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Avoid Pembina Pipeline Corp. and Buy This Pipeline Instead

The Canadian oil sands are currently Canada’s economic engine, with a projected annual growth rate of 4%, or 175,000 barrels of oil per day. This trend will continue steadily until a minimum of 2030 as oil sands resources are extracted in response to escalating global demand. However, for investors concerned with commodity price risk, which is a valid concern given recent crude price weakness, investing in oil producers may not be the best play on oil sands growth.

A better alternative is pipelines. Pipelines get most of their revenue independent of commodity prices, and contracts are often fee-based, which means the pipeline is paid per unit of production transported. Often, pipelines have cost-of-service contracts, where they are paid a fixed amount for costs plus a fixed return. With these contracts, the pipeline carries no volume or commodity price risk.

With the advantages of pipelines in mind, what is the strongest Canadian pipeline to consider? Pembina Pipeline Corp. (TSX: PPL)(NYSE:PBA) has been a winner for the past several years, with a 500% total return from 2004 to 2013, successfully outperforming all of its energy infrastructure peers. Despite this, the future may not be as bright.

Why you should avoid Pembina

Although Pembina has been growing its revenue well, it has been seeing its gross profit margin decline every single year beginning in 2010, falling from 41.67% to its current 15.58%. Similarly, Pembina’s return on equity, a strong measure of how well the company is using your money to generate returns, has been declining from 16% in 2010 to 8% currently. This is largely due to the fact that Pembina is seeing its costs rise at a much faster rate than its revenue, which is putting pressure on its ability to generate returns.

Since the beginning of 2012, Pembina has seen its share price increase over 100%, from $22.50 to its current $47.62. In this same period, though, its earnings per share only increased by 24%. This means Pembina’s share price has been growing much faster than its earnings, which should be a warning to investors that the stock is getting too pricey.

With a price-to-earnings ratio of 39, Pembina is more expensive than its peers Enbridge (TSX:ENB)(NYSE:ENB), which has a price-to-earnings ratio of 36, and TransCanada Corporation (TSX:TRP)(NYSE:TRP), which has a price-to-earnings ratio of 24.3.

Buy this pipeline instead

One of Pembina’s main competitors is Inter Pipeline Ltd. (TSX:IPL). Like Pembina, Inter Pipeline is a feeder pipeline, which means it transports products from oil batteries and storage tanks located at production sites in the field to key marketing hubs. Inter Pipeline has a dominant position in the oil sands marketplace and currently transports a substantial 40% of oil sands production.

Inter Pipeline has most of its cash flow secured by 20-year cost-of-service contracts, and estimates its dividend payments in the future will be secured by these contracts alone, regardless of what happens to its commodity exposed revenue. Compared to its peers, Inter Pipeline only has 10% of its projected 2015 EBITDA exposed to commodity risk, with 60% of its revenue coming from cost-of-service contracts, and 30% coming from fee-based-contracts. On average, Inter Pipelines mid-cap peers have 38% of their 2015 projected EBITDA exposed to commodity risk.

Inter Pipelines strong competitive position is demonstrated in its financials. With gross profit margins of 50%, Inter Pipeline is showing far better control over its costs than Pembina. This advantage is similarly noted in Inter Pipelines return on equity, which is currently sitting at 16%, double Pembina’s 8%. These stronger indicators come at a better price as well, with Inter Pipeline showing a price-to-earnings ratio of 34.1.

With a current dividend yield of 3.43% and strong competitive position, Inter Pipeline should be a source of stable and growing earnings, and is a lower-risk alternative to Pembina.

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This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Adam Mancini has no position in any stocks mentioned.

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