Tom Armistead's  Instablog

Jim Cramer commented favorably on electric utility Exelon (EXC) on 9/30, after the stock closed at 49.62. I was not listening (a little bit goes a long way) but according to Miriam Metzinger, he said that the cap-and-trade bill should benefit Exelon, which has nuclear power exposure. Investors have a good entry point because the "stock is way off." I mentioned Exelon as a recent portfolio addition on 9/1, without providing any analysis of the individual stock, since my focus at the time was on strategy and positioning. Now would be a good time to go over the basics on the company and assess the possible implications of cap-and-trade for its future earnings and stock price.

Overview – From the 10-K:

Exelon, a utility services holding company, operates through its principal subsidiaries—Generation, ComEd and PECO.... Generation’s business consists of its owned and contracted electric generating facilities, its wholesale energy marketing operations and its competitive retail supply operations. ComEd’s energy delivery business consists of the purchase and regulated retail sale of electricity and the provision of distribution and transmission services to retail customers in northern Illinois, including the City of Chicago. PECO’s energy delivery business consists of the purchase and regulated retail sale of electricity and the provision of transmission and distribution services to retail customers in southeastern Pennsylvania, including the City of Philadelphia, as well as the purchase and regulated retail sale of natural gas and the provision of distribution services to retail customers in the Pennsylvania counties surrounding the City of Philadelphia.

Generation produces 68% of the power it generates from nuclear plants, 25% from fossil fuels, and the remainder from hydroelectric. They generate 80% of their power, the rest is purchased under long term contracts. Here is a link to their most recent presentation, which provides a good understanding of their operation and strategy.

Cap-and-trade – legislation has been passed by the house and a Senate bill is under review. Exelon is on the record as supporting this legislation and has adopted a plan of compliance and begun implementation. The act, if it becomes law, will create another layer of regulation for an already heavily-regulated industry. My take: global warming caused by green house gases is scientific fact, something has to be done, and cap-and trade is a start. Now, who is going to pay for this?

Logically, the beneficiaries of any environmentally harmful activity should pay the costs of remediation. In the case of electricity generation, that would be rate-payers. Politically rate-payers are tax-payers and voters, leading to the conclusion that attempts to place the cost elsewhere will pressure utility earnings and harm shareholders. Exelon, due to its large nuclear fleet, and preemptive adoption of various actions to reduce its carbon footprint, has distanced itself from the fray.

The legislation under consideration calls for a 17% reduction of green house gases by 2020. Large utilities will be required to produce 20% of their energy from renewable sources by 2020. The actual effects on earnings of any utility are many quarters away, and passage is not guaranteed. As Cramer's bullish remarks demonstrate, the positive perceptions of a low carbon foot-print can come up any time cap-and-trade is in the news. Very possibly the poor 2009 market performance of the utility sector reflects concerns for the harmful effects of new legislation.

Capex – Exelon does have one new nuclear plant on the drawing board, to be located in Victoria, Texas. Because the approval process is so slow, this is strictly a back-burner project.

The company is systematically availing itself of the opportunity to uprate its nuclear plants, a schedule is included in their recent presentations. The net result will be the addition of 1,300 to 1,500 MW of capacity, roughly the equivalent of a new nuclear plant. This type of capex is predictable and low risk. The process of securing regulatory approval, where needed, has been proceeding successfully. Expansions from this source are approximately 5% of total capacity.

They have been successful in extending the operating licenses, originally issued for 40 years, by means of 20 year increments. A schedule of expirations is included in the presentation.

Regulation – Exelon is regulated by numerous State and Federal authorities. Profits have been steady, suggesting that rate regulation has not been hurting them. There is no indication they have got on the wrong side of any of their regulators.

Energy trading – an unregulated activity, performed by the Power Team within the Generation company. Their positions are hedged by various derivatives, leading to counter-party risks and potential exposure to collateral posting requirements and liquidity issues in the event of a credit downgrade of sufficient severity.

In discussing the company's repurchase plan, CEO John Rowe mentioned that there would be little activity on that front, just being prudent to stay on the right side of the rating agencies.

Energy trading has in the past created difficulties for electric utilities: Allegheny (AYE) comes to mind, it was a while ago. There was also Enron, a very bad mix of predatory trading and accounting fraud. Exelon describes their limits and controls on this activity as stringent, backed by a Risk Management Committee. My impression is that trading is pursued in a manner that is supportive of primary activities - generation and distribution.

