This is the fifth in a series of articles highlighting dividend growth companies that have large and durable economic advantages, or “moats”, that protect their business operations and allow years or decades of strong profitability. When looking for long-term investments, one typically wants to find a business that is performing well not simply because management is on top of their game right now, but rather because the business itself has fundamental and difficult-to-replicate advantages over its competitors. In the previous articles, examples of unrivaled economies of scale, powerful brands, huge patent shields, and high switching costs were provided.
Some companies have natural monopolies over their territories of operation.
This generally takes the form of heavy infrastructure investment into an area, which makes it impossible or nonsensical for a competitor to replicate the same infrastructure in an overlapping way, since poor returns wouldn’t be able to justify the investment.
Companies that have natural monopolies do of course still face risks; they must manage revenues, costs, and margins, and they must work with government regulators that wish to ensure that customers are not taken advantage of by natural monopolies. In addition, monopolies are not always black and white; sometimes a business may have complete control over an area, while other times, they may share a duopoly with another company when there is sufficient demand, which is still usually an appealing situation to be in.
These natural monopolies, when managed well, can provide rather lucrative and stable cash flows, due to the moat that is created by such a situation.
Below are four examples of dividend growth companies that I view as having natural monopolies:
Enterprise Products Partners L.P.
Enterprise Products Partners (EPD) is now the largest publicly traded MLP. The partnership has over 50,000 miles of pipelines for natural gas, NGL crude oil, refined products, and petrochemicals. They also have enough storage for over 190 million barrels of NGL and 27 billion cubic feet of natural gas. They also host fractionation, marine services, and import/export terminals. Pipelines in major hub areas are never complete monopolies, but when they build pipelines and other facilities in strategic locations, and when they provide transportation to key markets, they set themselves up with an expensive asset base that makes little sense for competitors to directly replicate. Instead, major players in this area tend to work out complimentary projects and joint ventures.
In addition, since EPD acquired its general partner, Enterprise GP Holdings, in 2010, the company now has a lower cost of capital thanks to not having large incentive distribution rights (IDRs). IDRs require limited partners to pay greater and greater percentages of their cash inflows to their general partner as they increase their distributions. This works well in the beginning, because it is a strong incentive for the general partner to grow the distribution payouts to the limited partners, since the bulk of the general partner’s ability to bring in good returns is hinged on their ability to pay distributions to limited partners, but the problem with IDRs is that once distributions increase over a number of years, they can be oppressive and hold down distribution growth. A number of limited partnerships, including EPD, have bought out their general partner to eliminate this problem.
Unfortunately, while I think that EPD is a great business, I do think the valuation is a bit expensive, so personally I’d only look to potentially purchase on a pullback. Units currently offer a distribution yield of 4.79%, and the distribution has grown by an annualized rate of 5.8% over the last five years.
Brookfield Infrastructure Partners L.P.
Brookfield Infrastructure (BIP) is one of my personal favorite partnerships, since there isn’t really any other partnership out there to directly compare it to. With a market cap of around $3.4 billion, it’s on the smaller side, but the partnership owns assets on multiple continents, and they’re mainly monopoly-type assets. A sample of BIP assets include the enormous Australian DCBT coal export terminal, Australian railways, UK port operations, a major Chilean electricity transmission network and toll roads, as well as timberlands in North America. Many of these assets are either utilities, which tend to be natural monopolies, or are based on specific and limited geographic features, such as ports, timberlands, export terminals, etc.
Unlike EPD, BIP does have incentive distribution rights to pay. But as a Bermuda-based publicly traded partnership, it has slightly different characteristics than MLPs, and one of those is that IDRs are capped at 25%. This is a good quantitative position, as the general partner is aligned with limited partners in benefiting from an increased distribution per unit, but not to the point where this distribution makes the cost of capital too expensive (unlike MLPs that can go up to IDRs of 50%).
As far as the distribution is concerned, BIP offers a 5.02% distribution yield after recently increasing its distribution. Unlike MLPs, BIP only targets to pay out 60-70% of its funds from operations (FFO) as distributions, so there is ample left over for acquisitions, distribution growth, and so forth. Over the past three years, the annualized rate of distribution increase has been over 12%. The recently announced $0.375 quarterly distribution is 21% higher than the quarterly distribution of $0.31 from this time last year. BIP’s valuation of course changes over time, and I generally find it appealing whenever the distribution yield is above 5%.
