Published by Nicholas McCullum on May 19th, 2017
Midstream energy companies are widely-known to be a source of quality dividend income.
In many ways, midstream companies benefit from favorable economics. They benefit from the continued necessity of oil in the worldwide economy while being exposed to much less commodity price risk than their peers in the refining or exploration industries.
Pembina Pipeline Corporation (PBA) is one example of a midstream company rewarding its shareholders with high dividend income. This Canadian company – cross-listed on the Toronto Stock Exchange and the New York Stock Exchange – currently has a 4.7% dividend yield, more than twice the average yield of the S&P 500.
For investors looking for stocks with even higher yields, click here to see the list of 295 established companies with 5%+ dividend yields.
Pembina Pipeline’s common stock is unique among midstream oil companies because the companies dividends are paid monthly. For retirees or other investors that rely on their dividend income to cover expenses, this is highly superior to quarterly dividend payments.
Pembina Pipeline’s high dividend yield and monthly dividend payments make it an intriguing investment from an income perspective.
This article will analyze the investment prospects of Pembina Pipeline Corporation in detail.
Business Overview & Merger With Veresen
Pembina Pipeline Corporation is a Canadian pure-play energy infrastructure company based in Calgary, Alberta, Canada.
With a market capitalization of $17 billion at the time of this writing, Pembina is a member of the TSX 60 – the 60 largest companies in Canada by market capitalization.
Pembina is well-known among its investors for its phenomenal track record of delivering outsized total returns.
Pembina’s ten-year total return performance is compared to its benchmark – the S&P/TSX Energy Infrastructure Index – in the diagram below.
Source: Pembina Pipeline 2016 Investor Day Presentation, slide 16
On May 1, Pembina announced the intention to merge with Veresen (VSN) – another Canadian midstream company – to create a ‘leading North American energy infrastructure company’. In many ways, this is similar to the merger of Enbridge (ENB) and Spectra Energy (SE) earlier this year.
The transaction value is approximately $9.7 billion, including the assumption of debt. Here are some details of the transaction from the company’s press release:
“Pembina is offering to acquire all of the outstanding Veresen common shares in exchange for either (i) 0.4287 of a common share of Pembina or (ii) $18.65 in cash, subject to pro-ration based on maximum share consideration of approximately 99.5 million Pembina common shares and maximum cash consideration of approximately $1.523 billion. Assuming full pro-ration, each Veresen shareholder would receive $4.8494 in cash and 0.3172 of a common share of Pembina for each Veresen common share. This offer represents a 21.8 percent premium to Veresen’s 20 day weighted average price of $15.31 and a 22.5 percent premium to Veresen’s closing share price of $15.23 on April 28, 2017.”
Current Pembina shareholders are expected to own approximately 80% of the combined company and existing Veresen shareholders are expected to own the remaining ~20%. Investors should be pleased to hear that the executive management and board members of Veresen are electing to receive the all-stock proceeds of the transaction, if approved.
Details of how the combined company compares to the current Pembina and Veresen businesses can be seen below.
Source: Pembina Pipeline 2016 Investor Day Presentation, slide 7
This merger will dramatically increase Pembina’s existing scale-based competitive advantage.
The Veresen merger will make the combined company the fourth-largest energy infrastructure company in Canada, behind:
- TransCanada Corporation (TRP)
- Enbridge Income Fund (ENF)
Quantitatively, the Veresen transaction will increase Pembina’s total enterprise value by 45% (to $33 billion) and expected 2018 EBITDA by 45% (to a guidance range of $2.55 billion to $2.75 billion).
Source: Pembina Pipeline 2016 Investor Day Presentation, slide 90
More importantly, the transaction will meaningfully improve the operational diversification of both existing companies.
Looking at hydrocarbon mix, Veresen was highly concentrated in gas, while Pembina was focused on crude oil and natural gas liquids (NGLs). The new entity will have a roughly even mix of these three hydrocarbons.
From a geographic perspective, Veresen has a much better U.S.-Canada split (nearly 50-50) than Pembina does. Once the transaction closes, the new entity is expected to generate approximately 28% of 2018’s EBITDA from the United States and will benefit from new exposure to the U.S. Rockies geography.
More details about how the Veresen transaction improves the company’s operational diversification can be seen below.
Source: Pembina Pipeline 2016 Investor Day Presentation, slide 11
Moving on, the next section will discuss the growth prospects of Pembina Pipeline Corporation in detail.
The historical growth of the Pembina Pipeline Corporation has been nothing short of amazing.
Source: Pembina Pipeline 2016 Investor Day Presentation, slide 17
Investors should rightly be curious if the company’s historical growth can continue.
Fortunately, the company has a strong growth runway. There are many areas of the energy infrastructure business that Pembina has not penetrated.
These new potential business lines (along with a rough timeline of their introduction) can be seen in the following diagram.
Source: Pembina Pipeline 2016 Investor Day Presentation, slide 22
Pembina will also benefit from a likely recovery in commodity prices. The company’s stock has been impacted by declining oil prices and is trading well below its all-time high from 2014.
Now that the price of oil is starting to show signs of life, Pembina has the potential to return to past highs.
Source: Pembina Pipeline 2016 Investor Day Presentation, slide 31
Pembina will also benefit from the previously-discussed merger with Veresen.
This company will have a much-improved asset base and is expecting to realize substantial cost synergies as duplicate costs are identified and eliminated.
More specifically, Pembina is expecting to realize $75 million to $100 million of annualized cost synergies in the first full fiscal year after the merger with Veresen.
While Pembina will be able to reduce expenses after the merger, the company will also benefit from substantially higher revenues.
The new company will have $20 billion of unsecured growth opportunities and $4 billion to $6 billion of near-term secured growth opportunities.
