The Mega-Merger That Everyone’s Talking About
Barely two months after a deal to create one of the largest energy infrastructure companies in North America fell apart comes another deal from competitors with hopes of achieving the same.
But unlike Energy Transfer Equity LP’s (NYSE: ETE) failed bid to acquire The Williams Companies (NYSE: WMB), we expect Canadian crude oil pipeline giant Enbridge Inc. (NYSE: ENB, TSX: ENB) will be successful in its play for Spectra Energy Corp. (NYSE: SE).
On Tuesday, Enbridge announced that it had agreed to acquire Spectra, the U.S. natural gas pipeline giant, for US$28.3 billion, along with the assumption of US$14.5 billion in debt. With a total enterprise value of US$127 billion, the resulting North American midstream empire would dwarf many of its rivals.
The deal’s announcement was met with the usual Wall Street triumphalism, stoked by a presentation that included a swoon-worthy map of the two companies’ complementary energy infrastructure.
Indeed, with infrastructure spanning from Seattle to the U.S. Northeast and from Fort McMurray to Houston, it’s not hard to see why Wall Street analysts and asset managers alike gushed over the size, scale and diversification that would result from the tie-up.
Of course, we remember similar exuberance over ETE’s deal. But this particular mega-merger has a couple of things going for it that ETE’s deal did not.
For one, there’s timing. ETE’s audacious bid came as sentiment in the energy sector was crashing along with commodities prices. We’ve now endured what appears to have been the final collapse in energy prices, and sentiment has improved along with the subsequent rebound.
Though such timing might not have killed an all-stock transaction, ETE had to resort to a substantial $6 billion cash sweetener to get Williams to the altar.
Unfortunately, that cash sweetener, which would have been financed by a term loan requiring a quick payback, proved too onerous for ETE amid such extreme uncertainty for the sector. So the very thing ETE used to entice Williams to the altar caused ETE to ultimately abandon Williams there.
To be sure, Enbridge’s bid is similarly audacious. We may have already seen the worst of the energy sector’s bust, but there’s still plenty of debate about where energy prices could be headed over the next several years, not to mention the supply-demand balance.
At the same time, the Canadians aren’t cowboys, like ETE’s chief dealmaker Kelcy Warren. Enbridge’s bid is an all-stock deal, thereby removing the risk of issuing a pile of debt to finance the transaction and further blowing out its balance sheet.
A Few Administrative Details
Under the terms of the stock-for-stock deal, Spectra shareholders will receive 0.984 shares of Enbridge for each share of Spectra. At the time of the deal’s announcement, this represented an 11.5% premium to Spectra’s prior closing price.
The relatively modest premium is likely due to the fact that Spectra’s shares continued to stage an impressive rally from this year’s low while negotiations were underway. At the same time, it’s easy to imagine that a short-term jump in energy commodities could have given Spectra’s share price a boost of similar magnitude, even if a bid hadn’t materialized.
Instead, the deal’s biggest sweetener is the promise of a significantly stronger dividend-growth trajectory than Spectra shareholders would have enjoyed if the company remained a standalone. While Spectra has been targeting dividend growth of 7% to 8% annually, Enbridge says shareholders of the combined entity will enjoy a 15% boost in the dividend next year, with the payout growing 10% to 12% annually through 2024.
Right now, Spectra pays out US$1.62 per share annualized, compared to Enbridge’s payout of about US$1.64 at the time of the deal’s announcement. Applying the aforementioned transaction ratio makes the annualized payouts roughly equivalent, though the value of Enbridge’s dividend will continue to fluctuate with the exchange rate.
Assuming management can deliver on such promises, the combined entity’s annualized dividend would grow to about US$2.88 within five years, based on the midpoint of the projected range and the current exchange rate.
Obviously, if the Canadian dollar were to appreciate during that time, then that would give the payout a further boost from a U.S. investor perspective. But even if the loonie stays stuck at current levels, the forecast dividend growth means Enbridge shareholders would enjoy a total pay raise of about 78% over the next five years.
