With major projects in the pipeline, TransCanada’s cash needs are expected to result in relatively slow dividend growth compared with its North American peers.Nathan VanderKlippe/The Globe and Mail
There are a lot of things going on at TransCanada. Major pipeline projects in the works. Ongoing asset sales to its U.S. subsidiary. Maybe even a breakup of the company, although TransCanada's board is currently opposed to the idea.
What's not likely to happen, however, is that TransCanada's shareholders bag a large gain over the next year.
In large part, it's because of the market's recent excitement over the idea that TransCanada could be the target of activist investors, who could push the company to jack up its dividend or split into pieces. At their 52-week high Sept. 19, the shares had handily outperformed their peers since the start of the third quarter. Even with a pullback in recent days, the shares are bumping up against the average target price of $59.15 from the analysts who cover the company.
The problem is that TransCanada won't – or, most likely, can't – do the things the activists may want to give the stock a short-term pop. But the current expectation of a quick fix makes the shares expensive, particularly since the company has said it plans to create value slowly and steadily.
A big part of the problem is that there is a growing divide in the energy industry, marked by the 49th parallel. U.S. energy companies are dumping their assets as quickly as possible in tax-advantaged master limited partnerships, or MLPs, exciting shareholders with promises of juicy payouts.
By contrast, the Canadian large-capitalization pipeline companies "are the last corporate structures with significant asset ownership and large-scale development opportunities," says analyst Andrew Kuske of Credit Suisse. They have greater capital-expenditure needs, with individual projects exceeding $5-billion (U.S.) and five-year capital programs "well beyond" $30-billion. As a result, they keep their dividend payouts lower.
"This financial model is generally built to last through economic cycles, interest-rate inflections, changing capital markets and evolving business conditions while building permanent book value," he says. And, he adds, it's exactly the opposite of what U.S. investors want. "We regard the Canadian large-cap pipes approach to certain issues as being akin to Aesop's Tortoise and Hare fable, with most of the U.S. contingent being the hare."
TransCanada has $38-billion (Canadian) in planned projects through the end of the decade, including four major ones (Energy East, Keystone XL, Coastal Gas Link and Prince Rupert) that exceed $25-billion. With cash needs like that, it's no surprise that analysts are forecasting relatively slow dividend growth and a continuing low payout rate for the company, compared with most North American peers.
Analyst Paul Lechem of CIBC says with TransCanada's current dividend yielding about 3.4 per cent, the company has been paying out roughly 80 per cent to 90 per cent of earnings and 30 per cent to 40 per cent of funds from operations, or FFO, a more cash-based measure that excludes depreciation of its assets. (The pipeline group averages 121 per cent of earnings and 57 per cent of FFO, with the MLPs averaging 89 per cent of FFO.)
Mr. Lechem says increasing the payouts closer to the peer averages could push the shares to $79 in 2015. And Mr. Kuske of Credit Suisse says a cash-flow payout of 80 per cent at a 4.5-per-cent yield would translate, theoretically, into a $94 stock price.
The problem, of course, is that the company would have to find other money to fund its project pipeline, likely billions of dollars worth of stock offerings that would dilute existing shareholders' stakes – and, Mr. Kuske notes, "prevent the theoretical share price from being achieved."
At least analysts agree that higher dividends could boost the share price. There's a great deal more skepticism about the idea that TransCanada could "unlock value" by splitting into pieces, an idea posited in June by Citigroup analyst Faisel Khan.
Mr. Lechem figures the two businesses, separated, would be worth $65.50 – except that his figure doesn't consider the extra administrative expenses of running two separate public companies or a couple of valuation risks. One, TransCanada's power-generation business might have increasing capital needs or face a deterioration of its Western Canada business. Two, the pipeline business "is likely to trade at a lower than group average multiple until there is improved visibility into the growth outlook" at the company's megaprojects, most of which won't come online until 2018 at the earliest.
TransCanada is doing its part to ride the MLP wave. It has a New York Stock Exchange-traded entity, TC PipeLines LP, that is gradually buying TransCanada's U.S. assets for cash and distributing the profits to the MLP's investors in a tax-advantaged manner. Wednesday's TransCanada sale of its final 30 per cent interest in Bison Pipeline LLC for $215-million (U.S.) was widely seen as a move to assuage agitated investors, but analysts note there are still a number of assets to "drop down" to the MLP, and no explicit schedule to do so.
Some analysts with "hold" ratings bumped up their target prices to the low $60s (Canadian) as TransCanada shares peaked last month. (Mr. Lechem, for one, raised his from $54 to $63). Others put their targets in the mid-to-high $50s, like Mr. Kuske's $58.
For a more sour view, we turn to Theodore Durbin of Goldman Sachs, who cut TransCanada to a "sell" Sept. 15 with a target price of $52. Mr. Durbin believes TransCanada will miss out on some of the biggest gains in gas supply because it is not well-positioned in the Marcellus and Utica shale formations in the U.S. northeast. And, importantly, he says the company is giving guidance for mid- to high-single-digit rates of return for its mega projects, versus rates of return of 10 per cent or better at most competitors. "Even assuming perfect execution," he says, he doesn't expect transformative earnings gains from the projects.
Mr. Durbin took the unusual step Tuesday of issuing a follow-up note acknowledging a "strong investor response" to the sell rating, with extensive "pushback." It suggests there are some out there who strongly believe they can push management into turning TransCanada from a tortoise to a hare. But only investors with the patience to go slow and steady have much of a chance in this race.
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David Milstead