In this episode of Industry Focus: Energy, The Motley Fool Canada’s Nate Parmelee joins the show to break down the pipeline industry and look at an ongoing bidding war between Pembina Pipeline (NYSE:PBA) and Brookfield Infrastructure (NYSE:BIP) for ownership of the pipeline assets of Inter Pipeline.
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This video was recorded on June 3, 2021.
Nick Sciple: Welcome to Industry Focus. I’m Nick Sciple. This week, we’re taking a look at the pipeline industry. Historically, these businesses have been reliable, steady dividend payers. However, with the rise of ESG investing, they become less loved by the market. Motley Fool Candidate Analyst Nate Parmelee joins me this week to share his thoughts on the pipeline business and its potential for investors. Nate, thanks so much for joining me today.
Nate Parmelee: Great to be here.
Sciple: Great to have you. For folks who’ve been listening to podcasts for a long time, this is Nate’s first time on the show, so I want to welcome Nate on the podcast. Could you tell our listeners what you do at The Motley Fool? How long have you been here? What kind of companies interest you?
Parmelee: I’m a generalist since I’ve been here, which means I invest everywhere and look at everything. That’s partly because in most of the 17 years I’ve been at The Motley Fool, I’ve been focused on international investing. By nature, you fall into more of a generalist than industry-specific sphere. But I also invest across styles, so growth, dividends, value, etc. Currently within the fall, I’m one of the co-advisors on our FinTech Fortune service. I also help out with our Dividend Investor Canada service and across really all the products we have in Canada.
Sciple: Very exciting. You mentioned the Dividend Investor Canada work, where we’re talking about the pipeline industry today. Historically, it has been very much a dividend-paying industry. What do you look for in a dividend stock? You’re picking stocks for Dividend Investor Canada, what are the trends you’re looking for?
Parmelee: Cash flow. It really comes down to cash flow with valuation if you want a big yield now. If you’re looking further how to switch the cash flow growth and what can that dividend growth be. I tend to prefer the dividend growth stories myself.
Sciple: You need to have that cash coming in the door and hopefully you got more cash coming in the doors, so you can pay me more and more. I mentioned off the top that historically these pipeline businesses have been these steady, reliable cash flow businesses that make for decent dividend payers. Why do you think these have historically been good dividend stocks?
Parmelee: I live in New England and I’ve got heat in my house and I use natural gas and a lot of my neighbors use natural gas really out here. You can either use natural gas for the most part, or you have a truck pull up once a month or so and you have a big tank in your basement and they fill it with heating fuel, which is essentially diesel, that’s color differently so people don’t try to resell it. But that’s really the option. It’s either that or go cold, and you can’t really have your pipes first, so nobody goes cold.
Sciple: This is a pretty steady demand here. People like to be warm, they will pay what they need to pay to get warm and then to go to where the pipeline business plays in. These companies have a stranglehold, if you will, on the supply, getting to your house as they go through their pipes to get there.
Parmelee: Exactly, and it’s not just to the houses, it’s also good to power plants which have increasingly been shutdown over the last decade from that recall, and new plants have been built that use natural gas and those are expected to last decades, not just a few years. There’s consistent demand. It’s not just heat, it’s also electricity. People use it for cooking, other industrial uses and it’s also pipelines aren’t just natural gas. There’s oil sands, gasoline, all sorts of things run through pipelines.
Sciple: Absolutely, and so when you think about yet, you have this pipeline in place, you own the pipe, you have a monopoly on that transportation source. Once you have this pipe in place, it doesn’t really make sense to put a parallel pipe in there until the first one is at full production. When you talk about competition with other forms of transportation, it’s cheaper to throw it in a pipe than it is to put it on a truck, or railroad, or any of those sorts of things.
Sciple: Safer, that as well. We mentioned earlier how you need to turn your house on, these things are systemically important. We just learned in the past few months with the Colonial Pipeline Incident, you turn this thing off for a weekend or half a week, I think it turned out and you have people across the country lining up to get gasoline. These things are super important. One thing I mentioned off the top, there’s the rise of ESG, and you mentioned the hazardous nature of these things. These are highly regulated entities.
