On September 09, 2024, TC Energy Corp (NYSE, TSX: TRP, $45.88, Market Capitalization: $47.5 billion) announced the distribution record date and timelines for a tax-free spin-off of the Liquids Pipelines business into South Bow Corporation.
As per the arrangement, TC Energy Corp. shareholders will keep their stake in TC Energy and gain a proportional interest in South Bow. Post-separation, TC Energy will continue to focus on Natural Gas Pipeline infrastructure, Power and Energy business driven by nuclear and hydro energy storage, while South Bow will focus on Liquid Pipeline business.
The spin-off has obtained necessary tax rulings in Canada and the US, along with shareholder and court approvals. If the remaining conditions are met or waived, the arrangement will take effect on Oct. 1, 2024.
Spin-Off Details / Timeline
a) Record Date: The record date for the spin-off is September 25, 2024.
b) Spin-Off Ratio: The spin-off ratio is 0.2:1, implying each TC Energy shareholder will receive 0.2 shares of South Bow common stock for every one share of TC Energy’s common stock.
c) Due Bill Trading: TC Energy Common Shares are expected to trade in the ‘due bill’ markets under the TRP ticker on both the TSX and NYSE.
d) When-Issued Trading: TC Energy Common Shares and South Bow Common Shares are expected to commence when-issued trading on TSX from September 25, 2024, until the close of business on October 1, 2024. There will not be when-issued trading for both the stocks on the NYSE. TC Energy will trade under “TRP.W” ticker and South Bow under “SOBO” during the when-issued period.
e) Regular-Way Trading: TC Energy Common Shares will resume regular-way trading on the TSX and NYSE on October 2, 2024. South Bow Common Shares will begin regular-way trading on the TSX on the same day. However, they will not trade regular-way on the NYSE until one trading day after the SEC declares South Bow’s registration statement on Form 40-F effective. TC Energy anticipates that South Bow Common Shares will start regular-way trading on the NYSE around October 7, 2024.
f) Exchange and Ticker: TC Energy will continue to trade on the TSX and the NYSE under the “TRP” ticker, while South Bow will list on the TSX and the NYSE under “SOBO” ticker.
g) Tax Status: The spin-off is expected to be Tax-Free.
We maintain a HOLD
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Deal Overview
On July 27, 2023, TC Energy’s board of directors announced that it has decided to pursue a tax-free separation of the Liquids Pipelines business into South Bow Corporation (spin-off entity). Accordingly, on September 09, 2024, TC Energy announced the distribution record date and timelines for the transaction. Post-separation TC Energy will continue to focus on Natural Gas Pipeline infrastructure, Power and Energy business driven by nuclear and hydro energy storage, while South Bow Corporation will focus on Liquid Pipeline business.
The spinoff has obtained necessary tax rulings in Canada and the US, along with shareholder and court approvals. As per management, if the remaining conditions are met or waived, the arrangement will take effect on October 1, 2024. The record date for the spin-off is September 25, 2024 and the spin-off ratio is set to be 0.2:1. This implies each TC Energy shareholder will receive 0.2 shares of South Bow common stock for every one share of TC Energy’s common stock.
TC Energy Common Shares are expected to trade in the ‘due bill’ markets on both the TSX and NYSE and the common shares of both the companies are expected to commence when-issued trading on TSX from September 25, 2024, until the close of business on October 1, 2024. There will not be when-issued trading for both the stocks on the NYSE. TC Energy will trade under “TRP.W” ticker and South Bow under “SOBO” during the when issued period.
TC Energy Common Shares will resume regular-way trading on the TSX and NYSE on October 2, 2024. South Bow Common Shares will begin regularway trading on the TSX on the same day. However, they will not trade regular-way on the NYSE until one trading day after the SEC declares South Bow’s registration statement on Form 40-F effective. TC Energy anticipates that South Bow Common Shares will start regular-way trading on the NYSE around October 7, 2024.
