Undervalued Dividend Growth Stock of the Week: Enbridge Inc. (ENB)

There’s an old cliché that oftentimes rings hollow for people:

“If I can do it, anyone can.”

However, I like to tell people this very same thing all the time.

Why?

Well, because it’s very true.

I was an unemployed, broke, college dropout as recently as late 2009.

But I turned it all around rather quickly, becoming financially independent in early 2016, at only 33 years old.

How? 

By living below my means and investing that excess capital into high-quality dividend growth stocks.

It sounds really simple. Perhaps even crazy.

But it’s all true.

And you can read about the entire journey via my Early Retirement Blueprint.

So when I talk about how anyone can do what I did and become financially independent at a young age, I truly mean it.

But a major aspect of my success is dividend growth investing, which involves buying up shares in great businesses that reward their shareholders with growing dividend payments (payments which are funded by the growing profit these businesses are producing).

Well, a dividend growth investor is never short on opportunities.

You can find more than 800 US-listed stocks that have raised their dividends each year for at least the last five consecutive years, via David Fish’s Dividend Champions, Contenders, and Challengers list.

This is an invaluable compilation, accumulating incredible data on hundreds of some of the best stocks in the world.

Jason Fieber's Dividend Growth PortfolioI used this strategy to build my FIRE Fund – a real-life and real-money portfolio that’s chock-full of some of the highest-quality dividend growth stocks in the world.

This portfolio is generating the five-figure dividend income I need to cover my basic expenses in life, rendering me financially independent in my 30s.

However, as great as dividend growth investing is, one must be thoughtful with how they go about investing their capital.

Analyzing a company’s fundamentals, competitive advantages, and risks prior to investing is a must.

Arguably most important of all, though, is a stock’s valuation at the time of potential purchasing.

The reasoning behind that is fairly straightforward.

An undervalued dividend growth stock should offer an investor a higher yield, greater long-term total return prospects, and less risk. 

That’s all relative to the dynamics the same stock might otherwise have if it were fairly valued or overvalued.

The higher yield comes about due to how price and yield are inversely correlated; all else equal, a lower price will result in a higher yield.

That higher yield provides for greater long-term total return potential right off the bat, due to the fact that total return is comprised of income (via dividends or distributions) and capital gain.

The former is given a boost via the higher yield.

But the latter is also boosted, as capital gain could be higher with the “upside” that exists between a lower price paid and higher estimated intrinsic value on an undervalued stock.

And that’s on top of whatever natural upside is available as a business becomes worth more through the process of increasing its profit.

All of this has a way of reducing risk, too, because it’s naturally less risky (in terms of capital risked) to pay less than more for the same asset.

Through undervaluation, an investor should be able to build a margin of safety, which is a “buffer” between price and estimated fair value.

This buffer protects an investor’s downside, just in case a company does something wrong or doesn’t perform as expected.

With all of these benefits in mind, an undervalued high-quality dividend growth stock should be a sought-after investment.

Indeed, it usually is.

Fortunately, the process of finding these gems is made a lot easier when you have a clear understanding of how to go about estimating the fair value of a dividend growth stock.

And that’s where fellow contributor Dave Van Knapp’s dividend growth investing “lesson” on valuation comes in.

Once you have control over the valuation process, it’s just a matter of finding a compelling idea and putting capital to work.

While it’s ultimately up to you to actually invest, I believe there’s a compelling idea available right now.

I’m going to highlight a high-quality dividend growth stock that appears to be undervalued…

Enbridge Inc. (ENB)

Enbridge Inc. (ENB) is an energy distribution and transportation company that owns and operates crude and natural gas pipelines across the United States and Canada.

After merging with Spectra Energy Corp. in 2017, Enbridge is the largest energy infrastructure company in North America.

With a business model where scale counts, this bodes well for Enbridge and its shareholders.

That business model is made to look even more appealing by the fact that there’s very little exposure to volatile energy commodity pricing, due to the fact that over 90% of the company’s cash flow is underpinned by long-term commercial agreements.

And 100% of the company’s revenue is generated from customers that are investment grade or equivalent.

Enbridge collects fees as energy commodities (like natural gas) pass through its network of pipes.

This sets the company up as what is akin to a “toll booth” business model – they run a “highway” that collects money as “traffic” passes through. It’s a monster for cash flow.

With an energy future that appears to be heavily reliant on natural gas, a massive highway of pipelines for said transportation, and long-term commercial agreements in place that limit fluctuations to cash flow, Enbridge is “locked and loaded” for paying big, reliable, and growing dividends.

Indeed, the company does just that. Which is why we’re all here.

Enbridge has increased its dividend for 22 consecutive years.

That time frame has included multiple shocks to energy commodity prices, the dot-com bust, and even the Great Recession.

So we can see that this dividend is durable and built for the long haul.

Plus, the 10-year dividend growth rate is sitting at 12.4%, which is well in excess of the US inflation rate.

That means shareholders are seeing their purchasing power increase year in and year out.

What’s even better about that dividend growth rate is that there hasn’t been a marked deceleration in dividend growth.

In fact, Enbridge’s management has already targeted 10% dividend growth through at least 2020.

They’ve already made good on that with a 10% increase earlier this year; double-digit dividend growth looks poised to continue for the foreseeable future.

My belief in that is supported by a payout ratio that’s sitting at just 62.4% (using midpoint of 2018 DCF/share guidance).

Now, these dividend metrics are thus far pretty fantastic.

However, I haven’t even brought up the yield yet.

This stock is yielding a gargantuan 6.67%.

That’s huge no matter how you slice it.

It’s more than three times the broader market.

And it’s also more than 300 basis points higher than the stock’s five-year average yield.