Parmelee: Yes, absolutely. That’s part of the reason you don’t have parallel pipelines, is never mind the economics and capacity. Nobody wants another pipeline running through unless it’s absolutely necessary, just because everything running through there is technically toxic. Nobody wants that leaching into groundwater or anything else.
Sciple: Nobody wants their house right next door to the pipeline, even though everybody wants to have the pipeline running and operating smoothly, because this is what allows the whole economy and those sorts of things to run smoothly. Again, to go back to the Colonial Pipeline example, and we’ve seen because of these regulatory issues and stronger and stronger attitudes against having these things constructed, it’s becoming more and more difficult to build pipelines. One example is right at the start of the Biden administration, the new presidency shutdown, the prevention of the Dakota Access Pipeline. You talk about difficulty building a pipeline, it’s been three presidents. They’ve had to figure out whether they are going to be able to build this thing or not. It’s getting harder and harder to build these, which in a way makes this existing infrastructure that much more valuable.
Parmelee: It does. It also limits the ways we can move things around without building new pipelines and how we go about it. Its longer-term area probably does make the alternatives of wind and solar and other means of power generation, whether it be hydro or other things more important. But these are things that will take decades to roll out, and you can’t just switch from one to the other cleanly, we need pipelines, we need those other technologies as well.
Sciple: That’s an important point to make, so that the higher the transportation costs is to get whatever the commodity is from the well or wherever it comes out of the ground to the end-user, that’s going to get baked into the end price, and the end-users looks at those substitutes and sooner or later folks switch away. One thing we’ve seen as it’s become harder to build pipelines, there’s also fewer people interested in owning pipelines, and we’re seeing some continued consolidation in the space. A lot of folks might be familiar with about a year ago, Berkshire Hathaway bought up Dominion Energy‘s pipeline business, natural gas pipeline business for, I think it’s about $10 billion enterprise value. This is a utility getting out of the pipeline business. Earlier this week, we had a similar deal with Kinder Morgan buying up the natural gas pipeline distribution from Stagecoach Services, which is a joint venture between Con Edison and another company. What do you make of this consolidation in the pipeline industry more broadly?
Parmelee: I think some of it comes down to COVID and a lot of folks who didn’t have expansion projects going on cash piled up, and a lot of these stocks are somewhat cheap. Now they’re looking at, do we buy the assets that are in place or do we look at expansion projects? I think what they’re finding is assets in place are more attractive than lower risk because they are already in place. You don’t have to deal with a lot of the extra hurdles you have to go through with expansion separate from costs or factored in the cost, I guess I would say. I think that’s part of what’s going on. I also just think there’s fewer and fewer opportunities. As the bigger folks use their scale to their advantage, they are going to look to buy up attractive assets where they can.
Sciple: What you’re talking about, so maybe a month or two ago, we talked about the Kansas City Southern deal about how there’s not that many railroads out there, and if you’re in the industry and you want to go make a deal happen, there’s not that many deals out there, and I think it’s obviously significantly less consolidated in pipelines than it is in railroads. Well, there is that dynamic a little bit. There’s only so much out there. When a deal comes open, there’s going to be lots of people bidding on it, potentially which ties us into maybe our main story that we want to talk about today, which is this week we’ve got to continue bidding war for pipeline assets. Inter Pipeline is up for sale and there are two different companies bidding on this asset. We’ve got Pembina Pipeline, which folks may or may not be familiar with, but folks are definitely familiar with if they listen to the show is Brookfield Infrastructure, the infrastructure arm of Brookfield Asset Management. Nate, can you frame up what’s going on here in this bidding war and what’s Brookfield doing and where we’re going here?