TC Energy will continue to trade on the TSX and the NYSE under the “TRP” ticker, while South Bow will list on the TSX and the NYSE under “SOBO” ticker. As per the arrangement, TC Energy shareholders will keep their stake in TC Energy and gain a proportional interest in South Bow. The spin-off is expected to be tax-advantageous to TC Energy and its shareholders for US and Canadian federal income tax purpose.
After the spin-off, TC Energy will transition to operate like a utility company, with a focus on natural gas infrastructure, nuclear energy, pumped hydro storage, and new low-carbon energy opportunities. Whereas, the South Bow will work on enhancing the value of its existing 4,900-kilometer crude oil pipelines, notably the critical Keystone pipeline system that transports oil from Alberta to refining hubs in the U.S. Midwest and Gulf Coast.
Following the separation, TC Energy and South Bow each intend to declare independent dividends for the quarter ended Dec. 31, 2024 on Nov. 7, 2024, reflecting their respective proportionate amounts of TC Energy’s dividend prior to the arrangement. All dividends are subject to the discretion and approval of each company’s respective Board of Directors.
Van Dafoe, appointed as the incoming Senior Vice-President and Chief Financial Officer (CFO
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François Poirier continues to be President and CEO of TC Energy, supported by Siim A. Vanaselja, Chair of the Board. Meanwhile, Stanley (Stan) G. Chapman, III assumes the role of Executive Vice-President and COO for Natural Gas Pipelines. The new Liquid Pipeline business will be headquarters in Calgary, Alberta, while also having an office in Houston, Texas. RBC Capital Markets and JP Morgan Securities Canada have been appointed as financial advisors, while Blake, Cassels & Graydon LLP and White & Case LLP has been engaged as the legal advisor. Bain & Company would be advising on the separation process.
Deal Rationale
TC Energy is a leading Canadian Energy infrastructure company with a presence in three core businesses: Natural Gas Pipelines, Liquids Pipelines and Power and Energy Solutions. Regionwide, its operations are divided into Canadian Natural Gas Pipeline, U.S. Natural Gas Pipeline, Mexico Natural Gas Pipeline, Liquids Pipeline and Power and Energy Solution. It mainly generates, stores, and delivers energy to people across North America. For the past two years, the management has been conducting a strategic review of their business and focusing on allocating capital to their business according to their growth prospects. Following the strategic review, the management decided to retain its Natural Gas Pipeline, Storage and Power business while it will be spinning off its Liquid Pipelines and Storage business.
TC Energy (consolidated) is a highly levered company with a debt-to-EBITDA ratio of 5.1x as of December 2023. The management has targeted reducing its debt-to-EBITDA ratio to 4.75x by 2024E. It has been taking various measures to deleverage itself and has sold 40.0% of its holdings in British Columbia Gas and Columbia Gulf system in July 2024 for $3.9 billion. These proceeds are being used to decrease the debt and lower the company’s leverage by 0.4x. Furthermore, the anticipated proceeds from the spin-off of the Liquid Pipeline business (~C$ 8.0 billion) will also be employed to repay the parent company’s debt. After the spin-off, the company will retain control of its Natural Gas Pipeline network spanning ~93,600 kilometers from western Canada to the US north-east and Gulf coast, addressing more than 25.0% of North America’s energy demands. Furthermore, the pipelines managed by TC Energy are responsible for delivering ~30.0% of the gas destined for export from US LNG liquefied natural gas (LNG) terminals. Additionally, TC Energy will be the provider for Canada’s inaugural LNG terminal, scheduled for completion in 2025E. Additionally, boasting a three-decade track record, the Power section commands a generating capacity of approximately 4,600 MW. Notably, 70.0% of this capacity relies on nuclear energy, categorized as a carbon-free source, contributing significantly to environmental well-being.
