Retirement Dreams Can Come Down The Pembina Pipeline (NYSE:PBA)


This article was coproduced with Dividend Sensei and edited by Brad Thomas.

As I explained in an article a few weeks ago, “whenever I include the word “retire” – or retiree, retirement, or some other derivation – in an article, I’m reminded it must pass my mother’s sleep well at night, or SWAN, test first.”

I went on to explain now that “my mom is now officially retired... she’s on the prowl for safe dividend growth stocks.” Thus, “every time I put ‘retire’ in the title, it’s a signal for her to spot.”

Source

So today I’m signaling to mom that she has the opportunity to own a terrific SWAN stock that can be purchased at a very attractive price.

While the U.S. markets figure out whether they’re bearish or bullish, now’s a great time to evaluate Pembina Pipeline (PBA) – one of the highest-quality midstream operators around.

Like most midstreams, Pembina has been smashed by the pandemic and the worst oil crash in human history. In recent weeks, it has fallen about 25% further due to what AllianceBernstein believes to be a potent combination of:

  • Tax loss selling
  • Rising political uncertainty in the U.S.
  • A generally bearish market sentiment.

However, such periods of extreme volatility – including 5% declines in a single day – can create exceptional opportunities with long-term returns to make grown men weep with joy. Right now, Pembina is one very reasonable and prudent high-yield investment for income seekers to make in these scary markets.

Here’s what we mean…

A Very Safe 9% Monthly Yield That’s Perfect for Retirees

Neither iREIT nor Dividend Kings (the combined brains behind this article) are yield-chasing services. We don’t recommend traps with unreliable payouts, recognizing that dividend safety is of utmost importance – for retirees and those hoping to become retirees alike.

That’s why the following dividend safety metrics can be so valuable.

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They can help estimate the probability of dividend cuts during both average recessions and the one we’re in right now.

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Here’s why PBA has 5/5 dividend safety – and therefore about a 1.5% chance of a dividend cut in this pandemic.

  • 2020 consensus discounted cash flow payout ratio: 66% vs. 83% safe for self-funding midstreams
  • Debt/capital: 38% vs. 60% or less safe
  • Debt/EBITDA (earnings before interest, taxes, depreciation, and amortization): 4 vs. 5 or less safe
  • Interest coverage: 4.8 vs. 2.5+ safe
  • S&P credit rating: BBB stable outlook = 7.5% 30-year bankruptcy risk
  • F-score: 4/9 vs. 4+ safe, 7+ very safe = low short-term bankruptcy risk
  • M-score: -2.77 vs. -2.22 or less safe = very low accounting fraud risk
  • Dividend growth streak: eight years and 23 years without a cut

Plus, Pembina’s balance sheet has low leverage for this industry and plans to keep it that way. Here’s how Canadian Imperial Bank of Commerce describes it:

“A best in class midstream company, Pembina offers investors a solid growth profile, low leverage, and an inventory of high-quality assets. The company bolsters sound credit and leverage metrics with a long-term target debt/EBITDA ratio of… 3.75x-4.25x. The company’s revenue stream is highly contracted and 50% of frac spread has been hedged.”

Moreover, its “recent acquisition of Kinder Morgan Canada… will help the company capture synergies in its portfolio of offerings.”

More Mostly Good News on Pembina (Especially Considering the Circumstances)

S&P also is a fan. It recently reaffirmed Pembina’s BBB stable credit rating, recognizing the solid steps it has taken since March to combat energy-price trends. This includes its decision to:

  • Defer C$900 million-C$1.1 billion of 2020 capital expenditures relating to various pipelines, facilities, terminals, and plants for two years.
  • Keep dividends as-is for the rest of the year
  • Obtain an extra C$800 million from its unsecured revolving credit facility.

S&P adds:

“The stable outlook reflects our view that Pembina will continue to maintain FFO-to-debt of about 16%-17%, as well as a high proportion of fee-based or take-or-pay type contracts, which we expect will constitute more than 85% of cash flows over our two-year outlook period.”

Morningstar, for its part, doesn’t expect the dividend to go anywhere anytime soon – either up or down – but analysts are more bullish. They expect modest dividend increases sometime into 2021 and 2022.

