Rating Agencies Unhappy With Enbridge

Enbridge announced some very shareholder-friendly moves yesterday:

  • 33% dividend increase, payable March 1, 2015
  • Plans to transfer Canadian Liquids Pipelines business to Enbridge Income Fund
  • New dividend payout policy range of 75% to 85% of adjusted earnings
  • 2015 Adjusted EPS guidance of $2.05 to $2.35
  • Parallel U.S. restructuring plan under consideration

These actions are intended to enhance the value to investors of the Company’s record organic growth capital program and enhance the competitiveness of its funding costs for new organic growth opportunities and asset acquisitions.

The Canadian restructuring plan has been approved in principle by Enbridge’s Board of Directors but remains subject to finalization of preliminary internal reorganization steps and a number of internal and external consents and approvals, including final approval of definitive transfer terms by the Enbridge Board and by the Boards of Holdings and the Fund following a recommendation by an independent committee of the Fund and Holdings, and the receipt of all necessary shareholder and regulatory approvals that may be required.

Enbridge also has under review a potential parallel U.S. restructuring plan which would involve transfer of its directly held U.S. Liquids Pipelines assets to its U.S. affiliate, Enbridge Energy Partners, L.P. (EEP). This review has not yet progressed to a conclusion.

Commenting on today’s announcement, Al Monaco, President and Chief Executive Officer, Enbridge Inc., noted the following:

“The 33% increase in our dividend that we announced today and 14% to 16% expected annual average dividend growth rate through 2018 reflects Management’s confidence in the strength and embedded cash flow growth from the existing assets and the capital projects that will be put into service over the next four years. The change in our dividend policy range to 75 – 85% of adjusted earnings is supported by the excellent progress we’ve made on our enterprise-wide funding program, raising some $16 billion in debt and equity capital over the last two years; the expected increase in free cash flow through 2018; and reliable access to effective sources of equity funding including from our sponsored vehicles.

Today, shareholders indicated they are in favour of shareholder friendliness:

Enbridge Inc. (ENB) surged the most in 27 years after Canada’s largest pipeline operator boosted its dividend and said it plans to shift assets to an affiliate.

The shares climbed 10 percent in Toronto, the biggest gain since October 1987. The stock has increased 29 percent this year.

Enbridge said yesterday it plans to move C$17 billion ($15 billion) worth of Canadian liquids pipelines to the Enbridge Income Fund to help pay for capital investment. The company also boosted its dividend 33 percent and said earnings per share next year will be C$2.05 to C$2.35.

The so-called dropdown allows Enbridge “to accelerate dividend growth immediately and for the next 4+ years,” Matthew Akman, a Toronto-based analyst for ScotiaBank, wrote in a note today.

The boost in dividend comes as oil producers are cutting their payouts. Canadian Oil Sands Ltd. yesterday said it would reduce its quarterly dividend by 42 percent to 20 cents a share in late January. Enbridge ships crude from Canadian producers through its network of pipelines across North America.

Assiduous Readers will have no problem with the following pop quiz: “Shareholder-friendly actions are creditor _______________” (for the answer, see the bottom of this post).

Moody’s affirmed the rating but changed the outlook to negative:

Moody’s Investors Service has affirmed its ratings on Enbridge Inc (ENB), Enbridge Energy Partners L.P. (EEP), Enbridge Income Fund (EIF) and Enbridge Energy Limited Partnership (EELP) and Enbridge (U.S.) Inc. At the same time, Moody’s changed the outlooks on ENB, EEP, and EELP to negative. The outlook on EIF has been changed to developing. This follows Enbridge’s news release dated December 3 announcing a material financial restructuring and significant dividend increase. For a complete list of Moody’s ratings actions see the end of this press release.

“The negative outlook reflects the uncertainty surrounding the announced financial restructuring plans and the prospects for increased structural subordination at ENB, the company’s weak consolidated financial metrics and the reduction in financial flexibility associated with the proposed increase in dividends.” said Gavin MacFarlane, Vice President/Senior Analyst.

The company’s financial restructuring plans represent a substantial change in the company’s structure, with approximately C$17 billion in assets to be transferred to EIF from ENB. This compares to current total assets at ENB of C$67 billion and EIF of C$2.7 billion at 30 September 2014. One of the entities being transferred, Enbridge Pipelines (Athabasca) Inc. has no external debt, highlighting the increased structural subordination that will result at ENB going forward. The Canadian liquids pipeline business currently with assets of $16 billion and an associated capital program of $15 billion dominates the proposed transfer. Management has also indicated that it is contemplating a potential parallel U.S. restructuring plan that would transfer all of ENB’s US liquids assets to EEP.