The business has solid growth prospects with 96.0% of its adjusted EBITDA linked to regulated and securely contracted assets. For the next five years, the Natural Gas and Power Business is anticipated to grow at a CAGR of 7.0%, with an EBITDA reaching $11.2 billion by 2026E. Hence, post spin-off, the remaining business is anticipated to have a strong growth potential and an environmentally sustainable business model compelling investors who want to invest in low-carbon companies. On the other hand, the liquid pipeline business is a relatively low-growth business. It is anticipated to grow at merely 2.0-3.0% CAGR for the next five years, with comparable EBITDA reaching $1.5 billion by 2026E. Currently, the segment has 4,900 kilometers of liquid pipeline network supplying low-cost crude to key demand markets. The management is committed to setting an impactful ESG target, but the liquid pipelines are prone to leakages and spillages, causing environmental hazards. In December 2022, the Keystone pipeline, owned by TC Energy, encountered a substantial oil spill, discharging more than 14,000 barrels of crude oil into a creek in Kansas in the U.S. This occurrence has sparked apprehensions regarding the security of the pipeline infrastructure and forced the company to reduce rates on the system.
Additionally, the Keystone XL project, which could have carried bitumen from the Northern Alberta oil sands to refineries on the US gulf coast, witnessed political attention in pursuing climate change issues. In our view, the cancellation of the proposed Keystone XL project in 2021 due to U.S. President Joe Biden revoking an essential permit could be one of the reasons behind the Liquid Pipeline business separation. Furthermore, in recent years, pipeline construction in the U.S. has encountered significant environmental resistance, driven by activists aiming to hinder the expansion of infrastructure that perpetuates dependence on fossil fuels. Therefore, the decision to separate the liquid pipeline business to concentrate on environmentally sustainable and low-carbon ventures appears favorable to the management. This move caters to investors who prefer not to invest in both businesses collectively. Furthermore, in recent years, pipeline construction in the U.S. has encountered significant environmental resistance, driven by activists aiming to hinder the expansion of infrastructure that perpetuates dependence on fossil fuels. Therefore, the decision to separate the liquid pipeline business to concentrate on environmentally sustainable and low-carbon ventures appears favorable to the management. This move caters to investors who prefer not to invest in both businesses collectively.
Investment Thesis
TC Energy (consolidated)
Sustainable business model set for long-term growth Over the past ten years, TC Energy has delivered around a 3.0% revenue CAGR meeting ~30.0% of North American natural oil gas demand. The company operates on a low-risk business model, with 97.0% of its natural gas and power business being rate-regulated (peer average ~57.0%) with long-term contracts. This helps not only mitigate the volatility in commodity prices but also assures long-term revenue visibility. Moreover, TC Energy engages in both constructing new projects and divesting less profitable ones to optimize cash flow. Expansion of sales is achieved through bringing additional projects online and adjusting contract prices upwards. This makes its business model less risky compared to midstream peers and sustainable in the long run.
Canada Gas Pipeline EBITDA to grow at mid-single-digit
In 2023, TC Energy’s Canada Natural Gas Pipelines segment, accounting for 29% of total EBITDA, saw low-double-digit growth driven by increased throughput on the Nova Gas Transmission Line (NGTL) following recent project completions. Looking ahead, strong volumes and ongoing projects are expected to drive EBITDA growth in 2024, with mid-single-digit annual gains projected through 2026, supported by $4.3 billion in capital investments in NGTL. This segment remains the most shielded from volatility, benefiting from regulated tolls that provide stable cash flow and safeguard rates against inflation.
Mexico Natural Gas Pipeline offers higher risk and return
Mexico operations of TC Energy has high execution risk however it offers attractive returns due to solid EBITDA growth. The completion of the lateral section of Villa de Reyes and the expected launch of the south section in the 2H24 could significantly increase TC Energy’s EBITDA from its Mexico Natural Gas Pipelines by a low double-digit percentage in 2025. Moreover, the Southeast Gateway project, which is anticipated to start in 2025, is likely to add C$800.0 million annually to EBITDA. In addition, TC Energy’s strategic partnership with CFE, Mexico’s state-owned utility, would strengthens its presence in the country and resolve previous arbitration issues that had hindered operations.
Opportunities for growth in the US gas market through LNG exports
TC Energy’s US natural Gas and Pipeline business’s EBITDA is anticipated to grow in the mid-single digit until 2026 due to various projects and expansion strategies to capitalize on coal to gas transition, increasing US gas to Mexico and the rise in LNG exports globally. These initiatives and expansions in projects such as GTN is anticipated to drive robust volume growth going forward.