Parmelee: Brookfield is always just, where can I find an undervalued asset? Can I still get it at a good price? I’ll buy it. That’s how they operate and they are everywhere. It’s not just in infrastructure, they’re on property, they’re on everything. Pembina is pipelines pretty much, it is its business. With the combination with Inter Pipeline, they have a potentially interesting relationship in that they have propane supply, and Inter Pipeline has built a new pipeline or is building a new pipeline and your petrochemical facility that needs propane supply. Pembina has it. There’s a nice integration possibility there. What Pembina doesn’t have is the balance sheet strength or the same access to capital as Brookfield. They have good access to capital, but almost nobody has the same access to capital as Brookfield except for maybe Berkshire and some few others in the state. I think it comes down to, in a sense, what does Brookfield want to pay? Because they can outbid if they want to and then how much do Inter Pipeline shareholders value what Pembina brings to the table as far as propane assets and the integration, and is the sum of the two greater than they are individually, because Pembina’s deal is an all stock deal. In theory, you would see that appreciation if you’re an Inter Pipeline shareholder whereas the majority of Brookfield deals are cash. Do you want cash now or do you want to hold out and see that bigger return in the future? That’s another thing shareholders need to weigh.
Sciple: Yes, so you got one group that has synergies and no cash, and another one that has a bucket of cash and arguably less synergies. Now, Brookfield sophisticated operators, I’m sure they see some ways that they can bring efficiency out of here but these are the challenges. Why do they have so much access to capital? What makes them such a big player in this industry and such a formidable person to face.
Parmelee: Great capital allocators that have been added for decades. I mean, that’s how you prove yourself, you do it for decades. You amass your own capital, never mind people who are willing to give you a capital to invest or lend you capital. But that’s really what it comes down to.
Sciple: I think another factor layered in here is the Brookfield offer can close much more quickly.
Parmelee: That is the cash aspect.
Sciple: If you’re a shareholder in Inter Pipeline, which would you prefer here and why?
Parmelee: I tend to lean toward where is the long term return I can get. A lot of times when my small caps get bought out, I’m disappointed because I feel like it could have achieved so much more, and a lot of time you get cash and you wish you could have gotten stock. With Pipeline it’s a little bit tougher, I think I would lean toward Pembina but I could see going either way. I think a lot of investors prefer if they’re getting bought out, just get the cash and go, what’s my next investment?
Sciple: I guess when you think about pipelines, this is a cash flow stream at the end of the day. Brookfield is essentially discounting this existing cash flow stream you would think with the price that they’re going to pay for this acquisition. With the Pembina deal, you can tell a story that it’s not just what we have today, it’s something that we can have in the future. We can go down market both ways I guess become more vertically integrated with how we sell our products. Perhaps there’s more margin they can capture. We’ll see what happens. How do you think it ends up playing out? I think you said privately that if Brookfield had this, do you think they can have it?
Parmelee: Pretty much. I mean, they really can’t be outbid. I’m sure Pembina can bring some cash to the table if they work at it. By the same token, if I were an Inter Pipeline shareholder and I could have Brookfield stock, which they’re probably not going to give you a lot of because that’s expensive capital they get good returns, then I would probably take Brookfield stock. I think it could really go either way. I’m really curious to see if Inter Pipeline sweetens their offer again.
Sciple: It comes back to one of these other themes that we were talking about earlier, there’s only so many pipes out here left. It’s very difficult to construct a new pipeline, should we expect more consolidation? In the cases where it becomes clear that some things are up for bid, more and more of these bidding wars.
Parmelee: I think now our assets are reasonably priced. I think we will see consolidation because you’ve got Kinder Morgan, Brookfield and some other players. There are a number of folks in the industry who’ve been pretty good at allocating capital and growing. Some of that has been, they’ve had a tailwind of sorts from gas and shale oil and other things. But they’ve done well and there’s some smart people out there. As long as they can get assets at reasonable prices, I think we’ll see consolidation.
Sciple: In any of those things about assets at reasonable prices you see these companies, you could think of Brookfield as a private equity business. When you see these folks come in, it’s because there’s some reason in the public market that these things maybe aren’t being adequately valued or are not getting as much valuation. We mentioned off the top that there’s more and more of the ESG pushing more and more folks who don’t want to own assets like pipelines. Do you think that’s structurally creating an opportunity that these stocks are undervalued for a reason?