Consolidated FFO/debt of 10.2% on an LTM basis remains weak and is slightly above the 10% adjusted FFO/debt level we have associated with a potential downgrade. The proposed increase in the dividend payout ratio from a range of 60-70% to 75-85% weakens the company’s financial flexibility as it moves forward with its current consolidated capital program of about $44 billion over the period 2014-2018. The increase is slightly mitigated by being tied to the execution of the capital program and any associated moderation in spend. On a consolidated basis, the business risk profile of ENB is unchanged.

We will look to resolve the outlooks when there is greater certainty and clarity surrounding the proposed restructuring in 2015.

It was only two weeks ago that I reported that S&P changed the outlook on ENB to Negative. Now the other shoe has dropped:

  • •We are placing our ratings on Calgary, Alta.-based Enbridge Inc. and Enbridge Pipelines Inc., Toronto-based Enbridge Gas Distribution Inc., and Houston-based Enbridge Energy Partners L.P. on CreditWatch with negative implications.
  • •The CreditWatch placements follows the announcement of dropdown of assets from parent Enbridge to Enbridge Income Fund (EIF), as well as a change to the company’s dividend policy.
  • •We believe that there is a potential for financial metrics to weaken further due to the additional dividend expense.
  • •In addition, the dropdown into EIF could raise the issue of subordination of debt at the Enbridge level.

The CreditWatch placements reflect our assessment of the existing weak forecast financial metrics at parent Enbridge, combined with the announced change in dividend policy and the dropdown of assets to subsidiary Enbridge Income Fund (EIF). Enbridge intends to increase its dividend payout ratio to 75%-85% of adjusted net income, from 60%-70%, effective March 2015. In addition, the dropdown plan covers US$17 billion of assets, comprising the Canadian liquids pipeline and renewable energy portfolio.

“We believe that there is a potential for financial metrics to weaken further due to the additional dividend expense, depending on the ultimate financing strategy,” said Standard & Poor’s credit analyst Gerry Hannochko. “As well, the dropdown to EIF could raise the issue of subordination of debt at the Enbridge level,” Mr. Hannochko added.

In addition, the company is contemplating transferring Enbridge’s U.S.-based liquids pipeline assets to subsidiary EEP.

On Nov. 21, 2014, we revised the outlook on the Enbridge group to negative based on weak forecast financials that we assess to be below the threshold for the “significant” financial risk profile category.

Compared with this, DBRS has been quite restrained:

DBRS Limited (DBRS) has today placed all ratings of Enbridge Inc. (ENB), Enbridge Pipelines Inc. (EPI) and Enbridge Income Fund (EIF or the Fund) as follows Under Review with Developing Implications:

The current rating actions reflect uncertainty associated with the ongoing corporate developments, percentage take-up of the debt exchange and the future funding strategy among the entities within ENB’s organization. For clarity, DBRS does not rule out potential future rating changes for any of the entities placed Under Review today and will provide updates as more information becomes available

From a financial risk perspective, DBRS expects a mix of factors to affect ENB’s future ratings. Firstly, a material increase in dividend payout combined with the proposed Transaction would mean that ENB would have to rely more on external funds to finance its portion of capex which, while substantial over the 2014 to 2018 period, would be reduced on a direct-to-ENB basis. Secondly, direct external debt at ENB would be reduced by the proposed debt exchange, although the sizable preferred shares outstanding at ENB would remain unchanged and would continue to weigh on ENB’s credit metrics. Finally, since all assets of EPI and EPA would be transferred to the Fund, holders of ENB’s direct external debt would be further away from the cash flow of the Transferred Assets than is currently the case. Dividend distributions from the Transferred Assets would have to be used to support debt service at the Fund before dividends could then be distributed to ENB. At this time, there are uncertainties with respect to the debt exchange details and the future financing needs at the ENB level as well as the amount of dividends to be received at ENB. Consequently, while DBRS believes that Under Review with Developing Implications is the appropriate rating action at this time, DBRS does not rule out a negative rating action in the future based on further analysis.

Enbridge Inc. is the issuer of (deep breath) ENB.PR.A (Straight Perpetual), ENB.PR.B, ENB.PR.D, ENB.PR.F, ENB.PR.H, ENB.PR.J, ENB.PR.N, ENB.PR.P, ENB.PR.T, ENB.PR.Y, ENB.PF.A, ENB.PF.C, ENB.PF.E and ENB.PF.G (FixedResets) and ENB.PR.U, ENB.PR.V, ENB.PF.U and ENB.PF.V (US-Pay FixedResets).

All told, I believe that total issuance comprises roughly 10% of the Canadian preferred share market, virtually all of which has come out since the issue of ENB.PR.B just over three years ago. A downgrade to junk would certainly make the market a bit more interesting for a while!

