Pipeline Overbuild And Regulatory Constraints Will Pressure Cash Flows And Margins Ahead

Catalysts

About South Bow

South Bow operates crude oil and natural gas pipeline systems with highly contracted, toll-based cash flows across Canada and the United States.

What are the underlying business or industry changes driving this perspective?

• While South Bow expects demand for pipeline egress to tighten in the late 2020s, prolonged crude pipeline overbuild and additional competing capacity could keep differentials narrower for longer. This may limit upside from walk up and spot volumes and cap revenue growth.
• Reliance on a single major corridor with ongoing integrity remediation and phased pressure restriction relief exposes the company to extended regulatory constraints or heightened compliance requirements. These factors could suppress throughput and weigh on normalized EBITDA.
• As producers pursue incremental debottlenecks, alternative routes and optimization on existing lines, customers may negotiate more aggressively on tolls and contract structures. This could pressure variable tolls and potentially compress net margins over time.
• Tax optimization wins and accelerated tax pools that temporarily lower the effective tax rate through 2026 are finite. The eventual reversion to a higher cash tax run rate may drag on distributable cash flow and earnings once these benefits roll off.
• South Bow's stated need to invest roughly $100 million per year in growth capital to sustain a modest 2 to 3 percent EBITDA CAGR may clash with shareholder return expectations. Any cost overruns or delays on future organic or inorganic projects could erode returns and depress net margins.

Assumptions

This narrative explores a more pessimistic perspective on South Bow compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts. How have these above catalysts been quantified?

• The bearish analysts are assuming South Bow's revenue will remain fairly flat over the next 3 years.
• The bearish analysts assume that profit margins will increase from 16.8% today to 21.5% in 3 years time.
• The bearish analysts expect earnings to reach $433.5 million (and earnings per share of $1.94) by about December 2028, up from $332.0 million today. However, there is some disagreement amongst the analysts with the more bullish ones expecting earnings as high as $498.7 million.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 11.8x on those 2028 earnings, down from 17.2x today. This future PE is lower than the current PE for the CA Oil and Gas industry at 14.3x.
• The bearish analysts expect the number of shares outstanding to grow by 0.1% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 6.73%, as per the Simply Wall St company report.

Risks

What could happen that would invalidate this narrative?

• South Bow's highly contracted, toll-based cash flows and reaffirmed normalized EBITDA guidance of approximately $1.01 billion for 2025 and $1.03 billion for 2026 suggest resilient demand for its services. This could support steadier revenue and earnings than a declining share price thesis assumes.
• Execution of the Blackrod project on schedule and within budget, with cash flows expected to ramp in the second half of 2026, indicates the company can add new revenue lines through disciplined organic growth. This may potentially lift long term revenue and net margins.
• Structural supply growth in the basins South Bow serves, combined with expectations that egress tightness and wider differentials return in late 2026 or early 2027, may increase walk-up and spot volumes. This could provide upside to both revenue and EBITDA versus a bearish outlook.
• Tax legislation changes in the United States and accelerated tax pools have created a lower effective tax rate through at least 2026, temporarily boosting distributable cash flow and net earnings relative to what a structurally weaker valuation case might expect.
• Cost savings from the early exit of transition services with TC Energy and ongoing process optimization, which management has not yet included in its 2 to 3 percent EBITDA CAGR objective, could deliver unmodeled improvements in operating leverage, enhancing net margins and earnings.

Valuation

How have all the factors above been brought together to estimate a fair value?

• The assumed bearish price target for South Bow is CA$27.85, which represents up to two standard deviations below the consensus price target of CA$38.25. This valuation is based on what can be assumed as the expectations of South Bow's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
  
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of CA$44.91, and the most bearish reporting a price target of just CA$22.97.
  
• In order for you to agree with the more bearish analyst cohort, you'd need to believe that by 2028, revenues will be $2.0 billion, earnings will come to $433.5 million, and it would be trading on a PE ratio of 11.8x, assuming you use a discount rate of 6.7%.
  
• Given the current share price of CA$37.73, the analyst price target of CA$27.85 is 35.5% lower. Despite analysts expecting the underlying business to improve, they seem to believe the market's expectations are too high.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.