Parmelee: I think in the near term, yes, I’ve seen this before with pipelines. Nobody wanted to own pipelines into the financial crisis. It happened again with COVID, but in between there was a period where pipelines were expensive. Everybody wanted to have them because of all the gas and other things that were going into the expansion projects and the growth etc. I think when you see it slow down, you see people lose interest. For now, yes, but I’m not sure pipelines are as far as investor interests are gone forever.
Sciple: Okay, which raises my question as we start to tie things up a little bit. What are you watching as we look out into the next, say five to 10 years? You’ve laid out this theme of more difficult regulatory pressure, consolidation things like that, what are you paying attention to going forward?
Parmelee: I think who has expansion projects still out there and what they can add to the businesses. I also think it’s curious, I’ve read about some cities starting to say, no new construction with natural gas, and some states saying that and trying to pre-empt their cities from enacting similar legislation. To meet that probably hurts the utilities that provide natural gas more than the pipeline folks, because still going to be making electricity using natural gas, and we still have all those other assets. Folks don’t need to keep their homes things like that, so I don’t see them going away, but that is a dynamic that I think is worth watching over the next few years and how it evolves.
Sciple: If we move away from natural gas for heating there’s going to be a substitution effect, because people aren’t going to stop heating their houses. I don’t think we’re all going to start sleeping in the cold anytime soon. In theory, you are going to go to some type of electric based heat pump something like that, well that takes electricity to power it, and so you can tell a story where you’re not taking natural gas straight into your house anymore or heating oil or what have you through small pipes, but instead, you’re using the same amount of energy to heat your home but it’s going to a big pipe to the utility, and then the utility is having to charge, it’s to charges you more for power. Can you foresee a world where there’s less at the home use of natural gas or some of these heating oil, but yet the net use of it and energy goes up?
Parmelee: It’s really tough, because electric heat is also less efficient. I think the heat pumps to a little bit better than the baseboard electric heat. But it’s more expensive in general to use electric heat. You are usually better off using natural gas then oil and then electric.
Sciple: Cut out the middleman?
Parmelee: Yes, exactly in a sense, but I think you’d have to see electricity prices change and it would be great to have solar or wind or something like that. But on a cloudy day in New England, you need something else solar that is not going to work for you. It’s going to be somewhere and shifting over the grid or something else.
Sciple: What do those substitutions look like over the next few years? Because this political trend is probably not going to reverse, I guess in the super near term. One last thing, Nate, so we’ve talked about pipelines, we’ve talked about various companies here. There’s probably folks who want to say, hey man, maybe I want to go look at some pipelines to invest in and I think there’s industry is interesting. What would be on the short list of if you wanted to make, these are the places I would start looking in the pipeline space for stocks to consider buying. What are the companies that come to mind for you?
Parmelee: I’m always keeping an eye on Kinder Morgan, that’s one. Pembina’s is one that I have kept an eye on and thought about in the past. They’ve got a great monthly dividend which is attractive. If you’re an income investor it’s great to get that payment coming in every month as opposed to two times, four times a year. That’s always great. Trying to think outside of that, some of the MLPs are interesting but then you’re dealing with the extra forms on your taxes. So, depending on how much of that bothers you, having to deal with the extra, I think it’s the K-1 forms on your taxes and jumping through those extra hoops. Enterprise Products Partners in New York, some of the others are interesting as well. But my preference is to simplify my taxes. I’ve done the MLPs in the past, and if I’m getting a great deal, I’m happy to do them but I have to make a lot of money to put in the extra time, plug in all the data into my taxes which never seems to go right.
Sciple: The return on brain damage thing?
Sciple: Yes. We’ll throw those tickers in the description of the show for everybody. Nate, thank you so much for joining me, I look forward to having you on again soon.
Parmelee: Great to be here. Thanks for having me.
Sciple: As always, people on the program may own companies discussed on the show and The Motley Fool may have formal recommendations for or against the stocks discussed, so don’t buy or sell anything based solely on what you hear. Thanks to Tim Sparks for mixing the show, for Nate Parmelee, I’m Nick Sciple, thanks for listening and Fool on!
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