Answer to Pop-Quiz : ʎlpuǝᴉɹɟun ɹoʇᴉpǝɹɔ ǝɹɐ suoᴉʇɔɐ ʎlpuǝᴉɹɟ-ɹǝploɥǝɹɐɥS

3 Responses to “Rating Agencies Unhappy With Enbridge”

  1. prefQC says:

    Hi James,

    This change in corporate structure by Enbridge has led to considerable losses to holders of their prefs over the past couple of months (over and above the interest-rate-driven decline experienced by most fixed resets across the market). I find it rather “scandalous” that a company can knowingly cause such material damage to its pref (and presumably bond) holders without seeking permission or providing some compensation to them. Did you not once mention that, when Bell Canada changed its corporate structure to fall under a new BCE umbrella some years back, the Bell Canada pref holders were given some sort of “sweetener” to compensate them?

    I am quite concerned now that the same thing might happen to TRP prefs, and indeed many other utility prefs. The reason we buy “good quality” prefs is to minimize our exposure to anything other than interest-rate risk. It is hard enough modeling and working out scenarios for pref shares without this unpredictable additional risk coming out of the blue at any moment.

    Your thoughts?

  2. jiHymas says:

    There’s not much you can do except diversify. As Fitch Ratings says, Shareholder-Friendly Actions Ongoing Risk for Bondholders:

    Shareholder-friendly actions such a stock buybacks or special dividends are an ongoing risk to corporate bondholders as borrowing costs remain historically low, Fitch Ratings says. While most stock buybacks and dividends are done in a credit-neutral manner, shareholder-friendly actions continue to drive a steady flow of downgrades and negative outlook changes.

    Fitch took six negative rating actions on U.S. corporates during 2013 due at least in part to share repurchases, similar to the number of such actions in 2012 and down from the 13 actions of 2011. Most of these actions in 2013 involved ‘BBB’ rated issuers, while the majority of actions in 2011-2012 involved issuers in the ‘A’ and ‘AA’ categories. This highlights the fact that even ‘BBB’ rated issuers currently face little cost in terms of market access or borrowing rates from moving one or two notches down the rating scale.

    Special dividends by non-investment grade companies that were LBO’d in the mid to late-2000’s but have yet to be sold or taken public are also an ongoing risk. Examples include retailers Michael’s Stores and NBTY, Inc., each of which paid sizable dividends during 2013 financed with PIK toggle notes issued at the holding company level. Aerospace/defense company TransDigm Group, Inc. paid a special dividend financed with a term loan and notes.

    Fitch downgraded one company in 2013 due to a special dividend, compared with two dividend-related actions in 2012 when companies were anticipating higher tax rates that took effect on Jan. 1, 2013. In total, non-investment grade companies obtained $50 billion in loans and $16 billion in new bonds during 2013 at least in part to pay sponsor dividends, in line with 2012 when a sizable portion of the dividends were paid in anticipation of higher tax rates.

    Negative rating actions in 2013 due at least in part to a more shareholder-friendly posture were spread across sectors. Two actions involved aerospace/defense companies (Northrop Grumman and TransDigm Group), and one action occurred in each of the telecom (CenturyLink), pharmaceutical (Merck), energy (Occidental Petroleum), chemical (CF Industries) and home services (ADT Corp.) sectors. Over the past three years, negative rating actions have been concentrated in the pharmaceutical/health care, media/telecom and retail sectors, which are relatively stable and cash generative in nature and therefore conducive to higher shareholder distributions.

    … and David Pett noted in the Financial Post The downside of share buybacks and more dividends:

    The recent rise in shareholder-friendly corporate activity is being lauded as one of the most important catalysts in the ongoing rally of many stock markets. But the trend that has companies showering equity investors with a steady stream of share buybacks and dividend increases is giving bondholders another headache.

    “While not always immediately credit negative, shareholder-friendly initiatives are typically to the detriment of bondholders,” said Altaf Nanji, a credit analyst at RBC Capital Markets. “All good things must come to an end and, in this case, the cocktail is no longer as enticing for credit investors as it once was.”

    The Bell / BCE conversion was different, in that the company wanted to change the guarantor of the preferreds, which requires the preferred shareholders’ permission. Regrettably, Enbridge does not require preferred shareholders permission to change its dividends and corporate structure in the way it is doing.

    The only way to address this power imbalance directly is to have covenants in the prospectus, such that – for instance – shares will be redeemed at a premium if the credit rating falls below a certain level. This sort of thing is not very popular with companies as it restricts their ability to make changes and can lead to a death-spiral if they get into difficulties.

    Another method is an automatic dividend rate adjustment given certain triggers: RatchetRate preferreds have this protection, for instance, but once they reached their maximum payout (100% of Prime) the buffering capacity was exhausted. Unlikely to reappear, too, for as long as Prime is roughly equal to or greater than 3-Month Bills + 200bp and the only significant Ratchet Rate issuer (BCE) can’t issue FixedResets with less than that spread.

    In both cases, these protections would render preferreds ineligible for Tier 1 Capital for a bank or insurer; OSFI is quite explicit in this and quite rightly.

  3. prefQC says:

    Thanks for your (as usual!) insightful explanation (albeit a bit depressing…)

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