Consistent dividend payer despite lack of FCF
The company is committed to consistently paying dividends and has an impressive track record of increasing dividends. TC Energy has also maintained a conservative Funds from Operations (FFO) payout ratio of 51.0% and an estimated dividend yield of around 6.0% bodes well for income seeking investors and also provides defensive options amidst any macroeconomic uncertainties.
Strategic actions in place to lower the high leverage
TC Energy’s net debt to EBITDA ratio is slightly above 5.0x, which is significantly higher than the midstream C-Corp peer group’s median leverage of 4.0x. However, leverage has improved since last year, primarily due to asset divestments totalling C$5.3 billion. Management is committed to further reducing leverage, aiming for a target of 4.75x by the end of 2024. To achieve this, they plan additional asset divestments of C$3.0 billion in 2024, along with new operations, and capex optimization. The deleveraging would also be aided by proceeds from ~$7.9 billion South Bow debt issuance, which will be used to repay TC Energy deb. Future leverage reduction is expected through incremental EBITDA from new operations, maintaining a capex limit of C$6.0-7.0 billion, and cost-saving initiatives.
Post spin-off synergies to drive EBITDA growth
Given the slower growth in the liquids segment, TC Energy’s EBITDA gains are likely to accelerate in the coming years after the spin-off of South Bow. Following the spin-off TC Energy is expected to increase its EBITDA by 5.0% to 7.0%. This growth will be driven by ongoing investments and strong performance in its Canadian, US, and Mexican natural gas units..
South Bow (Spin-Off Entity)
Wide network of pipelines connecting vast oil reserves
South Bow boasts an extensive liquid pipeline network spanning 4,900 km (3,045 miles), including the Keystone Pipeline System, which directly connects the vast oil reserves of the Western Canadian Sedimentary Basin (WCSB) to major refining markets in the US Midwest and Gulf Coast. With a capacity of approximately 14.0 million barrels per day (bbl/d), this network is crucial in the energy landscape. Additionally, its Alberta assets, such as the Grand Rapids and White Spruce facilities, provide further market diversification, serving global markets via Canada’s West Coast. The outlook for North American oil production remains strong, reinforcing its role as a key energy sector component for the foreseeable future. Projections suggest a steady growth trajectory for WCSB crude oil supply, expected to increase by 500,000 bbl/d by the end of the decade. Furthermore, refining utilization in TC Energy’s key markets is anticipated to remain robust until 2050, ensuring a stable and reliable demand for pipeline services.
Gradual expansion supported by robust commercial contracts
The Keystone Pipeline, which transports heavy Canadian oil to the US Gulf Coast, derives about 88.0% of its EBITDA from long-term contracts, ensuring cash flow predictability. Nearly 96.0% of these contracts are with investment-grade counterparties. Additionally, the company has a favourable average contract value of 8-years on the Keystone system which is above the peer average and longest amongst the peers. Additionally, the segment has a strong demand across the Keystone system and has received approval for re-contracting at market driven rates which is advantageous. However eventual expansion of Trans Mountain Expansion (TMX) pipeline could potentially strain the Keystone Pipeline’s spot barrels.
Balancing sustainable EBITDA growth but high leverage will be a concern
The liquids business is expected to achieve steady annual EBITDA growth of 2.0% to 3.0%. While this growth rate is slower compared to other segments within TC Energy, it remains consistent and is primarily driven by organic factors. However, post-separation, South Bow’s balance sheet will be highly levered, with the company projected to hold $7.9 billion in debt against an EBITDA of around $1.5-$1.6 billion, resulting in a net leverage ratio of 5.0x, which is significantly higher than the peer average. Although the company plans to accelerate its deleveraging efforts within three years post-spin, aiming to reduce the leverage ratio by about 0.25x to 0.50x, short-term challenges following the separation could hinder achieving these targets.
