- Exxon has sheer unrivaled economies of scale and low cost of capital.
- Enbridge pipelines offer some of the same advantages as a network of railroads.
- Exelon's fleet of nuclear power plants is almost impossible to copy.
When I'm searching for long term investments there is one thing that I consider to be especially important: Does the company have a durable competitive advantage? If I can determine this, I don't have to be exactly right about the price to pay. Over the years it will outpace the market.
The second most important quality is a willingness to return cash to shareholders. Does the company buy back many shares? Does it pay a dividend? Over the long term you can hold the company even when it is somewhat overvalued. The dividend it will be throwing off can be invested in more attractively valued securities, and you don't incur as much trading costs. However, if you are certain the company is overvalued, you should still switch to better options of course.
The energy space has been on my radar for some time now. I think there are still some bargains to be found there. These are three of my favorite energy companies:
|Enbridge, Inc (NYSE:ENB)||Pipelines are like railroads (which I also like)||2.8%||90|
|Exelon Corp (NYSE:EXC)||Largest fleet of nuclear power plants||3.8%||16.3|
|Exxon Mobil Corporation (NYSE:XOM)||Economies of scale and low cost of capital||2.67%||12.8|
Exxon Mobil Corporation
The most important competitive advantages that give Exxon its edge over smaller competitors are its low cost of capital and its economies of scale. Overhead required to run a global energy juggernaut is carried by operations totaling yearly revenues of $400 Billion. Exxon can achieve operating margins (13.2%) others can only dream of. Smaller operators have a lot of problems achieving similar operating margins.
Exxon's healthy cash flow, huge market cap, diversified operations and reputation also allow it to drill the capital markets at rates that are hard to obtain for others. This gives it another advantage over smaller and less efficient competitors and allows the company to continue to outperform.
Exxon is well known for its ability to return large amounts of capital to shareholders and is a favorite of mine in that respect. As I wrote last year: 6 reasons Exxon Mobil Is Currently A Buy.
With its P/E of 12.8, it compares favorably to the S&P 500 average. If viewed in the light of its financial position and track record of returning cash to shareholders, the company is a great buy.
- Low cost of capital;
- Economies of Scale;
- Attractively valued.
Enbridge's main competitive advantage is its wide network of pipelines. Once a pipeline is in place in a certain geography, it's pretty hard to compete with. It works the same way as with a railroad. If one is already in place, very often there is not enough demand to carry the development of a second one. This enables the first one to charge great rates.
If a competitor would want to build a copy of the initial pipeline it's faced with difficulties. It is hard to get the regulatory approval required. Meanwhile the original pipeline can upgrade its capacity at lower cost than the development cost of a new line. Finally, a new pipeline is not so different from the already installed one. A new development is unlikely to be able to transport at much lower costs or greater speed.
Basically, a pipeline can operate as a monopoly in a specific geography, though its returns are somewhat limited by regulators and substitutions.
Valuing this company just by its P/E is dangerous. It trades at 90 times ttm earnings and at a price/cash flow of 12.3 (3yr average) or 5 times book. This is not exactly reassuring that the company can be acquired at a fair price.
However, with ttm operating margins are at the lowest point they have been in 10 years at 4.1%. Usually operating margins are hovering somewhere around 10%.
Return on equity is also at the lowest it has been in the past 10 years. Average long term return on equity is closer to 16%. Right now it sits at 5.89%. Perhaps the former RoE is a pipedream. The company is much larger and thus harder to grow now. Yet I expect management to be able to post much better numbers. Especially because the company does have a strong durable competitive advantage with its network of pipelines.
- Network of pipelines;
- Bad TTM numbers, obscuring potential.
Exelon derives its competitive advantage from its existing fleet of nuclear plants. Nuclear power plants produce energy at extremely low cost once they are up and running. They are also very clean producers from an emission perspective, which is an advantage in the current climate. I like the stock a lot. My latest focus article on Exelon was published on march 11.
It takes years and years to build nuclear plants. In addition, the industry is under intense regulatory and community scrutiny. Together that makes it extremely hard, even when someone has the capital to go for it, to copy Exelon's fleet of nuclear power plants.
The company's P/E is not that attractive, but given that it trades at only 1.2 times book value at a price/cash flow of 4.4 (3 year average), the company is still attractively valued. Unfortunately the company has repeatedly shown to be unreliable as a dividend payer. If you need steady secure dividends this is not the place to look.
A company with earnings that are depressed from "normal" values is hard to value, but that also makes it worth the effort. I based my valuation on 10 years of historic free cash flow.
Because the current cash flow of the company is so far below that historic average, I adjusted it upwards to 50% of operating cash flow. A number that has historically been easily achievable.
When you look at a chart of Enterprise Value to Revenues, you can clearly see what depressed profitability does to the valuation of a company. At the same time, the company has a P/E of 15, a number that isn't particularly exciting.
When valuing a company that has a significant competitive advantage, I model cash flow up to 10 years into the future. Exelon does have a solid competitive advantage. It's incredibly hard to enter the market of nuclear generated power, and thus match Exelon's efficiency.
I don't expect Exelon to be able to grow much anytime soon. The company might be able to keep up with inflation. Based on my updated calculation, the net present value of a share of Exelon is $39.67
This exercise leads me to believe that the stock is still very attractive at $32.71
- Fleet of low-cost to operate Nuclear plants that can't be copied;
- Undervalued by about 30%.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.