My Valuation Test
I am always on the lookout for companies with attractive prospects that have been unfairly discounted by the market. That means I typically shy away from stocks that have already made strong advances, or those that are cheap for a reason.
You will never see me buy into a company like Tesla Motors (Nasdaq: TSLA). While its prospects for success appear good, Tesla is commanding a premium on almost every valuation metric. The stock is trading at what I consider to be an irrationally exuberant level, and while it certainly may trend higher from here, I value fundamentals over bullish investor sentiment — which can change very quickly. So Tesla passes my test for "good prospects going forward", but badly fails my value test.
Petrobras (NYSE: PBR) is just the opposite. I was once an investor in this giant Brazilian integrated oil and gas company, whose stock has fallen by nearly two-thirds over the past five years. Over that same span, shares of US integrated majors Chevron (NYSE: CVX) and ExxonMobil (NYSE: XOM) rallied 98 percent and 48 percent, respectively.
So market sentiment has been firmly against Petrobras, and there are more and more articles being written about the "bargain" PBR has become. Many made similar claims a year ago. But if you had bought then, you would have seen your shares decline another 35 percent in the year since.
The problem with Petrobras is that while it is indeed deeply discounted, the factors responsible for the discount remain in place. The Brazilian government owns the majority of the voting shares in the company, and has forced Petrobras to sell fuel at a loss in order to keep the Brazilian citizens happy. This practice is what caused me to sell my shares.
The policy has cost the company billions in foregone profits, and there are no signs that it will end anytime soon. In fact, late last year Brazilian President Dilma Roussef! f resisted a proposal to index gasoline price increases to inflation.
Petrobras and Tesla could both double over the next year, but I don't like my odds with either company. What I prefer is to find companies with the sunny outlook of Tesla, but the negative market sentiment of Petrobras.
It probably won't come as a surprise that those opportunities aren't generally obvious, and tend to be very controversial. After all, market sentiment is usually negative for a reason. If the opportunity were more obvious, sentiment wouldn't be so negative. So if you plan to invest in a company or sector with a negative prevailing market sentiment, there are going to be a lot of people ready to tell you why you are wrong.
Natural Gas Sector Passes the Test
Natural gas producers meet my test of suffering from market skepticism despite bullish fundamentals. Three weeks ago in The Energy Letter I explained the situation with natural gas inventories in Flirting With a Natural Gas Shortage.
In a nutshell, because of the extremely cold winter, natural gas inventories over the winter were drawn down at the fastest rate and in the greatest volumes on record. Since I wrote that article, natural gas in storage — which is reported weekly in the Energy Information Administration's (EIA) Weekly Natural Gas Storage Report — has dropped below 1 trillion cubic feet (tcf) for the first time in 11 years. The present inventory level is 49 percent below the level of a year ago, and 48 percent below the five year average.
Of course this doesn't mean we are going to run completely out of natural gas in storage. Within the next three weeks we should enter injection season, which is when gas inventories start to rebuild. Every year, inventories tend to bottom near April 1, on average.
So of course inventories will soo! n begin t! o rebuild, but we are going to go into injection season with a serious deficit. And historically a significant deviation of inventories from normal will have a lingering effect on natural gas prices.
That doesn't mean I believe natural gas is going to be $10/MMBtu for the rest of the year. It could spike to that level briefly, and has already spiked above $8/MMBtu twice (on Feb 5 and Feb. 10), but this is not my thesis. My thesis is that natural gas producers are going to have to produce a lot, and they are going to get better prices for their gas than they did a year ago. In other words, quarterly results should consistently top last year's comparables.
The EIA is projecting that the inventory situation is going to remain tight all the way until the winter of 2015-2016:
But how has the market reacted toward natural gas producers? It isn't all that impressed. Companies are being undervalued based on the very low prices of two years ago and even last year, instead of the prospects for better prices this year. In fact some of the major natural gas producers are trading down at near double-digits over the past month, even as the country sank into a deeper inventory hole.
