U.S. Energy Independence: A Strategic Portfolio

by: The Wall Street Transcript

An energy policy for the United States has become like the weather: everyone talks about it, but no one ever does anything about it. This lack of consistent direction has created volatile, and recently, sharply negative returns to investors in the Alternative Energy space.

With a lot of hot air being generated in the months until the Presidential election, perhaps the wind power generation sector is a place to invest? On the contrary -- equity research analysts are warning that this sector is about to be…well, gone with the wind.

Christopher Blansett, the Senior Equity Analyst covering the alternative energy and semiconductor capital equipment sectors at JPMorgan Chase & Co. (NYSE:JPM), put it this way in an August 20 interview:

Unfortunately, we're looking at the end of federal subsidization for the wind sector at the end of the year. So we're seeing a lot of last-minute rush work getting done this year to try to make sure wind projects are completed before the subsidy program expires. We're going to have a very strong second half of the year, but unfortunately, unless Congress does something to extend the current wind subsidy, we're going to have a very weak 2013, down easily more than 50%, and potentially more than 75% year over year.

A 75% drop in top line industry revenues is not a market investors want to buy. Sadly, the domestic solar power production sector is little better. The alternative energy expert from Raymond James & Associates, Pavel Molchanov, had this to say in a recent interview:

Unfortunately, for investors, most of the publicly traded companies in the solar value chain are the manufacturers -- in other words, the very companies that are facing significant oversupply -- and as a result, persistent margin pressures -- and in many cases, negative earnings and even negative cash flow.

Margin pressures, negative earnings and negative cash flow are not headlines that inspire investing confidence, and sophisticated investors immediately recognize a bad asset class when two different research analysts both start sentences with the word "unfortunately."

So are there "Clean Energy" and "Alternative Energy" stocks relevant for investors? Is an energy independent U.S. investment thesis completely dead?

Instead of stocks that rely on government subsidized revenues and inherently volatile international commodity sources, I suggest an investment focus on pure domestic energy sources and local electrical power generation. Several stocks and sectors are positively correlated to this premise.

Currently, natural gas powered turbines generate 25% of electricity in the United States. This component of U.S. electrical power generation will continue to grow as coal based electricity declines from ever increasing emission restrictions. As Curt Launer, an Institutional Investor Hall of Fame analyst, said in a recent interview:

So to go to the main point about your question, natural gas becoming a baseload fuel really just has utilization factors for natural gas rising. And with the environmental benefits that are there, the advent of the shale plays in terms of production of more natural gas, we see natural gas becoming a baseload fuel, and we also see natural gas demand for power generation growing dramatically over the next five years. Our specific number in that regard is that natural gas demand for power generation will grow nearly 5% per year in each of the next five years.

The increase in supply will continue to come from the "fracking" of extensive shale formations all over the continental U.S. Since there are currently a grand total of zero LNG export terminals in the lower 48 states, the export of significant amounts of liquefied natural gas from the U.S. will not become a reality until 2016 at the earliest. Simply put, the natgas found within the U.S. is going to stay here.

The equity values of the domestic producers of natural gas have dropped dramatically as the ever increasing supply of this commodity has driven prices to historic lows. Interestingly, the pipelines that deliver natgas to the electricity utilities that use it are enjoying new growth prospects. Similar to railroads in the 19th century, these "midstream" pipeline companies are deriving the benefit from being the intermediary between the increase in natural gas supply with the increase in demand from electrical generation utilities.

These pipeline companies enjoy extremely high barriers to entry: significant existing regulation, a vocal environmental lobby, and an average of $1 million per mile in construction costs. Several of these "midstream" pipeline companies have been identified as having trustworthy management, hefty yields and safe balance sheets: Williams Companies (NYSE:WMB) and its pipeline only subsidiary master limited partnership Williams Partners (NYSE:WPZ), and the similar Spectra Energy (NYSE:SE) and its subsidiary Spectra Energy Partners (NYSE:SEP).

Another area of interest is the development of single home kilowatt solar power rather than megawatt sized projects. In this case, small is beautiful. Consider a new home built using the Dow Chemical Company's (DOW) new Powerhouse shingles. Using any local roofing contractor, and thereby putting construction workers back on the job and off the unemployment line, the Dow shingles generate electricity that feeds back into the electrical grid, running your meter backward.

To convert the direct current power from the sun into usable grid power, the solar roof system benefits from the efficiency of the Enphase (NASDAQ:ENPH) "MicroInverter." Forbes Blue Chip Analyst Molchanov of Raymond James identified Enphase as a company to watch:

One good example that actually went public just in March is Enphase Energy . Enphase is a unique pure play on microinverters. What is a microinverter? It is a replacement to a traditional solar inverter, and just about every installed PV system has to have an inverter of one kind or another to take DC power and convert it into AC power for the grid. Microinverters are a cutting-edge product that brings smart grid functionality and advanced communications into the solar arena. Microinverters boost power output of PV systems and improve project IRRs by between 1% and 2%.

The target market is residential and small commercial systems -- in other words, this is not for large solar farms. Because microinverters are a very new technology with a narrow set of competitors, Enphase is emphatically not a commodity company. In fact, it is the world's only major producer of microinverters…

Company Ticker Price P/E Yield EV
Dow Chemical DOW $28.46 18.0 4.4% $51.8 billion
Spectra Energy SE $28.29 17.1 4.0% $30.2 billion
Williams WMB $32.14 51.5 3.9% $29.2 billion
Williams Partners WPZ $51.50 12.3 6.1% $24.2 billion
General Motors GM $21.75 7.7 -- $15.6 billion
Spectra Energy Partners SEP $32.12 19.2 6.1% $3.8 billion
Tesla Motors TSLA $27.94 N/A N/A $3.2 billion
Veeco Instruments VECO $34.13 15.9 N/A $807 million
Enphase Energy ENPH $5.28 N/A N/A $150 million

If you get tired of feeding the solar energy generated back to the grid you can always use it to power up your new Tesla Model S electric sedan. While a record 2500 Chevy Volts sold this August is encouraging to General Motors (NYSE:GM) shareholders; Daimler (OTCPK:DDAIF) and Toyota Motors have already licensed the Tesla (NASDAQ:TSLA) powertrain technology. The new Model S is sold out a year in advance, a business state that the executives at GM cannot fail to notice.

And be sure to light up your Tesla laden garage and the highways it goes (zero to 60 mph in 4.4 seconds) on with energy saving LED lights. These lights are produced from factories with Veeco Instruments (NASDAQ:VECO), a top pick from JPMorgan analyst Christopher Blansett:

I think the key thing to look for here that investors really focus on is lack of new entrants, because whether I'm making LEDs or other parts of the food chain, there seems to always be the ability for someone new to show up. But in this very critical capital equipment segment of the food chain, it's very difficult for a new entrant to come. It's one of the few places where there is a huge barrier to entry. So we like that aspect, like their variable cost model, and we like the fact that they have very low capex to revenue.

Perhaps an energy sufficient and efficient U.S. is not such a poor investment after all? Using roof top solar to generate sufficient electrical energy to power your car, and pouring the excess back into an electrical grid supported by domestically supplied natural gas is an envious situation. Certainly, the United States is the only country on the planet capable of developing this positive productivity loop all by itself. It would be a fine way to earn a long term return on your portfolio.

Disclosure: I am long SE, WMB, TSLA. 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.