Of course, if you’re a U.S. investor, there are a couple of tax hassles associated with going from being the shareholder of a U.S. company to a shareholder of a Canadian company.
Thanks to a treaty with Canada, the Canadian government should only withhold about 15% of dividends as a tax (in the absence of an agreement, the 25% rate would prevail). But to ensure you receive that more favorable rate, you may have to file a special form with the Canada Revenue Agency (Form NR301) through your broker, a filing that you’ll have to renew about every three years.
Additionally, at tax time in the U.S., you may need to file another form with the IRS (Form 1116) to claim a credit for having paid foreign taxes. For most investors, that credit should fully offset any tax on the dividends that would be due to Uncle Sam, thus avoiding double taxation of the dividend.
Bigger, Faster, Stronger?
One concerning aspect of the deal that’s been largely absent amid Wall Street’s jubilation is the resulting leverage of the combined entity.
Spectra’s consolidated leverage is already at worrisome levels, while Enbridge’s is even worse. In fact, financial aggregators such as Bloomberg list net debt to EBITDA (earnings before interest, taxation, depreciation and amortization) ratios for each firm that are cause for serious anxiety.
Not quite as bad, but still deeply troubling are the adjusted ratios calculated by Moody’s Investors Service. The credit rater notes that Spectra’s net debt to EBITDA ratio was recently at 5.8x, while Enbridge’s ratio was at 7.2x. The combined entity would have a ratio of 6.7x.
By comparison, the net debt to EBITDA ratio of the average S&P 500 company is around 2.5x.
So if you’re a Spectra shareholder who was already worried about leverage, then your situation is about to get worse, at least temporarily.
However, both firms consulted with the major rating agencies while negotiating this deal and seem to have their conditional blessing.
While Moody’s believes the deal should ultimately prove “credit positive,” the bond rater is maintaining a negative outlook on Enbridge, pending the deal’s completion, the announcement of next year’s capital plan, and, of course, subsequent deleveraging. Enbridge’s credit rating from Moody’s is two notches above junk.
For its part, Enbridge has identified at least C$2 billion of potential divestitures following the deal’s completion, with another C$6 billion of assets that could be auctioned off.
The firms also see potential synergies of US$415 million annually by late 2018, with another US$200 million of annual tax savings starting in 2019.
In addition to asset monetizations, synergies, and tax savings, cash flows are expected to ramp up as Enbridge’s $26 billion of growth projects enter service.
Management says these items will bring net debt to EBITDA below 5.0x sometime during 2019.
Even so, that means at least two more years until Enbridge is out of the danger zone. Management’s promises notwithstanding, a lot can happen in two years.
To be sure, we’re talking about almost fully contracted infrastructure—96% of cash flows are supported by long-term, take-or-pay contracts, which guarantee a minimum level of income for an asset even if shippers fail to fully utilize their contracted capacity.
And the combined companies will enjoy speedy diversification that they couldn’t possibly hope to achieve organically, especially given the recent intransigence of local and federal regulators and politicians when it comes to anything related to energy infrastructure. The new Enbridge will have a nearly even split in revenues derived from moving natural gas and crude oil.
But it is curious that just six months after the energy sector’s meltdown, so many people would be so nonchalant about such high leverage.
Enbridge, itself, is clearly comfortable shouldering this burden: Its net debt to EBITDA ratio has averaged a staggering 7.9x over the past five years, and it’s still standing.
There’s no question that we’re talking about best-in-class infrastructure that moves a substantial amount of North America’s energy from top resource plays to high-demand markets. If Enbridge can make good on all of its promises, it will be a continent-beating firm.
Nevertheless, if you’re a conservative income investor, you may want to consider cashing out of Spectra’s shares and waiting to reinvest in Enbridge until after deleveraging has brought debt to more reasonable levels.
If you’re a more aggressive income investor, then two more years of super leverage probably won’t deter you from becoming an Enbridge shareholder, especially given all the goodies that have been promised.
Either way, you’ve got time to think about it. The transaction isn’t expected to close until sometime during the first quarter of 2017.