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Operating cash flow is expected to decline this year. But the discounted cash flow (DCF) payout ratio should fall to a very safe 64% next year and 61% in 2022. And that’s factoring in modest dividend increases.

Notably, Pembina’s cash flow is more exposed to potential production declines than larger Canadian midstream corporations such an Enbridge (ENB) and TC Energy (TRP). So its credit rating isn’t as high.

Morningstar points out that its “gathering and processing operations are tied directly into natural gas producer’s wellheads,” though this is balanced out with the long-term contracts it typically operates with.

Management Speaks

As for its growth backlog, Pembina hasn’t canceled most of that. It’s only postponed the projects. And management still believes it can achieve its pre-pandemic guidance of 5% – including for the monthly dividend – with its current ventures.

It has good reason to think so considering the growing supply and demand for hydrocarbons in western Canada. Because, as Pembina’s website points out, it “owns an integrated system of pipelines that transport various hydrocarbon liquids and natural gas products.”

Here’s CEO Michael Dilger on the subject during the Q2 conference call on Aug. 7:

“Pembina’s business continues to operate safely and reliably throughout the pandemic, ensuring uninterrupted service to our customers… We also continued projects in flight to ensure customers had the service as they needed.

“Second is our commitment to financial guardrails: Our strong contractual underpinning, fee-based take-or-pay revenue streams, prudent dividend payout, commitment to a… BBB credit rating, and focus on working with solid counterparties…”

Dilger, who has been with Pembina since 2005 and served as president and CEO since 2014, has a total of 25 years’ industry experience. So there’s a lot of reason to trust him there. And here too:

“… our top customers, many of which have just reported their own Q2 results, are performing well under the circumstances. Although higher prices are likely needed to incent significant growth in the basin… many are generating free cash flow after dividends and (capital expenditures) capex, and are focused on paying down debt and strengthening their balance (sheets).”

Overall, the company expects to end the year “in a solid financial position” – ready to tackle 2021 with its dividend in place.

Speaking of Management…

Keep in mind that Pembina’s payout survived two previous recessions, including the financial crisis. It’s not a new kid to this troubled block. A new kid wouldn’t be able to boast this, as CFO Scott Borrows did during the call:

“With no debt maturities for the balance of 2020 and $600 million of maturities distributed throughout 2021, Pembina’s liquidity position (of $2.8 billion) is ample. The recent debt issuances at a weighted average term to maturity of 17 years at a rate of approximately 3.2% provide a strong endorsement from a broad cross-section of the debt capital market.”

Speaking of management, it’s among the most experienced and proven capital allocators in the industry. Morningstar gives the team an Exemplary stewardship rating, and we concur given its 23-year track record of dependable dividends.

Altogether, we give Pembina the following ratings:

  • Dividend safety – 5/5
  • Business model – 2/3 above-average (narrow moat asset base)
  • Management quality/dividend culture – 3/3
  • Quality – 10/11 SWAN.

Consider how its business model is utility like in how stable its cash flows are.

(Source: investor presentation)

Even during oil crashes, adjusted EBITDA/share barely dips. And in 2016, it actually grew. Perhaps that’s because of its portfolio, which is diversified across the fossil fuel industry, with business mostly done in U.S. dollars.

(Source: investor presentation)

In addition, long-term contracts and fee-based revenues account for 93% of cash flow to support the 9%-yielding monthly dividend. 75% of the contracts are with investment-grade counterparties. And those that lack an investment-grade rating have to provide collateral.

(Source: investor presentation)

Pembina does not rely on equity markets to fund its growth plans. Not at all. Self funding is the gold standard of safety in this industry, and Pembina follows it to a T.

Modest Growth Potential for “Negative Growth”

Pembina is struggling through the negativity that’s plagued the energy industry for six years now. However, it’s trading at 6.4x cash flow.

According to the (Benjamin) Graham/Dodd fair value formula, that implies -1.1% compound annual growth rate expectations. Which isn’t likely.

Obviously, in the short term, the global pandemic is hurting oil and gas demand. However, even the relatively high-cost Canadian tar sands – a major customer for Pembina – isn’t in as much trouble as investors think.

Production costs, for one thing, are higher, yes. But Morningstar expects producers there to generate enough free cash flow to still pay down debt and pay out dividends. Furthermore, it continues to expect current key pipeline expansion projects to move forward, finishing up in 2023.

