In a widely expected move, the Federal Reserve lowered interest rates this week. It reduced the federal funds rate by 0.5%, much bigger than the quarter-point cut many anticipated. The Fed has signaled that it will likely continue trimming interest rates in the coming months.
Lower rates should be a boon for the energy sector. The industry tends to borrow heavily to fund expansion projects and acquisitions. With rates falling, interest expenses should head lower. On top of that, higher-yielding dividend stocks (which are quite common in the energy sector) tend to be more rate-sensitive. As rates fall, investors are willing to accept a lower dividend yield, which boosts stock prices.
Many companies across the sector should benefit from falling rates. North American pipeline and utility giant Enbridge(NYSE: ENB) is a top beneficiary. Here's why that makes it look like a great stock to buy now.
Cheaper funding
Enbridge is one of the largest energy infrastructure companies in North America. It operates oil and gas pipelines andnatural gas utilities, and produces renewable energy. The company spends billions of dollars each year to maintain and expand its infrastructure.
It typically finances its business with long-term, fixed-rate debt. However, it does have some exposure to interest rates because about 10% of its debt has a floating rate. With rates falling, the interest expense on this debt will decline.
Meanwhile, Enbridge typically issues new debt each year to refinance existing borrowings and finance new investments. It will now cost less to refinance debt and borrow additional money than it would have at higher rates.
Lower borrowing rates could also help make more expansion projects economically viable. Enbridge funds its expansion with a mix of debt and equity. As the cost of debt declines, it would enhance the returns of its expansion projects, which could push some over the top as attractive investment opportunities.
A likely higher valuation
Enbridge currently offers a dividend yield above 6.5%. That high yield is partly due to the company's lower valuation, as income investors desired a higher yield when rates were higher. The company expects to produce between $3.97 and $4.27 per share of distributable cash flow this year. With its share price recently around $40 apiece, Enbridge trades around 10 times earnings.
That's much cheaper than the broader market due to its slower growth rate and higher dividend yield. The S&P 500 trades at nearly 24 times earnings (and a less than 1.5% dividend yield).
However, with rates falling, investors will be willing to pay a higher value for income-generating investments like Enbridge. That should cause its market rate dividend yield to fall as its valuation rises.
Additional value catalysts
Interest rates aside, Enbridge already offers investors a strong value proposition. The company expects to grow its distributable cash flow per share by around 3% annually through 2026 and by 5% per year after that. Fueling that view is its massive pipeline of expansion projects and investment capacity to make accretive acquisitions.
That outlook gives Enbridge the confidence that it has plenty of fuel to continue increasing its dividend. It could grow its payout by as much as 5% annually over the medium term. That would continue the company's long streak of increasing its payout, which is currently up to 29 years.
The fuel to produce robust total returns
With a current dividend yield of more than 6.5% and its earnings growing by around 3% annually in the near term, Enbridge should have the fuel to deliver an average total annual return of around 10%. Its total return potential could accelerate to about 12% annually after 2026.
That doesn't factor in the upside from falling interest rates, which could enhance its cash flow, growth prospects, and valuation. That catalyst could help power even higher total returns from here. This additional upside potential makes Enbridge an even better buy right now.
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Matt DiLallo has positions in Enbridge. The Motley Fool has positions in and recommends Enbridge. The Motley Fool has a disclosure policy.