Source: Pembina-Veresen Transaction Presentation, slide 4
Altogether, it appears that Pembina has very bright growth prospects, bolstered by the recently announced merger with Veresen.
Competitive Advantage & Recession Performance
Pembina’s competitive advantage comes from being an established player in an industry with two significant barriers to entry.
The first barrier to entry is regulatory. Due to the nature of pipeline construction, new projects must be approved by regulatory agencies and sometimes this approval can be very difficult to receive.
The second barrier to entry is scale-based. Pipelines are extraordinarily capital-intensive to construct. Pembina’s large size gives it a scale-based competitive advantage over its smaller competitors.
To sum up, Pembina is already an entrenched player in the energy infrastructure industry and will be the fourth largest company by enterprise value after the Veresen merger is completed. These barriers to entry give Pembina a durable competitive advantage.
Pembina appears to be fairly recession-resistant. The company continued to grow its dividend from 2007-2009 during the depths of the global financial crisis (although it kept its payout constant from 2009-2011).
Looking ahead, Pembina’s financial strength (relative to many other oil and gas companies) helps to ensure it will perform similarly well during the next recession.
Pembina has an investment-grade BBB credit rating, which it is committed to maintaining through the Veresen merger. Further, each of the company’s leverage metrics will be in Pembina’s target range after the transaction is completed.
Source: Pembina Pipeline 2016 Investor Day Presentation, slide 85
The company has five financial goals – which is calls ‘guard rails’ – that is is using to maintain its credit rating.
Investors should be pleased to see that each of these metrics is either going to improve or stay constant after the Pembina-Veresen transaction.
Source: Pembina Pipeline 2016 Investor Day Presentation, slide 83
Pembina also benefits from a long-dated debt maturity profile.
Pembina’s outstanding bonds have a weighted average maturity of 13 years, which compares well to the industry average of 8 years.
Intuitively, you would think that Pembina’s long-dated debt maturity profile would mean that the company has a higher interest expense than its peers. Longer maturity bonds have higher yields than shorter maturity bonds, all else being equal.
Surprisingly, this is not the case. Pembina’s weighted average coupon payment is 4.3% versus the industry average of 4.6%.
More details about Pembina’s current outstanding debt can be seen below.
Source: Pembina Pipeline 2016 Investor Day Presentation, slide 96
Altogether, Pembina’s historical performance and current balance sheet positioning mean the company will likely perform reasonably well through the next recession.
Valuation & Expected Total Returns
Future returns for Pembina’s shareholders will be composed of the stock’s current dividend yield, future valuation changes, and growth in the company’s earnings power.
Pembina currently pays a monthly dividend of CAD$0.17 per share which yields 4.7% on the company’s current stock price of CAD$43.25. The company’s stock listing on the New York Stock Exchange will trade at a similar yield under normal circumstances.
Assessing the valuation of the Pembina Pipeline Corporation is difficult because the company’s large fixed asset base generates substantial depreciation and amortization charges. These accounting charges reduce GAAP earnings-per-share, which make it troublesome to measure the company using the traditional price-to-earnings ratio.
There are a number of valuation techniques that can be used as an alternative: EV/EBIDTA and price-to-FFO are two of the more common fundamental metrics.
For a simpler (and likely equally effective) alternative, investors can compare Pembina’s current dividend yield to its historical dividend yield. As mentioned, Pembina currently yields 4.7%.
This yield is compared to the company’s long-term average in the diagram below.
Pembina’s current dividend yield is roughly in-line with its average dividend yield over the past several years. Thus, I would not expect valuation changes to have a material impact on the corporation’s future shareholder returns.
Aside from dividend payments and valuation changes, the remainder of Pembina’s expected total returns will be composed of growth in the company’s earnings power.
Pembina aims to achieve 8%-10% annual growth in cash flow (see the above slide on ‘guard rails’). Based on the company’s impressive track record, I believe this is possible, although investors may want to expect a more modest growth rate of 7%-9%.
Altogether, Pembina’s future shareholder returns will be composed of:
- 4.7% dividend yield
- 7%-9% growth in cash flow per share
For total returns of roughly 11.7%-13.7% over full economic cycles before the impact of valuation changes.
Pembina Pipeline is a Canadian Corporation. Accordingly, investors should be concerned about the tax implications of dividends from an investment in this midstream company.
Normally, the withholding tax on Canadian dividends for stocks held by international investors is 25%. This means that for every $1.00 of gross dividends paid, the Canadian government will withhold $0.25 (and additional tax will be paid to the IRS come tax time).
However, because of a special treaty between the Canadian government and the United States government, this withholding tax is reduced to 15% for U.S. investors. This means that for every $1.00 of dividends paid by Pembina to U.S. investors, $0.15 will be withheld on the Canadian side (and further tax will be paid to the IRS).
However, there is an alternative to paying this withholding tax. The withholding tax is waived when Pembina shares are held in tax-advantaged accounts like Roth IRAs, Traditional IRAs, and 401-ks.
With all this in mind, investors looking to generate portfolio income from an investment in the Pembina Pipeline Corporation would be best served to hold the shares in a tax-advantaged account.
Pembina Pipeline Corporation’s high dividend yield and monthly dividend payments are some of the biggest reasons why investors might take an initial interest in the company’s publicly-traded securities.
Looking more closely, Pembina appears to be well-positioned to grow over the mid-to-long term. The stock has been depressed from its 2014 high due to low oil prices, but the recently-announced Veresen merger has the potential to restore this stock to its previous growth trajectory.
Pembina’s current dividend yield and growth guidance together give a high probability of double-digit total returns for today’s shareholders. And, Pembina appears to be reasonably valued for investors desiring to initiate a position today.
If you’re interested in other Canadian midstream oil and gas companies, click here to read about Enbridge, one of the dominant players in the North American midstream sector.