Better a buyer than a builder be?

It’s the biggest foreign deal for a Canadian company ever. Yet at a time when new pipelines are an extremely tough sell, Enbridge’s $37-billion Spectra Energy buy stands tallest for solving that problem—and earns distinction as Listed’s 2016 Deal of the Year
By Robert Thompson

The "timing was right" for Enbridge to buy Spectra, says CEO Al Monaco, and fit with a plan to diversify the company's sources of growth

Al Monaco had been planning something big for years. All the indicators were there. After all, Monaco, who became chief executive of energy giant Enbridge Inc. (TSX:ENB) in 2012, announced last year that his company was freeing up $30 billion in assets to create a war chest to pursue a number of possible scenarios.

Any deal would have to help Monaco with his pledge to increase the company dividend by 33%, that much was clear. At the same time, Enbridge was already facing increased political and environmental scrutiny over any further pipeline development it wanted to undertake. That, coupled with foundering oil prices, meant expanding organically to meet future revenue growth targets would be increasingly difficult.

It turned out Monaco had an ace up his sleeve.

“Enbridge has been assessing opportunities to extend and diversify our sources of growth,” Monaco said after the unveiling of his company’s $37-billion acquisition of Texas-based Spectra Energy Corp. on Sept. 6. “We’ve been talking about that for a couple of years. That’s what our shareholders expect of us.”

Given Monaco’s earlier comments, news of a deal shouldn’t have been startling. However, the Spectra acquisition’s scale—an all-stock transaction that is not only the largest deal Enbridge has ever undertaken, but also the largest foreign takeover by a Canadian buyer in history—is eye opening and revolutionary for Canada’s largest energy company.

What happens when the terms “massive,” “giant” or “largest” just don’t do justice to the scope of a transaction? Call it a colossus instead, or proclaim it the “biggest ever.” But even that seems to discount just how significant Enbridge’s takeover of Spectra really is, as well as understating its implications for the Canadian oil and gas industry going forward. Yes, this is a massive deal—when approved, it will give Enbridge a market cap of nearly $100 billion and an enterprise value of $165 billion—but the potential ramifications for the North American energy sector are similarly staggering. For all of these reasons, Listed selected it as its 2016 Deal of the Year. (See our three runner-up choices here).

“There are lots of past deals of the year where you might scratch your head,” says Barry Munro, Canadian oil and gas leader at EY. “But in this transaction is a good example of a Canadian company that sees the world as a possibility and they wanted to take greater control of pipeline infrastructure and stepped into the U.S. to do that.”

In fact, given the way the two companies fit together, creating an energy giant with massive scale in oil and natural gas infrastructure, the notion of their union seems surprisingly straightforward. Enbridge had sought to diversify its business, which is highly reliant on moving crude, by taking over Spectra, which has more interests in natural gas. Spectra brought 140,800 kilometres of gas pipelines to the deal, while adding only 10% to Enbridge’s 27,600 kilometres of liquid pipelines. While it is more nuanced than that, on the surface it appears to be a deal where two companies bring complimentary assets to the table.

Based on Monaco’s comments in a conference call with analysts the day of the deal, he’d long seen the potential of bringing the two firms together. “They fit perfectly and fulfill both companies’ diversification strategies,” said Monaco.

Indeed, it turns out Enbridge had coveted Spectra for some time. By their own admission, the two energy giants kept in contact, reviewing and considering options where their respective businesses might benefit, options the companies say were “in light of industry, regulatory, and economic trends and developments.” In other words, the energy business is full of uncertainty—especially for any company that wants to build new pipelines—so where’s the harm in like-minded executives kicking around a variety of potential scenarios? According to documents released when the deal was announced, those discussions had gotten all the way to the possibility of a merger in the past.

Tag team: Once the deal’s approved, Enbridge CEO Monaco will keep his current job and Spectra CEO Greg Ebel (right) will chair the Enbridge board

THAT POSSIBILITY ACCELERATED in early May of this year, at Enbridge’s regular board meeting in Calgary. There, a transaction involving Spectra was raised and the notion of how the two companies might be brought together was considered.

