Enbridge: Going Long With Calls


Enbridge (ENB) is a company that has been on many value investors’ radars for some time now, including ours.

Following a period where it looked as though Enbridge shares, while cheap, fell into the “value trap” category and a period following that, where shares were falling precipitously and resembled a “falling knife,” this article will attempt to explain why the time is finally now to make your move on North America’s largest energy infrastructure company – and how to use deep-in-the-money call options to boost your returns.

Enbridge Acquires Spectra Energy: The Good and The Bad

In September 2016, Enbridge announced it was buying Houston-based Spectra Energy for $28 billion.

The deal was the largest M&A transaction within the pipeline space since the fall in natural gas prices back in 2014 and created the largest energy infrastructure company in North America, with a combined enterprise value of $133 billion.

The good news is that the transaction will go a long way to helping Enbridge diversify its operations – an objective that Enbridge’s CEO Al Monaco had been in pursuit of for more than two years.

Prior to the deal, Enbridge’s primary business was the transport of crude liquids from Alberta to the Gulf Coast.

Spectra’s primary business, meanwhile, is the transport of dry natural gas to the U.S. east coast, so the transaction effectively diversifies Enbridge’s risk exposures, both from a commodity point of view and also from a geographical perspective.

The bad news is that the $28 billion price tag didn’t exactly come cheap, and in combination with the deal, Enbridge also assumes $22 billion of Spectra’s debt.

The move certainly makes sense from a long-term perspective, but with the added financial obligations that Enbridge now carries post-transaction, Enbridge’s shareholders can expect the company to slow down on the pace of its dividend increases – which had previously averaged a compound annual growth rate (“CAGR”) of 16.1% between 2010 and 2017.

Enbridge’s Dividend Growth Will Slow, But the Shares Should Still be Expected to Outperform

Enbridge’s dividend growth will assuredly slow over the next three years, 2018-2020, from its previous pace, which could explain at least partly why some investors have bailed on the stock over the past few months.

This is essentially referring to the “clientele effect” or the theory that a company’s share price will naturally react to changes in a company’s dividend policy.

But while “dividend growth” investors may now be in search of opportunities elsewhere – thanks to the recent sell-off in the company’s shares, the current 6.71% forward yield on Enbridge stock is extremely attractive in light of the company’s plans to increase its payout by 10% annually between 2018 and 2020:

Enbridge: Going Long With Calls

Source: Enbridge Investor Center

According to traditional financial theory, this suggests the expected total return on an investment in Enbridge shares to be 16.7% annually, based on the current share price:

Total return = Dividend Yield + Dividend Growth

The end result is that Enbridge’s shares should be expected to outperform over the short-to-medium term, until the market reaches a more appropriate equilibrium with respect the company’s dividend yield.

Where Should Enbridge’s Shares Trade?

Normally we would approach this problem using a Free Cash Flow (“FCF”) framework:

FCF = Cash Flow from Operations – Capital Expenditures

However, in the case of Enbridge, the company typically reinvests 100% of its Cash Flow from Operations (“CFO”) back into the business, rendering this approach meaningless.

Instead, we can look to the value that the market has typically placed on the company’s CFO to get an idea of where shares should trade.

Over the past three, five, and ten years Enbridge’s shares have tended to trade between 10-14x the company’s annual CFO per share.

If we take the mid-point of that range, 12x, and apply it to our forecast of CFO per share in 2018 of $4.55, we get an estimate of fair value for the Enbridge shares of $54.60 (NYSEARCA:CAD).

$54.60 = 12 x $4.55

At a price of $55 on the Toronto Stock Exchange, (US$43), Enbridge shares would yield 4.9% which also happens to be the mid-point of the range that the company’s dividend has traded at over the past three years.

Understanding the Charts: Why Now is the Time to Make Your Move on Enbridge

Having been following the company for a while, we’ve been using technical analysis (the study of stock prices and patterns) to help identify the “floor” for the Enbridge shares.

While the shares appear to be undervalued, fundamentally, by 38%, there are also several technical signals indicating that shares have now “bottomed out.”

Source for all charts:

The monthly chart (shown below) indicates that share are oversold on the Relative Strength Indicator (“RSI 14”) and are in the process of forming a “double bottom” against the critical $38 level.

Enbridge: Going Long With Calls

The weekly chart (shown below) confirms the oversold thesis, showing that Enbridge shares are also oversold on the weekly RSI 14.

Enbridge: Going Long With Calls

Meanwhile, the daily chart (shown below) reveals a “bullish divergence” pattern, and a recovery in the daily RSI from an oversold condition, at the same time the share price has continued to fall.

The daily chart below also shows a bullish MACD pattern, indicating that a potential trend reversal may be imminent.

Enbridge: Going Long With Calls

Leveraging Up Using the Enbridge Calls

While we have referenced the company’s dividend in assessing where the shares should trade, we are in fact not interested in collecting Enbridge’s 6.71% yield.

Instead, we are going to use leverage with this trade, buying the January 2019 25-strike calls underwritten against the Enbridge shares traded on the NYSE.

We chose the January 2019 calls to allow ourselves some time to let the trade play itself out.

We chose the 25-stike calls as, given the current share price, this is the strike at which the calls have a delta that approximates one, while also minimizing the time value, or premium that we are required to pay.

Based on our price of $5.33 per underlying unit, even if we were to use the stock’s 200-day moving average as our price target (shown below) and the nearest point of overhead resistance, depending on how things play out, this could potentially represent a 100% gain for us on the trade.

Enbridge: Going Long With Calls

Disclosure: I am/we are long ENB.

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.

Additional disclosure: I/we are long the Enbridge January 2019 25-strike calls.

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