Canadian National Railway
Canadian National Railway (CNI) is the largest railway in Canada, and also has considerable lines in the U.S. Their rail system spans the Atlantic Ocean to the Pacific Ocean through Canada, and stretches down to the Gulf of Mexico through the U.S. Railways can be a healthy monopoly, since once tracks are put down over a long area, that transportation need has already been provided for, and competitors need to look elsewhere. Railways such as CNI transport petroleum, metals, forest products, coal, grain and fertilizers, as well as many other goods. Due to the strong geographic positions that are natural for railways, rather than facing steep competition from other railways, the future for CNI is mainly based on good management and macroeconomic conditions. Seeing as how railways have inherent energy efficiencies over other forms of transportation such as trucks, I view their position as rather entrenched and positive.
Current analyst estimates are for an annualized EPS growth rate of nearly 11% over the next two years. When combined with the 1.93% dividend yield and the fact that CNI grew the dividend by an average of 12% annually over the past five years, I view this as a rather strong stock. I’d personally look for a slight pullback to bring the yield up to 2% before entering or adding to a position.
Waste Management
Trash is a dirty but profitable business. It’s especially profitable for the major players, the owners of the landfills, and Waste Management (WM) happens to be the largest trash collector in North America. Landfills are naturally unattractive assets, and people generally don’t want them anywhere near where they live. This creates natural difficulties in opening up new ones, so the companies that already own them, do have certain moats against competitors.
The business model is rather (economically, though not aesthetically) attractive:
-Customers pay Waste Management to remove their waste.
-Waste Management recycles the material that is recyclable and gains some cash flow.
-Waste Management can use a combustion process to turn waste into energy- enough to power about 650,000 homes which provides another stream of cash flow.
-Waste Management deposits a lot of trash into landfills, and generates additional cash flow by charging fees for lesser waste companies to also deposit trash into their landfills.
-Waste Management uses the methane that comes up from landfills to produce electricity for which they can generate more cash flow. They generate about 500 Megawatts of electricity this way, which can power about 400,000 homes.
Waste Management does however face some strong competition. The industry is consolidating, and large competitors have challenged WM’s pricing power. Landfill ownership and the large amount of assets and infrastructure needed for collecting, sorting, energy production, and maintenance are a strong defense, but some of the top competitors boast the same assets, and unlike some of the other industries on this list, trash companies are a bit more mobile with their competition. I’d look for a pullback of a couple of bucks, down to the low $30’s before I’d view the stock as having a solid entry price. Specifically, the current dividend yield is 3.86%, and I’d look for a valuation that provides for a yield comfortably above 4%. The company has grown the dividend at an annualized rate of approximately 7.8% over the past five years.
Conclusion
Keep in mind that a good company only makes a good long-term investment if it’s purchased at a reasonable price. A trend that readers may have noticed in this article is that, in general, stocks are a little bit pricey at the current time, and I observe that this sentiment is rather common at the moment. I’ll be discussing this in my dividend newsletter later this week, and providing a number of what I consider to be fairly appealing stocks at current prices. There are bargains out there, but generally not big ones, and there are certain areas of the market that seem to still be fairly valued rather than richly valued.
Full Disclosure: At the time of this writing, I own units of BIP.
You can see my dividend portfolio here.
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I bought EPD and BIP a while back and love both these stocks! Not very attractive right now, but always on the lookout for dips.
I’ve been a buyer of EPD on the way up, though I stopped at $41.
Another near monopoly is the tobacco industry, particularly in the U.S. Regulation plus established brands prevent competitors from entering the space. My favorites here are MO, LO.
I bought BIP almost 2 years ago, and I’ve also been very happy with its performance so far. (I probably wouldn’t have known about it if you hadn’t done an analysis on your blog, so thanks for that!)
Have you taken a look at Brookfield Renewable Energy Partners (BEP.un on the TSX)? It has a similar structure as BIP, but holds hydroelectric, wind, and other renewable power assets. I understand they are supposed to be listing on the NYSE sometime soon.
Thanks for writing about these companies. I have had Bip since the spinoff, and picked up Epd last summer. You have a good analysis of the current valuations on them.