Valuation
TC Energy (Consolidated Entity)
TC Energy’s sustainable business model is well-positioned for sustainable long-term growth backed by its strong market footing, low-risk rate-regulated and long-term contracted model. Additionally, the company’s solid track record of growing dividend payouts and an impressive dividend yield of around 6.0% bodes well for income seeking investors. However, the company’s higher leverage (even higher than the peer median) remains an overhang. That said, the company is taking strategic actions such as divestitures, cost savings, capex optimization and upcoming commercialization of news assets to reduce the leverage and so far, it has met with reasonable success in bringing down the leverage in recent times. We compare TC Energy with other listed companies engaged in natural gas, power and oil business such as Enbridge Inc, Enterprise Product, OneOk Inc, Suncor Energy, Williams Cos Inc, Kinder Morgan, Imperial Oil, Targa Resources, Pembina Pipeline, Antero Midstream, Keyera Corp, Enlink Midstream, Equitrans Midstream, Plains GP Holdings, Mattr Corp. Our ascribed EV/Adj. EBITDA on FY25E Adjusted EBITDA is at a slight premium compared to peers considering the strong market footing, growth prospects and a healthy dividend yield. We apply EV/Adj. EBITDA multiple of 10.2x to arrive at a fair value estimate of C$66.30 per share. Considering the USD:CAD rate of 1.36, we arrive at a target price of $48.75 per share, suggesting a 6.3% upside from the last closing price. We maintain our HOLD rating on TC Energy.
South Bow Inc. (Spin-Off Entity)
South Bow has a wide network of liquids pipeline covering an area of 4,900 kms notably through its Keystone Pipeline System which derives about 88.0% of its EBITDA from long-term contracts, providing the company with wide organic growth opportunities and ensuring cash flow predictability. However, the pace of growth is slow compared to other segments of TC Energy with an additional concern around high leverage post spin (~5.0x) which weighs on its valuations. We compare South Bow with other publicly listed companies operating in the natural gas, power, and oil sectors, including Enbridge Inc, Enterprise Product, OneOk Inc, Suncor Energy, Williams Cos Inc, Kinder Morgan, Imperial Oil, Targa Resources, Pembina Pipeline, Antero Midstream, Keyera Corp, Enlink Midstream, Equitrans Midstream, Plains GP Holdings, and Mattr Corp. Our valuation multiples are at discount compared to peers considering higher leverage after separation and tepid EBITDA growth over the next couple of years. We ascribe an EV/EBITDA of 6.5x on FY25E adj. comparable EBITDA of C$1.5 billion to arrive at a fair value objective of C$14.9 per South Bow share. Considering the USD:CAD exchange rate of 1.36, we arrive at a fair value of $10.90 per South Bow share.
TC Energy (Stub)
We deduct South Bow’s equity value of C$3.1 billion from the TP Energy consolidated implied equity value of C$69.2 billion to arrive at a stub value of C$66.2 billion. Our fair value estimate for stub comes out to C$63.40 per share. Considering the USD:CAD exchange rate of 1.36, our fair value of TP Energy (Stub) is $46.60 per share.
Company Description
TC Energy Corporation (Parent)
TC Energy Corporation is incorporated in the year 2003 and headquartered in Calgary, Alberta, Canada. TC Energy is involved in the transportation, production, and storage of natural gas, crude oil, and other energy products across Canada, US, and Mexico. TC Energy operates through three main divisions: natural gas operations, liquid pipelines, and power and energy solutions. TC Energy manages a 93,600 km (58,100 miles) network of natural gas pipelines, which supplies more than 30% of the natural gas consumed daily across North America. TC Energy’s portfolio includes investments in 10 power-generation facilities with a capacity of 4,600 megawatts (MW). Approximately 75% of the capacity is in nuclear, solar and wind generation. TC Energy has 7300+ employees as of June 30, 2024.
South Bow Corporation (Spin-Off)
South Bow will be an oil infrastructure company that manages the pipeline network transporting Alberta crude oil to US refining markets. South Bow operates 4,900 km (3,045 miles) of crude oil pipeline infrastructure. South Bow delivers approximately 1.25 million barrels of crude oil every day, meeting the energy demands of North America. Additionally, the company will operate storage facilities in Hardisty, Cushing, and Houston. The company is dedicated to addressing energy requirements by utilizing its current resources and exploring fresh possibilities.