Valuation – EXC is another situation where a 5 year average EPS makes sense. Over the past five years, the stock has traded in a range of 12.8 to 30.9 on that metric, with the mid point coming in at 20. Projecting to the end of 2010, 3.72 X 20 equals 74 as a target price within the next two years. It reached a high of 92.13 during 2008, when the market seemed to perceive it as a growth utility, something of an oxymoron. It is indeed “way off” that price; however, that price was “way out.” A historical average line of reasoning applied to book value or revenue produces 66 and 55, respectively. Net income as a percentage of revenue has been consistently high in recent years, and may not be sustainable.

The dividend at 2.10 yields 4.2% with shares trading just under 50.

Taking all of this together, I plan to invest on the basis that shares will be fairly valued at 66. If that target is achieved within two years, annualized returns will be 15%, excellent for a low risk situation.

Investment strategy - EXC is a defensive stock, suitable for buy-and-hold or dividend investing. It has been mentioned twice on Seeking Alpha in articles on safe dividend stocks. Those who prefer something with a little more pop could consider substituting LEAPs for share ownership. The Jan11 35 calls make sense to me, the time premiums are not excessive and the sale of shorter expiration calls at 55 could provide current income and an exit point at a conservative valuation. In addition to the perennial attraction of cheap leverage, the options would have the benefit of limiting the downside in the unlikely event of a nuclear accident or rogue trader incident.

Disclosure – long VFRAG, EXC Jan11 35 calls, short EXCAK, EXC Jan10 55 calls, no position in AYE

 

 

 

 

 

 

 

 

 

S&P cut MBIA (MBI) another notch, from BBB to BB+.  I still remember when the company starting shedding those nine A's, every loss was huge, the stock would tank, plunge, plummet, etc. 

Market response has been mild, the stock is off 4% as I type this, and looking at a 3 month chart it is still above a rising trendline.  It has yet to give back what it gained on its last upward run.

At this point the rating agency opinions don't mean much, Case Shiller may have as much to do with it as anything: that, and the courts. 

Gulf Islands Fabrication Inc. (GIFI), at Friday's closing price of 18.06, is a value play in the oil and gas equipment and services industry. The initial attraction is a combination of low P/B (1.0) and low Price/5 Year Average Earnings (11.5). The company has numerous strengths, which over time should allow it to overcome current weakness in revenue and backlog and participate strongly in the growth area of deep water equipment.

I picked up the idea from a screen by Alan Brochstein here on Seeking Alpha. Checking further, the same name appears on a screen he did on 3/28 which also included Carbo Ceramics (CRR) and Lufkin Industries (LUFK), both successful picks I wrote up favorably and bought for my discretionary account. To some extent I work by affinity – I follow Alan and since this idea is a case where our thinking leads in the same direction, I did my own research, developing the following information and opinion.

Overview – Excerpts from the 10-K:

We are a leading fabricator of offshore drilling and production platforms, hull and deck sections of floating production platforms and other specialized structures used in the development and production of offshore oil and gas reserves. The company was founded in 1985 ... and began operations at our fabrication yard on the Houma Navigation Canal in southern Louisiana, approximately 30 miles from the Gulf of Mexico. Our Houma facilities are located on 630 acres, of which 283 are currently developed for fabrication activities with 347 acres available for future expansion. Effective January 31, 2006, we acquired the facilities, machinery and equipment of Gulf Marine Fabricators (“Gulf Marine”) located in San Patricio County, Texas.

Our acquisition of Gulf Marine ... enables us to perform dockside integration, provides us with increased rolled goods capabilities, affords 45 feet of water depth access to our facilities, gives us the ability to construct 1,300 foot conventional jackets and tendons for floating production platforms, offers us much greater lifting capacity dockside (4,000 tons), and makes available an additional labor pool.

We believe that spending by our customers and potential customers for projects for use in the Gulf of Mexico and international deepwater (generally depths over 1,000 feet) will continue to grow as a percentage of their total offshore expenditures. These projects are typically much larger than projects for use in the shallow water. We can now fabricate and assemble all components of deepwater construction projects, which we were previously limited from doing by the physical constraints of our Houma yards. The acquisition of Gulf Marine positions us as a leading U.S. deepwater fabricator. In addition, it has increased our labor pool, provided opportunities for additional work from our cooperation agreement with Technip and given us the largest fabrication capacity on the Gulf Coast.

