Canadian Pipeline Valuations Reach Four-Year High as Investors Seek Yield
Canadian investors are so starved for income that they’re buying pipeline owners trading at the highest valuations in four years.
TransCanada Corp. (TRP), Enbridge Inc. (ENB) and the four other Standard & Poor’s/TSX Composite Index companies that store and transport oil and gas are offering average dividend yields of 4.05 percent. That’s 1.48 percentage points above the full index’s rate and 1.16 points more than the payout on Canadian 10-year government bonds. The industry’s valuation has jumped to 21 times earnings and reached 22 in May, the highest since 2006.
Toronto-Dominion Bank, Goodman & Co. and Sentry Select Capital Corp. recommend pipeline operators because of their payouts and reliable profit growth. BlackRock Inc., Franklin Resources Inc. and Deutsche Bank AG bought shares of both TransCanada and Enbridge this year.
“That’s a very powerful combination,” said Jason Gibbs, manager of Goodman’s C$190.7 million ($197.5 million) Dynamic Global Infrastructure Fund, which has returned 6.3 percent this year to beat 94 percent of its peers, according to data compiled by Bloomberg. “You have earnings visibility, cash flow visibility, dividend yields above the TSX, dividends that are growing.”
Investors are buying as the European debt crisis spurs demand for the safety of North American government bonds, driving down yields. New money exceeded redemptions at income funds by C$1.52 billion during the first five months of the year, the most for a comparable period since 2007, according to data compiled by the Investment Funds Institute of Canada. Assets rose 16 percent to a record C$51 billion.
Beating the Market
Storage and transportation stocks in the S&P/TSX have risen 9 percent this year, compared with the index’s 1.6 percent decline, as concern that a Greek default will slow growth drove investors to industries least-tied to the economy.
During the two years ended in November 2009, a period that included the first global contraction since the 1930s, the industry grew earnings by 15 percent. Companies in the MSCI World (MXWO) Index of shares in 24 developed nations saw a 48 percent decrease. Profits among pipeline operators rise and fall independently of other companies’, with the so-called correlation coefficient over the last 30 months at 0.08, according to Bloomberg data. Readings of zero mean there’s no connection, while 1 means they’re moving in lockstep.
About 80 percent of Enbridge’s income comes from contracts lasting about 20 years on average, in businesses where rates are set by governments, said Jennifer Varey, a company spokeswoman. TransCanada forecasts that 90 percent of its earnings before interest, taxes, depreciation and amortization will be “contracted and predictable” this year, Greg Lohnes, president of its gas pipelines unit, said at a May conference in Orlando, Florida.
The typical pipeline operator is “not a manufacturing company that can have a good year this year and a bad year next year,” Gibbs said. “It’s a company with hard assets in the ground, with contracts with good customers.”
The industry’s valuation is 9.7 percent more than the S&P/TSX’s multiple. When the premium was 15 percent on June 17, it was the biggest gap since March 2009, three weeks after global equities entered a bull market.
The surge in pipeline valuations makes the stocks more susceptible to a temporary pullback following bad news, said Dennis Mitchell, a money manager at Sentry Select in Toronto, which oversees about C$7 billion, including pipeline companies’ shares. The industry index fell 2.4 percent in June, the first monthly drop since November. The S&P/TSX Composite dropped 3.6 percent, the fourth straight retreat.
TransCanada has decreased 5.5 percent this month after a University of Nebraska study said the company’s proposed Keystone XL pipeline could contaminate the water supply for hundreds of thousands of people if there were a rupture.
The decline in pipeline shares will be short-lived because industry prospects remain positive, said Robert Catellier, an analyst at Clarus Securities Inc. in Toronto. The stocks will continue to advance as interest rates remain low and developments in extraction technology, such as horizontal drilling and hydraulic fracturing of rock formations to release gas and oil, increase fuel volumes.
“The short-term risk has definitely increased, but the long-term factors still remain strong,” said Catellier, whose recommendations produced gains of 48 percent in the past year. “As long as you believe in the fundamentals, you take advantage of short-term gyrations in support of your long-term view.”
Not Much Riskier
Pipeline companies may retain an advantage given that bond yields are forecast to remain at current levels. Most economists in a Bloomberg survey forecast the yield on Canadian 10-year government bonds will remain under 3.90 percent until at least the fourth quarter of 2012.
TransCanada, based in Calgary, yields 4.20 percent after rallying 5.4 percent since Dec. 31. Enbridge, also of Calgary, pays out 3.13 percent of its stock price in dividends after its 11 percent advance in 2011. Canadian 10-year government bonds yield 2.89 percent.
“The yield on the pipeline stocks is very attractive relative to Canadian bond yields, so they’re not really looking expensive,” said Michael Lough, co-manager of the C$4.1 billion TD Dividend Growth Fund. “As an income play, they’re looking quite reasonable.”
As economists’ forecasts for North American economic growth in the next two years have declined, the stability of pipeline companies’ earnings are more important, since a growth slowdown may limit profits in other industries, Gibbs said. Economists’ median forecast for the U.S. gross domestic product increase in 2011 has dropped to 2.5 percent from 2.7 percent in May, and the median forecast for 2012 has declined to 2.9 percent from 3.1 percent, according to Bloomberg surveys.
The gains in Canadian pipeline stocks are part of a global trend toward equities less sensitive to an economic slowdown. Two so-called defensive industries, health care and consumer staples, advanced the most among 10 groups in the MSCI World Index of developed-market stocks last quarter.
“People are trending toward defensive stocks that have less risk of imploding,” Mitchell said. Pipeline owners’ dividends will attract more investment as interest rates and bond yields remain at historical lows, he said.
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