So this sector fits perfectly with my investment thesis. The prospects look good going forward based on the current inventory situation, and the companies and their stocks are out of favor. The inventory situation could normalize if the next winter is abnormally warm, but if we have a normal winter inventories will still be uncomfortably low throughout, and if we have a winter resembling this one we are going to be looking at natural gas prices north of $10/MMBtu.
Conclusions
In 2013 the average closing price for Henry Hub natural gas was $3.73/MMBtu. I predicted the average would be higher this year, and as a result of the very cold! winter I! would guess we will end up averaging something like $4.50/MMBtu for the year. That is money in the bank for many natural gas producers. In fact, the latest monthly Short-Term Energy Outlook (STEO) released by the EIA projected the average natural gas price for 2014 at $4.44/MMBtu, which is 6 percent higher than the forecast from February's STEO.
Thus the downside risk appears to be low and fairly well known, while there is substantial upside. Of course it's possible that these companies will remain cheap. Many stocks remain cheap for a very long time, and sometimes it takes that long for market sentiment to shift. I expect within six months we will see higher valuations, and if we go into the winter without restoring inventories to a healthy level it's going to be very difficult for the market to ignore the sector.
(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)
Portfolio Update
First Solar's Bright Tomorrows
Not many companies get to dramatically lower their current-year earnings forecast and not get beat up too badly in the market, and none can reasonably hope to see their stock jump 20 percent on the news, as First Solar (Nasdaq: FSLR) did Wednesday.
The solar panels maker and utility-scale projects developer managed that nifty feat by overshadowing its lackluster 2014 profit forecast with unexpectedly sunny bottom-line outlooks for the following two years.
The company is now aiming for earnings of $2.20 to $2.60 a share this year, well short of the prior consensus estimate of $3.21 a share. On the other hand it's projecting $4.50 to $6 per share in fiscal 2015, and $3.50 to $5 in fiscal 2016 on the bottom line, the low points of those ranges still beating Wall Street estimates by some 20 percent.
To get there from here will require a significant expansion in margins recently pressured by the market inroads of inexpensively financed Chinese-made rooftop panels assembled with the rival crystalline silicon technology.
But Fir! st Solar�! ��s forecast can't just be written off as hopeful wishcasting during a business lull. First, there's the matter of the continuing efficiency gains for First-Solar's proprietary cadmium telluride thin-film panel technology, which is continuing to gain on silicon more rapidly than expected, such that within a couple of years crystalline silicon's cost advantage should vanish and possibly turn into a deficit.
There is also the matter of the current management's conservative forecasting record, with the company meeting or exceeding most financial targets laid out two years ago amid a painful contraction and restructuring.
First Solar remains bullish on the future utility-scale projects in the US, noting the growing competitiveness of big solar plants as natural gas prices rise and coal faces new environmental restrictions.
But it's also marketing First Solar's expertise and services aggressively (and increasingly successfully) overseas in places like Japan and the Mideast, while expanding into silicon-based rooftop installations for commercial and industrial properties.
First Solar continues to deepen its technology partnership with General Electric (NYSE: GE) announcing a new product marketing its arrays with a new powerful GE transformer as an integrated system.
And management has clearly been devoting a significant amount of time to considering a "yield-co," an affiliate akin to a master limited partnership, albeit one delivering tax-deferred distributions based on accelerated depreciation and net operating loss carryforwards rather than an income-tax exemption.
Like MLPs, "yield-cos" are often more highly valued than their issuers on a cash flow basis, lowering the parent's cost of capital while juicing its returns. First Solar's CEO described his company as "the belle of the ball rather than a straggler" as it considers its options on this score. But the $1.5 billion of net cash on the balance sheet pretty much removes any financial pres! sure to m! ove quickly in this direction.
This is a long-term story still worth investing in, but now mostly with house money for subscribers who bought on our advice on Aug. 28 and sold half of their initial stake on Thursday. The remainder now shows a total return of 99 percent. It will be well north of that if management once more delivers on its promises. Sell half of your initial stake in FSLR.
– Igor Greenwald
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