“Assuming that… we expect oil sands producers to tap into their vast resource potential and generate significant long-term free cash flow if oil prices recover to our midcycle average annual $55/barrel West Texas Intermediate forecast…

“Beyond 2021, we still expect robust crude oil demand growth, as disruptive factors like electric vehicles are likely to take much longer to meaningfully reduce the intensity of global crude consumption. Yet U.S. shale would be the cheapest source of incremental supply, and it has a marginal cost of $55/(barrel) for WTI. Prices must therefore recover to encourage this expansion, or the glut will flip into a painful shortage.”

We do expect prices to recover, however. So here’s Pembina’s long-term growth profile:

  • FactSet growth consensus through 2022 (factoring in the pandemic): 1.5% CAGR
  • Reuters five-year growth consensus: 24.5% CAGR
  • FactSet long-term growth consensus (looking beyond the pandemic): 3.9%
  • Ycharts long-term growth consensus: 3.6%
  • 20-year rolling growth rates: 8.5%-23%
  • Management growth guidance: 5%.

For sure PBA’s growth outlook has dimmed during the oil crash. But the 11 analysts who collectively know it better than anyone outside of management – as well as the credit rating agencies and bond investors – all expect at least modest growth in the future.

And some expect a return to hypergrowth).

Source: FASTGraphs

Pembina: A Proven Winner in the Past With Positive Points for the Future

PBA has beaten growth forecasts in eight of the last 10 years. And over the past 20, it’s met or beaten expectations 80% of the time.

Analyst margins of error are 33% to the upside and downside, giving it a 2%-6% CAGR, a range that doesn’t include zero, much less -1.1%.

But let’s say it does grow at zero somehow.

(Source: FAST Graphs, FactSet Research)

Even if PBA merely trades at the Graham/Dodd fair value multiple of 8.5, it would generate 13% CAGR total returns over the next five years.

(Source: FAST Graphs, FactSet Research)

Yet its market-determined fair value multiple is NOT 8.5x. It’s 13-15.

With that said, PBA is expected to grow much slower than in the past. So let’s be extra conservative and use the “depths of despair” bear-market average range:

  • PBA grows at 2% and trades at 9x cash flow = 16% CAGR five-year total return potential
  • PBA grows at 6% and trades at 11x cash flow = 22% CAGR five-year return potential.

2025 Consensus Return Potential

(Source: FAST Graphs, FactSet Research)

Note that, according to Ben Graham, the 3.9% CAGR long-term growth consensus justifies a return to historical multiples of 13-15.

So if PBA grows at 3.9% CAGR (near management long-term guidance) and trades at 15x cash flow, that would equal 26.7% CAGR five-year return potential.

Even if it merely returns to the average 10x cash flow it’s enjoyed over the last two years – in an awful bear market – analysts expect almost 19% CAGR total returns.

2022 Consensus Return Potential

(Source: FAST Graphs, FactSet Research)

And if it were to return to a cash flow multiple of just 9.5x by the end of 2022, then grow as analysts expect, it could nearly double your money in the next few years.

The Straight-Up Facts About Pembina Think we’re being overly bullish? Take a look at Pembina’s historical returns, which confirm its quality and market-crushing ability.

Pembina Total Returns Since 2004

(Source: Portfolio Visualizer)

In fact, over the last 16 years, PBA has outperformed the market by 3.5% annually. Even its lowest rolling returns over three or more years are much better than the worst equivalent periods for the broader U.S. market.

Here’s its risk-adjusted expected returns:

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(Source: Dividend Kings Investment Decision Tool)

Even adjusting for:

  • PBA not returning to fair value over the next five years
  • Analysts being wrong about its future growth rate
  • The 7.5% probability of going bankrupt

We get a risk-adjusted expected return of 13% CAGR and a probability-weighted expected return of 14% CAGR, which is virtually identical to actual returns PBA has delivered over the last 16 years.

Pembina: One of the Most Undervalued SWANs Around

When valuing a company, Dividend Sensei let millions of investors risking real money tell him what a company is worth. That’s why he looks at periods of similar growth rates, fundamentals, regulatory environments, and even interest rates where applicable.

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Remember we’re using the depths of the midstream bear market for these historical multiples. Not one of these average multiples is from a period when people loved Pembina. Yet we’re still seeing it as a 10/11 quality SWAN.

