Kenneth Lam's  Instablog

Profile:

• Consists of three segments (Consumer, Pharmaceutical, Medical device & diagnostics)
• Consumer accounts for only 10% of operating profit
• The remaining 90% of operating profit is shared equally by pharmaceutical and medical device & diagnostics)
• 52% revenue outside US

Risk:

• Product recalls and suspension of production at McNeil facility in 2010 (resulting in $900M sales reduction, insignificant comparing to $60B worldwide sales)
• Operational issues call into question the current CEO’s competence
• Health care reform in US estimated by the company to reduce sales by $500M and impose a fee of $200M in 2011 (insignificant comparing to $13B net income in 2010)
• Competition from generic drugs for patent expired drugs              

Opportunity:

• Dividend increased every year (compound annual growth rate of 13%) since the current CEO took the job in 2002
• Regarding McNeil situation, alternate supplies of products are planned to be available in the latter half of 2011
• Significant portion of products are protected by patents
• 2011 sales forecasted to grow by 4%
• Negatively impacted by McNeil situation, 2010 operating profit still grew by 7%
• $24B working capital as of 2010 year end
• high dividend %
• More demand from aging population

• Henry Hub natural gas price is currently around US$4 per mmbtu
• Strong demand in Europe and Asia as prices are around US$10 per mmbtu
• In US, the current inventory is about 500 billion cubic feet more than 2008 when Henry Hub natural gas price was above $8 per mmbtu (multi-year high)
• According to the Department of Energy, the inventory level will remain similar for 2011 and 2012 
• The excess inventory resulted from the new techniques developed in North America, namely horizontal drilling and hydraulic fracturing, that have enabled economical extraction of natural gas from an unconventional source called shale gas
• There is no major facility in North America to liquefy the excess natural gas for export to Asia and Europe
• Several North American companies (Apache Corp, Cheniere Energy Inc, Dominion Resources Inc, and Freeport LNG) have announced plans to build four export terminals, scheduled to start operating in 2014 and 2015. They have a combined capacity of at least 1 trillion cubic feet each year, twice the amount of inventory difference between today and 2008 mentioned above. Preliminary agreements have already been signed by the customers for half of the output.
• Henry Hub natural gas price should bounce back to above US$8 per mmbtu in 2014 as the excess inventory is eliminated through the new export terminals
• According to the Department of Energy, electricity generation accounted for 30% of natural gas consumption in 2009. The usage has been increasing 5% a year on average from 1999 to 2009. The main driving force for this trend is the replacement of coal-fired power plants with natural gas-fired ones.
• Many states and countries are phasing out coal-fired power plants due to their greenhouse gas emission.  Natural gas-fired power plants emit only half as much greenhouse gas.
• Natural gas will replace coal as the major source for electricity generation as renewable energy such as wind and solar still suffers from cost and weather issues. US and EU set their renewable energy targets to only 20% and 30% by 2020. In contrast, the current usage for coal and natural gas are 45% and 25% respectively in US.
• There was a 30% (capacity) spike in the construction kickoff of natural gas-fired power plants in 2008. Given the average 3 year construction time, these generators will come online in 2011 and push up the Henry Hub natural gas price.
• US is on track to a gradual economic recovery as many companies reported earnings comparable to or higher than the years just before the financial crisis. Energy consumption will increase in 2011 and beyond as the economy continues to improve.
• Between now and 2014, Henry Hub natural gas price will move up for the two reasons listed above, more natural gas-fired power plants and better US economy.

Rapidly rising commodity and food prices have caused a series of riots across countries in the Middle East recently.  The political leaders in Tunisia, Egypt, and Jordan have all agreed to step down.  These latest developments are exactly the kind of nightmare the Chinese communist government has been trying to avoid, and will likely reinforce its determination to cool down its steaming economy.  Last year, it raised the major banks’ required reserve six times (in addition to interest rate hikes) resulting in a ratio of 20%, a record high for the country. However, copper investors seem to think that China’s economy will continue its lightning pace and remain out of the government’s control. Copper price has been breaking record every month, trading at three times of its recent low of $1.50 just two years ago. This may prove to be a risky investment position as there is evidence suggesting that roughly 2.5 million tonnes of current demand is a direct result of Chinese government’s one-time massive economic stimulus.  Copper consumption in China jumped by 45% from 5.5 million tonnes in 2008 (a record high back then) to 8 million tonnes in 2009, the year of global financial crisis. The increase is more than five times the global supply shortage (444K tonnes) in 2011, estimated by a recent Reuters poll of analysts. Any effect from the government’s tightening policy should be sufficient to wipe out the entire shortage and create a surplus situation. Analysts at Deutsche Bank have projected that there is a danger that Chinese copper consumption disappoints in 2011, with growth close to zero. Investors should also recognize that it is likely in the interest of the Chinese government to maintain cheaper copper price to develop the country at a lower cost. However, a price level above breakeven point is necessary to ensure adequate supply for the long term. Scotia Capital estimated that on average copper miners recover all their costs including interest and depreciation at $1.36 per pound.  This implies that even if the price falls back to $2, miners will still earn healthy and sustainable profit. To capitalize on this possible pullback in copper price, one could buy June 2011 put option on JJC (copper ETN) with exercise price of $50. If the copper price falls back to $3.50, this investment will break even. At $2, the option’s value will appreciate by roughly 14 times. With this kind of favourable combination of odds and payout, it is worth to allocate a tiny bit of your portfolio into this investment. A relatively more conservative approach would be to split the investment in half and purchase another 6-month put option in June.