TC Energy spun off South Bow this week. Its dividend is hard to ignore

TC Energy spun off South Bow this week. Its dividend is hard to ignore

David Berman, Oct 4, 2024

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Spinoffs can be bittersweet affairs for small investors. When a company hives off a division, you get a shiny new stock with a fresh start. But what are you going to do if you’re saddled with a trivial number of shares?

This question may be on the minds of investors after TC Energy Corp. TRP-T completed its restructuring this week.

The Calgary-based energy infrastructure company separated its oil pipelines from assets that include natural gas pipelines and storage. For every one share in TC Energy, investors received an additional 0.2 shares in a new company called South Bow Corp. SOBO-T

If a small investor held, say, 100 shares prior to the restructuring, their portfolio now has 20 shares in South Bow, valued at $580 when regular trading began on Oct. 2.

Nothing wrong with that. Well, unless your portfolio is growing unwieldy with small holdings after other spinoffs. Or, if the new shares – whatever number of them – are an insignificant slice of your overall portfolio.

Either way, spinoffs can demand further action: Buy more to build meaningful exposure to a company or sell what you have to focus your bets.

For South Bow, there’s a strong case for buying more if you want steady income from a generous dividend.

Spinoffs, in general, have been producing strong returns this year, supporting the argument that narrowly focused companies can perform better when they are carved out of unwieldy conglomerates.

The S&P U.S. Spin-Off Index, which tracks U.S. stocks that have been birthed from parent companies within the past four years – yeah, there’s a benchmark for just about everything – is up about 24 per cent in 2024, not including dividends. It outperformed the S&P 500 by four percentage points over the same period.

These spinoffs include GE Vernova Inc., up 80 per cent since the energy equipment company emerged from the former General Electric Co. in April, and Veralto Corp., up 43 per cent since the water treatment company was spun out of Danaher Corp. about a year ago.

Granted, it’s hard to imagine South Bow soaring by double digits over the next year.

The company – which transports Canadian crude oil to refining markets in the U.S. Midwest and Gulf Coast through the Keystone Pipeline System – begins life with a lot of debt: $7.5-billion, or 5.2 times 2023 earnings before interest, taxes, depreciation and amortization (EBITDA).

Dividend payments currently eat up all of its profits, dimming prospects for immediate dividend growth until the high payout ratio declines.

And growth is likely to be modest at best. That’s because 88 per cent of cash flow comes from long-term contracts with oil producers and refiners, while additional pipeline capacity can be constrained by a tough regulatory environment.

In this sense, South Bow resembles a utility that offers stability over explosive profit potential. But is that such a bad thing?

Canadian utilities are no slouches right now. The sector has rallied 12 per cent over the past three months, outperforming the S&P/TSX Composite Index as investors warm to attractive dividends and economically defensive stocks.

What’s more, South Bow’s annualized dividend is a big one, at US$2 a share. When the stock officially launched this week – conditional trading began on Sept. 25 – the implied yield based on future dividend payments was a dazzling 9.3 per cent.

If that were any other company – say, a struggling telecom or a real estate investment trust with exposure to vacant office space – the high yield might raise a red flag over the payout’s sustainability. But the likelihood of South Bow, with its long track record, running into financial trouble right out of the gate seems unlikely.

The company has put debt reduction at the top of its to-do list, and expects it can reduce its debt-to-EBITDA ratio from five to as low as 4.5 within three years.

Moody’s Ratings, S&P Global Ratings and Fitch Ratings have rewarded South Bow with an investment-grade stamp of approval, supporting the case that the company has some financial flexibility here.

Just don’t count on a bigger dividend any time soon. Robert Catellier, an analyst at CIBC Capital Markets, expects that the payout ratio will remain above 100 per cent through 2027, implying that dividend hikes won’t happen for at least three years.

With a yield above 9 per cent, though, investors are being nicely compensated while they wait.

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The GlobeandMail Newspaper, Toronto, Canada