Slightly more than a week later, Monaco contact Greg Ebel, Spectra’s president and CEO, to discuss whether a deal might be possible. In early June, they went a step further, bringing together the two companies’ senior management teams in Denver. Given the economic climate both companies were facing, and the challenges of expanding revenue opportunities, EY Munro’s says it’s easy to imagine what they were thinking.

“These guys are looking at five-year growth plans and are seeing the macro cycles that affect the plan,” he says. “In some cycles it is about getting cash, but in this cycle it is about access to opportunity. They are asking whether they will ever get any greenfield projects approved [and saying], ‘If I can’t, how can I grow inorganically?’ ”

By the time of their meetings in Denver, Enbridge and Spectra had clearly navigated a long way to completing a deal. Beyond the euphemistic notion of synergies between the two businesses, Ebel’s team had worked out dividend payout assumptions, and a preliminary proposal that included a 10% premium on Spectra’s stock, with a deal where 90% would be stock, with the remainder in cash.

Two weeks later, with Spectra involving its law firm, Wachtell Lipton, and its bankers (Bank of Montreal, at that time), the companies met again. Soon after, a confidentiality agreement was struck, which led to the creation of data rooms and due diligence planning that took much of the next three months. In July, Enbridge involved Credit Suisse in the deal and began reviewing the financial structure of the arrangement.

By the end of July, Enbridge met with Spectra to detail the consistency of the board of the combined entity, while ensuing meetings detailed the role of the chairman, a position Ebel was tapped to take. Dividend growth was also a key to completing the arrangement, with Spectra anticipating a 10% annual bump.

Dan Barclay, head of investment and corporate banking for Canada and international markets at BMO Capital Markets, in an exclusive interview with Listed, says one of the secrets to the transaction was the transparency of the positions of both companies. While the details on the financial makeup of the sale were bandied about over months of negotiations, he says neither company lost sight of what they were trying to accomplish.

“The two sides were very aligned on how they saw it,” Barclay says. “It wasn’t about one saying, ‘Pay me more.’ It was about one plus one equaling two and a half, and they both had that shared vision.”

That was a perspective Monaco supported after the deal was announced. “Greg and I really believe that we are even better together, and the timing is right for this to happen now,” he said.

As the close of summer approached, most of the details of the deal were agreed to. Enbridge brought RBC Capital Markets into the discussion, along with its Canadian law firm, McCarthy Tétrault.

Enbridge’s five-year stock chart (click to enlarge)

Spectra had already said it preferred the deal to be largely stock, and both operations spent significant time working out the correct mix, with Enbridge initially offering 0.87 of Enbridge common shares plus $3.82 in cash for each Spectra share, a 7% premium. In time that would increase to 0.966 of Enbridge common shares, before the deal transitioned to an all-stock arrangement at 0.984 per Enbridge share, giving Spectra a premium of 11.5% and a value of $40.33 on September 5. The deal would be announced the following day.

WHAT CAUSED ENBRIDGE TO pull the trigger on a deal now, when it had decided against it in the past?

Barclay says this is one of the unusual circumstances where financial stars aligned between two massive companies. “We as investment bankers talk in code often and we know that,” he says. “But when I say the valuations lined up, it is very rare that when we have companies of this magnitude, you can create a transaction that makes strategic and financial sense, and it has to make financial sense for both [sets of] shareholders.”

While value, timing and driving Enbridge’s dividend growth rate over the next decade are key to the acquisition, uncertainty was clearly another factor. Creating new oil infrastructure projects in Canada and the U.S. has become increasingly challenging, with major political and social obstacles at play. Whether it is the headlines grabbed by the Keystone XL pipeline, or the Liberal government’s just-announced decision to reject Enbridge’s Northern Gateway pipeline while approving its Line 3 Alberta-Wisconsin rebuild and Kinder Morgan’s Trans Mountain pipeline, such projects are increasingly volatile and influenced by a wide array of factors, from indigenous organizations to the environmental lobby. The end result is uncertainty, something Enbridge is well aware of.

