What happened on November 6 may not have been a surprise for TransCanada Corporation (TSX: TRP)(NYSE: TRP) shareholders. After eight long years, President Obama rejected the Keystone XL Presidential Permit and stated that the pipeline did not serve the national interest.
The question TransCanada shareholders are likely asking is, What does this mean for the company’s long-term returns? After President Obama vetoed a bill to build Keystone XL earlier this year, many would argue that TransCanada shares have already priced in a rejection of Keystone, and they would likely be right.
While shares did plunge about 6% on the news of President Obama’s decision, further downside is unlikely. However, the decision could very well have an effect on the long-term returns of the company, and shareholders should temper their long-term growth expectations. Here’s why.
1) TransCanada is much less undervalued
The main growth driver for TransCanada is its $46 billion capital growth program, which extends out to 2020. This growth program is basically divided into two parts—$12 billion in small- to medium-sized projects, which are expected to be in service before 2017, and $34 billion of large-scale projects, which are expected to be in service around 2020.
The problem for TransCanada is the bulk of its growth program (the $34 billion) is uncertain and dependent on approvals by regulatory authorities. These projects would contribute substantially to TransCanada’s earnings growth over the next several years.
The company expects its $12 billion in small- to medium-sized projects to drive a earnings before income, taxes, depreciation and amortization compound annual growth rate (CAGR) of about 8% between 2013-2017. If the other $34 billion of projects are approved, growth would jump up to a 16% CAGR between 2017 and 2020.
Keystone XL comprised about $8-10 billion of that $34 billion, and with Keystone out of the question for now, the company can expect lower growth between now and 2020. TransCanada is currently trading a forward price-to-earnings ratio of about 16.5 (below the group average of 22), and the rejection of Keystone reduces TransCanada’s odds of trading in line with its peer group. TransCanada’s peers have higher growth rates; Enbridge, for example, is expecting a 11-13% five-year CAGR.
Analysts at RBC estimate that Keystone was worth about $4 per share, and the rejection means less upside for TransCanada.
2) TransCanada could see lower dividend growth
TransCanada is currently planning to grow its dividend by a CAGR of 8-10% through 2017. TransCanada’s CEO has stated that a potentially higher rate of dividend growth is dependent on the approval of major growth projects.
Once TransCanada has better visibility of higher earnings and cash flows from the approval of some or all of their projects, management would be more comfortable boosting the dividend-growth rate. With Keystone out of the picture for now, the company may be less likely to consider a boost in dividend growth due to lower long-term earnings growth.
In addition, the company still has other significant projects to fund, and since part of these are being funded through cash flow, this may add to the company’s reluctance to increase the payout ratio because it could jeopardize the financing of these projects.
Since a high payout ratio leads to a higher valuation, and because TransCanada currently pays out less than its peers, an inability to boost dividend growth could weigh on shares.
3) The Keystone rejection could add more uncertainty to TransCanada
The rejection of Keystone can also serve to embolden climate change activists and people who oppose pipelines, since it would be the first pipeline to be rejected partially due to climate change reasons. This could add to overall pessimism around the pipeline sector.
In addition, there are also questions about the actual economic need for export pipelines like Keystone because low oil prices have kept production down. Some experts have said only one or two of the proposed export pipelines will be necessary, which also limits TransCanada’s growth.