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Pembina is a classic Buffett-style “fat pitch,” anti-bubble, ultra-value company. And it’s priced for negative growth, which is a very low probability outcome for this company.

Pembina Investment Decision Score

Here’s another way to look at Pembina and what a good buy it could make right now.

Goal

Scores

Scale

Interpretation

Valuation

4

Potential Good Buy or Better

PBA’s 47.36% discount to fair value earns it a 4/4

Preservation of capital

5

Average

PBA’s S&P credit rating, BBB, implies a 7.5% chance of bankruptcy risk and earns it a 5/7

Return of capital

10

Exceptional

PBA’s 50.03% vs. the S&P’s 10.87% 5-year potential for return via dividends earns it a 10/10

Return on capital

10

Exceptional

PBA’s 13.1% vs. the S&P’s 3.88% 5-year probability-weighted returns earns it a 10/10

Total score

29

Max score of 31

Investment Score

94%

Investment Letter Grade

A

Excellent

S&P’s Score

73/100 = C

(Market Average)

(Source: Dividend Kings Automated Investment Decision Tool)

It’s an extremely reasonable and prudent long-term investment retirees can make in this still dangerously overvalued market. Though, as always, that doesn’t necessarily mean it’s right for you.

Pembina Risk Profile: Why This Stock Isn’t For Everyone

The most critical fundamental risk to remember about Pembina is that it has indirect exposure to commodity prices. So should the world experience a major second wave of the virus, energy demand – already deeply depressed – could continue to suffer or deteriorate further.

And some medical experts are predicting just that, which could cause some countries to reimpose lockdowns. Which means less fuel used.

This brings us to the second fundamental risk: Reliance on open credit markets for 50% of its capex funding with safe amounts of low-cost debt. S&P writes:

“We could consider a negative rating action during our two-year outlook period if FFO-to-debt declines and is sustained below 15% with no immediate path to recovery. This could be due to higher debt-financed capital expenditures or decreasing revenue from commodity-exposed business segments. In addition, any cost overruns mostly financed by debt or project delays could also result in a negative rating action.”

For now, analysts, credit rating agencies, and management expect PBA to have no trouble maintaining a very safe 3.75x-4.25x leverage ratio, along with very safe interest coverage. Then again, as we saw in March, the world can change in a hurry.

Other Risks Pembina Faces

Valuation risk is fortunately very low, with PBA trading at its lowest valuations in history. But even anti-bubble stocks priced for unlikely negative growth can still be highly volatile.

After all, PBA was highly undervalued back in February. Yet that didn’t stop it from dropping right along with the rest of the market in March, taking a total 63% plunge – its worst ever.

Pre pandemic, its average annual volatility was 18%, which was literally on par with regulated utilities. (It’s an energy utility after all.) But JPMorgan’s blue-chip economists expect Pembina to remain highly volatile until the pandemic is over.

It’s that kind of short-term negative potential that has us buying it up a little at a time, using limit orders along the way. Remember that SWAN equates to fundamental quality and dividend safety.

It has nothing to do with short-term volatility.

This is where the power of sound risk management and overall portfolio construction comes in.

If you want to sleep well at night no matter what happens with the economy or stock market, you need a diversified and prudently risk-managed portfolio that fits your specific needs.

In Closing…

This truly is an unprecedented time for the world’s economy, especially companies like Pembina. There are few more hated companies on Wall Street right now, but not due to poor fundamentals.

As we’ve shown in great detail, PBA’s:

  • Balance sheet is strong
  • Business model is fundamentally attractive for conservative income investors
  • Management is world class.

Are there risks to consider? Absolutely. No company is risk free, after all.

But for those searching for the highest-yielding, safe, monthly dividend stock – with very dependable and mouthwatering income?

Pembina Pipeline looks really, really good right now.

As long as it generates positive cash flow growth of any kind, there’s a 90% probability that its very safe 9% yield will significantly outperform the broader market over the next decade.

More importantly, that eye-popping – and very safe yield – is one management plans to grow 5% CAGR over time. If it can manage that, it makes Pembina a retiree’s dream stock.

Author’s note: Brad Thomas is a Wall Street writer, which means he’s not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.

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Disclosure: I am/we are long PBA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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