Does IPL belong in BTSX? (June 2019 BTSX Update)

Post published:June 1, 2019
Post category:Beating the TSX
Post comments:13 Comments

Inter Pipeline Ltd. (IPL) and Pembina Pipeline Corp (PPL) both sport dividend yields that place them in the top ten of the TSX 60 index. Understandably, I am frequently asked why they are not included in the BTSX portfolio. The answer is simple: they used to be income trusts and the previous authors/caretakers of Beating the TSX excluded them out of concerns that the dividends of such companies may not be stable over time. I have followed suit.

But Inter Pipeline completed this conversion in 2013; Pembina in 2010. Isn’t it about time we reconsider whether these big Canadian dividend-payers should earn a place in our BTSX portfolios? To do so, we are going to engage in a little fundamental analysis. We’ll take on IPL this month, and PPL next month. What’s is their business? How are their finances? And, most importantly, is their dividend safe?

Here’s the quick and dirty on IPL:

Dividend yield: 8.3% (as of June 1, 2019)
Ten years of increasing dividends
Dividend payout ratio: 110%
P/E ratio (trailing): 14.82
Market Cap $8.41 billion

Business overview

Inter Pipeline is a Canadian energy infrastructure company, based in Alberta. It currently has four distinct business segments:

Oil Sands Transportation (48% of EBITDA)
NGL Processing (34% of EBITDA)
Conventional Oil Pipelines (13% of EBITDA)
Bulk Liquid Storage (5% of EBITDA)

Don’t know what EBITDA is? Click HERE.

More details about IPL’s business can be seen below:

Source: Inter Pipeline March 2019 Investor Presentation

Inter Pipeline currently operates in Western Canada (95%) and Europe (5%). Over 80% of revenue is generated from investment-grade entities – i.e. their contracts are with solid, stable companies who are likely to honor their commitments. Furthermore, supply and service contracts are long-term, as the slide below outlines.

This low risk business model wherein 70% of EBITDA comes from cost-of-service and fee-based contracts should result in robust recession protection, as it has in the past.

Historical profitability

Inter Pipeline has a proven track record of growing their funds from operations (FFO) on a per share basis. Over the last ten years, FFO has grown 8.3%. The last five years has been even better at 11.8%.

EBITDA has also been growing consistently over time:

Future prospects

Will IPL be able to maintain this EBITDA and cash flow growth? This is a key question for investors since dividends are paid from these funds.

IPL’s existing business segments (transportation, processing, pipelines and storage) have been profitable, but the company is also investing heavily in Canada’s first integrated propane dehydrogenation (PDH) and polypropylene (PP) complex, which will add a fifth segment to the business.

The Heartland Petrochemical Complex will take advantage of the long-term oversupply of propane in Western Canada, producing ~525 kilotonnes per annum (KTA) of polypropylene (PP). Delivered PP costs are anticipated to be some of the lowest in the marketplace with profit margins among the highest. It is anticipated that when the Heartland Petrochemical Complex starts production in late 2021 it will add $450 to $500 million per year in long-term average annual EBITDA (about 40% of 2018 EBITDA).

Is the dividend sustainable?

With a current dividend yield of over 8% (paid monthly) and a payout ratio of over 100%, it behooves us to have a closer look at the sustainability of IPL’s dividend payments.

As we mentioned at the beginning of the article, IPL has a ten year history of steadily increasing dividends. The dividend compound growth rate over this time period has been 7.3%.

So far so good, but with a dividend payout ratio (DPR) of 110%, should investors be concerned? To answer this question, we need to understand that dividend payout ratios are calculated based on company earnings. Earnings include non-cash depreciation of assets. In the case of IPL and other energy infrastructure companies, it is essential to understand that by nature of their industry, they own significant long-lived assets like pipelines, storage tanks, and processing facilities. These depreciation charges impact the earnings figure making it difficult to compare metrics such as P/E and DPR with companies in other industries.

In such cases, a more straightforward means of assessing dividend stability is to compare dividend payments to funds from operations (FFO) since these are the funds from which dividends are paid. As you can see from the figure below, since 2013 the dividend payments have been more than covered by FFO. Using this metric, IPLs payout ratio based on recent FFO would have been ~63%.

IPL’s high dividend yield of over 8% is the result of share price depreciation over the last few years (it is trading near 6-year lows). But, given the 5-year average yield of 5.4%, and the apparently solid fundamentals, I believe IPL is likely trading under its fair market value (given the depressed stock price, however, there are clearly many investors who disagree!).