National Post (National Edition)
STRATEGY GAP
Pipelines riskier than producers
When it comes to income from oil, pipelines riskier than products.
Since defensive infrastructure stocks have been the focus of investor dollars over the past few years while their customers, the oil and gas sector, have been sold off, it appears as though investors have completely shrugged off the risks of one while overreacting to the decline of the other.
To begin, let’s take a closer look at the Canadian infrastructure space, which includes such companies as Enbridge Inc. and TransCanada Corp. This sector has experienced a huge multiple expansion with share prices, in many cases, reaching record highs while earnings have been fairly flat.
In particular, the average company’s forward price-earnings multiple currently tops 20 times projected 2013 earnings, which compares with the historical multiple of 15.
Interestingly, investors seem to be looking past the sector’s large capital commitments with the average payout ratio being 200%. This means many of these infrastructure companies are paying out twice their current cash flow when capital spending and dividends are combined.
This is fine and dandy in a low-interest-rate environment, because they can access low-cost debt to pay the dividend. But what happens when interest rates rise and the debt-to-dividend strategy is no longer an option?
From a fundamental standpoint, the infrastructure sector has an unimpressive return-on-capital track record, with an average 4% historical return. Again, this may be a reasonable return in a lowinterest-rate environment, but what happens when rates rise?
For example, TransCanada’s share price has appreciated more than 20% to record highs since the end of 2007, while its earnings per share (EPS) fell 9% to the end of 2012. Looking forward, it gets a bit better as the company’s 2013 estimated EPS is expected to result in a 1.5% total cumulative growth rate since the end of 2007.
There are those that may be OK with a flat earnings growth profile, given the company’s 3.7% dividend. However, no one seems to be questioning the fact that TransCanada is spending nearly one-and-ahalf times what it is taking in. Compare this with Suncor
Energy Inc., an integrated producer with a larger market capitalization. Its earnings per share are expected to increase by 44% from the end of 2007 to the end of 2013. Consequently, its forward P/E multiple has shrunk to 8.5 times from near 20 times in 2007.
TransCanada’s multiple, by comparison, has expanded to more than 23 times from 18 times.
Suncor is also expected to increase its dividend to yield 2% to 2.5%. While this is below TransCanada’s 3.7% yield, Suncor has a much lower total payout ratio of only 85% to 90%.
We think the large gap between infrastructure-sector stocks and oil and gas producers is not sustainable over the longer term.
This gap could also represent some near-term downside risk for investors herding into the infrastructure space, especially if certain pipeline projects such as the Keystone or Gateway do not get approved. There could be even more downside risk should interest rates normalize.
Therefore, the safer trade for investors chasing energy income is through the beatenup Canadian oil and gas producers.
For investors interested in the energy income sector and wanting to benchmark their active mutual funds or individual holdings, TriVest Wealth Counsel recently launched the Canadian High Yield Energy Index.
The index is the first of its kind to track high-dividendpaying companies in the Canadian energy sector, including the producers, service companies, mid-stream and infrastructure companies that have a dividend yield surpassing 4%. Martin Pelletier, CFA, is a portfolio manager at Calgary-based
TriVest Wealth Counsel Ltd.