Pairing a yield over 6.5% with double-digit dividend growth is practically unheard of, yet that’s what you may be getting here with this stock.

But let’s break down the company’s top-line and bottom-line growth, which will surely have a lot to say about its dividend growth moving forward.

We’ll first see what Enbridge has done over the last decade (using that as a proxy for the long haul) in terms of revenue and profit growth.

And then we’ll compare that to a near-term professional forecast for profit growth.

Blending the known past and estimated future in this manner should give us a pretty good idea as to what kind of overall business and dividend growth Enbridge is capable of.

Revenue increased from $16.131 billion CAD to $44.378 billion CAD from fiscal year 2008 to FY 2017. That’s a compound annual growth rate of 11.90%.

That’s a very high growth rate for what’s a fairly large and mature pipeline company; however, the growth rate was given a boost through the aforementioned Spectra acquisition.

Earnings per share is basically flat over this same time frame – going from $1.82 CAD to $1.96 CAD (adjusting for 2017 tax reform in the US).

The issue, though, is that a pipeline company like Enbridge reports EPS that is somewhat similar to what you see with REITs.

They routinely issue shares (and debt) in order to fund growth/projects. That naturally causes dilution.

And then there’s reported depreciation on their pipelines, even though the assets may actually be (and most likely are) appreciating.

Thus, Enbridge also (and more accurately) reports profit on a per-share basis in terms of DCF, or distributable cash flow (formerly ACFFO).

That number came in at $3.68 CAD per common share in 2017. And the midpoint for 2018 guidance is $4.30 CAD.

If that midpoint is hit, that would represent almost 17% YOY growth, although management is targeting 10% annual DCF growth (in line with dividend growth).

For further perspective on profit growth, CFRA is calling for Enbridge to compound its EPS at an annual rate of 7%.

However, even if Enbridge massively disappoints with DCF growth, the dividend alone puts a pretty strong floor on the stock’s return and aggregate income prospects.

The company could grow its DCF/share at just 5% year (50% of the rate they expect/target) for the next five years and still provide for an excellent long-term investment.

Looking at the balance sheet, the long-term debt/equity ratio is 1.05.

That’s actually a rather strong ratio for a pipeline company.

The interest coverage ratio, at a bit over 1, looks dangerously high, but that’s only because of one-time hits to EBIT.

Profitability is as one would expect.

Over the last five years, Enbridge has averaged annual net margin of 3.05% and annual return on equity of 7.90%.

This company provides the necessary infrastructure for moving energy commodities that are necessary for everyday life.

With massive scale that provides for huge barriers to entry, Enbridge should continue to dominate for years to come.

Recent proposed policy changes by FERC, which relates to tax allowance recovery, could marginally impact cash flow and dividends for many pipeline companies, including Enbridge. However, Enbridge has come out and stated that it doesn’t expect any material impact on its operations.

And while there are standard business model risks to consider – spills, regulation, and the cost to maintain the network (requiring the regular issuance of equity and debt) – the right valuation could provide for a very compelling long-term investment.

Well, I think that kind of valuation is clearly upon us…

The stock is trading hands for a P/E ratio of 24.1.

While that’s not necessarily a truly accurate way to value the stock’s cash flow and earnings power, it does give us some relative insight when comparing it to the stock’s own five-year average P/E ratio of 64.7.

We’re talking a current P/E ratio that’s less than half its five-year average. And that’s during a period in which they largely lacked Spectra, which has bolstered scale in a major way.

Likewise, we can see major disconnects between the stock’s current basic valuation metrics (P/S, P/B, etc.) and their respective recent historical averages.

And the yield, as noted earlier, is substantially higher than (almost double) its five-year average.

So the stock does appear to be extremely undervalued at first glance. But how much so? What might be a reasonable estimate of intrinsic value? 

I valued shares using a dividend discount model analysis.

I factored in an 8% discount rate (due to the extremely high yield) and a long-term dividend growth rate of 4.5%.

That DGR is obviously very conservative when you look at this company’s long-term track record for dividend growth, it’s forward-looking estimates for business growth, and management’s own stated objectives regarding dividend growth for the foreseeable future.

However, I take a cautious stance with higher-yielding securities, especially when a business model has inherent “black swan” risks (pipeline disasters/spills in this case).

The DDM analysis gives me a fair value of $63.30.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

My analysis shows a deeply undervalued stock, which is actually in line with what the basic valuation metrics indicate.

However, my perspective is but one of many.

And so we’ll also take a look at two professional estimates of this stock’s value, which adds depth to the overall conclusion on this stock and its valuation.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates ENB as a 5-star stock, with a fair value estimate of $47.00.

CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

CFRA rates ENB as a 4-star “BUY”, with a 12-month target price of $41.00 (used in lieu of an inconsistent FV).

I came out high – and that was even with a very conservative look at future dividend growth. Averaging out the three numbers gives us a final valuation of $50.43, which would indicate the stock is potentially 59% undervalued. Even the lowest of the three numbers shows a stock that could be extremely cheap.

Bottom line: Enbridge Inc. (ENB) is a high-quality infrastructure company that is positioned perfectly for future energy needs. Massive scale and very little exposure to volatile energy commodity prices bodes well for this firm, its shareholders, and the dividend. A yield well over 6%, management guidance for double-digit dividend growth, and the possibility that shares are 59% undervalued means this could be the single greatest opportunity in the market for long-term dividend growth investors. That’s why it’s one of my Top 10 Stocks for 2018 (and beyond).

— Jason Fieber

Note from DTA: How safe is ENB’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 55. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, ENB’s dividend appears average with a moderate risk of being cut. Learn more about Dividend Safety Scores here.

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