Enbridge declined Listed’s request for an interview, saying it couldn’t comment until the deal is fully approved, likely in the first quarter of 2017. But at the time of the deal, Monaco said both companies have $48 billion in “probability-weighted” projects in the offing, but admitted he wasn’t sure exactly how that would play out. The questions around infrastructure development are so uncertain that neither company actually includes it in their growth projections. “I don’t know if we win all that or how much or less it would be, but certainly that opportunity set is big enough that even if we win a portion of that, we’re going to be driving out this growth that we’re talking about in the next five-year horizon, with a pretty good degree of certainty,” he said.

Nevertheless, with Enbridge offering investors aggressive dividend growth, the promise of adding guaranteed revenue streams through Spectra made the purchase appealing. Once the deal is completed, Enbridge promises to raise its dividend by 15%, and expand it by 12% per year until 2024. For an investment manager, it makes Enbridge a very safe bet for consistent returns. “We believe the go-forward Enbridge and Spectra provides a very compelling investor value proposition by combining the highest quality liquids and natural gas infrastructure assets in North America to the largest secured organic capital programs in the industry,” Monaco said, adding the acquisition provides “many opportunities for organic growth and visible annual double-digit dividend growth well into the future, while maintaining conservative payout policy.”

Analysts seem to agree. “The greater growth diversification expected post-closing of Spectra mitigates the risk of [Enbridge] underperforming its impressive 10-15% average annual dividend growth guidance through fiscal 2024,” wrote Veritas analyst Darryl McCoubrey in a report.

That’s significant given the current political environment, says Munro. “The new factor in all of this is the regulatory environment,” he says. “The challenge from the Canadian perspective is that it is fast-evolving and not well-defined. People don’t know what to expect. When you’re a big organization and you have no idea what the process is to get a transaction approved, it can be very difficult to plan for.”

Infrastructure, and how it is utilized going forward, is key, says Bill Harris, a partner with Avenue Investment Management. Questions in both Canada and the U.S. over oil infrastructure make existing pipelines even more potent. A bird in the hand, essentially, has never been as valuable.

“If I own the infrastructure isn’t it even more valuable because I can’t get anything else built? Don’t I get to charge more on the stuff I already have?” Harris asks. “This deal is all about asset allocation. Now, they have the choice between oil and gas, while covering the full continent. They are thinking about their business as being about energy infrastructure in North America and the deal allows them to do big projects as well as incremental projects.”

The other key takeaway is the scale of the transaction, Harris says. By creating a company with a market cap of nearly $100 billion with a North American scope, Enbridge is in a better position to battle in a challenging market. Big, in this case, is significantly better, Harris argues.

“In a way we’re seeing a totally integrated North American business model,” he says. “This is going to make money and in short order it will be a $100-billion company. And the reality is, for bigger companies it is easier to get your margin when you’re that big. And if I’m looking for a consistent rate of return, the processes of a $100-billion company are so good that they are the ones who make the margin.”

Not everyone is so certain. Ivey School of Business Professor Adam Fremeth says with scale often comes increased scrutiny.

“I think there are a number of issues with scale. Now they are managing a super entity, and that can be a challenge and Enbridge has a bit of a track record that suggests they need to pay close attention to their operations,” Fremeth says, pointing to the Kalamazoo River oil spill in 2010 that occurred when a Enbridge pipeline burst, creating one of the costliest spills in U.S. history. “And when you start to become this big, issues take on greater magnitude. While buying another big pipe company is one way of getting around laying new pipe, I think the issues with First Nations, environmental and other groups may persist and they will just show up at these new forums.”

WHICHEVER VIEW PREVAILS, the die is cast. But if the deal succeeds and present market, regulatory and societal conditions persist, there’s a good chance this won’t be the last big international deal for Enbridge. Industry analysts are already speculating that future growth for the company might continue to come through deal-making.

“We believe a willingness to pursue strategic M&A could create a clearer growth trajectory, better potential diversification, and greater ability to de-lever,” said Goldman Sachs’ Theodore Durbin in a report on the deal.

It’s a prospect Monaco seemed to embrace in discussing the deal in September, even as he stressed that getting bigger for the sake of getting bigger isn’t an objective in its own right. “It’s growing cash flow and earnings per share that matters,” he said, before adding: “But it is a fact that scale mitigates exposure to industry downturns and a challenging project execution environment, and will generate new, large and more diverse opportunities for us.”

Photography: Enbridge Inc.

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