managed, profitable enterprise. While I cannot say I am particularly fond of its shareholder dilution, it is a growth strategy that has worked well (so far) for the company.
All said, Inter Pipeline merits further research or potential investment for investors looking to accumulate additional energy exposure in their portfolios. This holds especially true for Canadian investors as they will avoid any tax complications that occur from holding international securities in taxable accounts.
Disclosure: I am long XOM.