Our customers are primarily major and independent oil and gas exploration and production companies. We also may perform work as a sub-contractor for one or more of our competitors. Over the past five years, sales of structures and related services used in the Gulf of Mexico by oil and gas exploration and production companies accounted for approximately 76% of our revenue. The balance of our revenue was derived from the fabrication of structures installed outside the Gulf of Mexico, including North Africa, West Africa, Middle East, Latin America, the Caribbean, Offshore Canada and the North Sea.

 

Strengths - conservative management has kept the company free from long term debt, steadily growing tangible book value per share at a pace of 12 % per year for 10 years.

Under customary contractual terms, material costs are passed through, while labor costs are subject to a variety of plans ranging from fixed cost to cost-plus, with various intermediate possibilities. The company's labor force, supplemented by a small amount of contract labor, is carefully managed to maintain alignment with production needs. Capex proceeds unevenly year by year but over time has been kept consistent with cash flow, being met from retained earnings.

The track record demonstrates that management has been effective in managing skilled labor, large and complex projects, and capital expansion to enhance shareholder value.

Deepwater vs. shallow water – for many years GIFI prospered by building shallow water platforms for the Gulf of Mexico. Due to the development of directional drilling, fewer shallow water platforms will be needed going forward. Deep-water is becoming much more important, and that is where the larger and more expensive projects are.

In 2006 GIFI acquired the assets of Gulf Marine, which gave them the facilities necessary to compete for these large projects. The timing and positioning were adroit and can be anticipated to bear fruit over time.

Adjacent or compatible businesses – the company has expanded its steel sales operation, which utilizes the material handling capabilities of its primary operations. In 2007 they expanded operations in the marine construction area to reduce the fluctuations in work volume caused by the decrease in awards of projects for shallow water structures, adding experienced management level personnel and acquiring additional work.

Backlog - an area of concern. Large projects may last more than a year and under normal conditions GIFI has a backlog averaging about 85% of TTM Revenues. As of 6/30/09, backlog stood at about half its normal level, due to the indefinite postponement of the MinDOC II project for ATP Oil & Gas (ATPG). I looked at ATPG's operations and did not form a favorable impression. Normal contractual terms allow GIFI to recover the cost of canceled projects and in some cases provide for penalties.

After oil prices tanked earlier this year, capex for many oil and gas companies was reduced. With oil prices around 70 and the world economy in recovery, companies will again be taking a longer term view about the expense of deep-water projects, which are necessary to maintain adequate production.

Most work in the industry is awarded by bid: as production companies increase their capital spending Gulf Island is well positioned to compete for large deepwater projects.

Risk management – this is heavy industry with maritime exposures. The company self-insures their worker's compensation and longshoreman's and harbor workers exposures up to 300,000. 2008 results were impacted by a loss involving four cranes, which were damaged and required expensive rental replacements. Also, there were 3^rd quarter losses due to hurricanes. I don't have details on the crane loss but it does constitute a reservation: it was an operating accident sufficient to affect profits, and presumably was preventable.

The industry is cyclical, a risk that is counteracted by conservative financial management – no long term debt.

 

Competition - The productive assets are conveniently located and would be difficult for competition to replicate due to environmental and NIMBY issues. Management believes that barriers to entry for smaller projects are not difficult, but for larger projects they are substantial.

Most of the work in the industry is awarded by bid, and is won or lost on price, although past reliability, safety record, financial strength etc. are additional considerations. The 10-K names two domestic competitors. Foreign competition is intense, with some competitors receiving government support or subsidies.

Valuation – For a cyclical industry, 5 year average EPS is useful when looking beyond a trough year. At the end of 2009, my estimate works out to 1.54. Based on historical share prices, an average multiple on that metric would be 20, leading to a target price of 31 within two years. The stock traded as high as 52.59 in 2008, 45.00 in 2007, and 40.24 in 2006. A strong balance sheet and tangible book value provide margin of security.

Strategy - share prices have fluctuated dramatically for the past 4 years, driven by the price of oil and general market irrationality. The contrast between the relatively steady increase in shareholder's equity or tangible book value and the gyrations of the stock is food for thought, particularly considered in the context of the good visibility afforded by the backlog, which is normally large, and the expected demand for deep water platforms.

I have taken up a starter position and plan to accumulate and monitor the backlog and conference calls as quarterly earnings come out.

Disclosure – long GIFI, no position in ATPG