Kevin Smith takes a look at one long-term holding and two more recent acquisitions, all of which performed very well in July 2020, each stock rising by more than 40% for the month.
High volatility has been a feature of the equity markets in the region during the past two years, with the key events being trade tension between the United States and China and the subsequent Covid-19 pandemic with the associated disruption to economic activity across the world. Three-year annualized volatility for the Asia region to the end of July was close to 20%, well above the long-term average and a big jump from the 13.5% volatility figure recorded in the region twelve months earlier. While volatility has been at high levels, market returns have remained well below their long-term average. During the year to end July 2020 our benchmark index of small to mid-sized companies in the Asian region in Australian dollar terms fell by 3.1%, while our Asian portfolio net of all fees increased by 0.5%. It is very pleasing for us as fund managers to achieve a positive return when the underlying markets are in decline. If you had not looked at markets in the past twelve months and had avoided all news stories you would have concluded that markets had been quiet during that time with the small negative outcome for the index. The purpose of this article is to take a closer look at our responses to three examples of highly volatile companies in our portfolio, China Lesso, United Microelectronics and BayCurrent Consulting, all of which increased by more than 40% in July, a month when the overall index recorded a decline of 2.6% in Australian dollar terms.
We first acquired a position in China Lesso (Lesso) (HKG.2128) in the fourth quarter of 2018 at an average price of HKD 4.08, at the time of writing the shares trade at HKD 15.50 to be the strongest performer in our Asian portfolio. During the month of July shares in Lesso increased by 48.4% from HKD 10.08 to HKD 14.96. We have taken profits along the journey, in particular for risk control purposes, it is important not to let an individual stock position grow too large in a diversified portfolio. Lesso was a major contributor to our performance in the past year. Lesso typically has coverage provided by seven or eight analysts and the progression of the company share price versus their target prices is shown in Figure One. The analysts have struggled to keep pace with the underlying share price.
In October 2018 we concluded that “Lesso meets our standards for accounting, strategy and governance. Lesso has a strategy directed towards the development of China, the company has a strong home market in Southern China and is well placed to benefit from urbanization of the interior of China and major infrastructure projects funded by local government bodies and the national government.” Lesso has 90% of sales from plastic pipe systems, revenues grew by 11.0% and earnings per share increased by 22.5% in 2019. Figure Two illustrates the level of valuation of Lesso when we first acquired the shares in 2018 on a p/e ratio of 4.3x, the valuation has since expanded to the current (and still reasonable) level of 12.9x. With continued growth in profits expected out to the year 2022, Lesso trades on a prospective p/e ratio of less than 10x.
Figure One: China Lesso Share Price Versus Average Target Price
That expansion in multiple explains the majority of the return achieved in the past two years. We are happy to retain a position in the company since our original reasons for investing remain intact, the company continues to score well on our measure of VMQ (valuation, momentum and quality) and high standards of governance are being maintained. Lesso remains a key beneficiary of the urbanization of the interior of China with 25 production bases located across 16 provinces in China and a nationwide sales network of more than 2,000 exclusive distributors.
Figure Two: China Lesso Valuation History and Forward Estimates
Source: marketscreener.com
United Microelectronics Corporation (UMC) (TPE.2303) manufactures and markets integrated circuits. The company provides wafer manufacturing, assembly, testing, mask production and design services. UMC operates 12 fabs that are located throughout Asia with a maximum capacity of more than 750,000 8-inch equivalent wafers per month. The company employs approximately 19,000 people worldwide, with offices in Taiwan, China, United States, Europe, Japan, Korea and Singapore. In Q3 2019, UMC ranked fourth in the pure semiconductor foundry industry with 6.7% market share (source: Trend Force). UMC manufactures semiconductors using advanced production processes for customers based on its own proprietary integrated circuit designs. UMC’s wafer fabrication process includes services such as design, mask making, testing and assembly services. We believe UMC will transform into a specialty foundry, changing its business model, and focus on 28nm, 40nm and 8″ foundry products, which will result in significantly improved profitability by reducing capex and R&D.
We built our initial position in UMC during May 2020 at an average price of TWD 15.15. There are 20 analysts producing forecasts for UMC, in July 2020 there was considerable positive earnings surprise when second quarter earnings were reported some 56% above the market consensus that is derived from those 20 analysts. The share price of UMC responded by rising 40.6% during the month of July to close at TWD 22.35. We did not buy our position because of any particular insight regarding the next set of quarterly results, our time-frame is to take a view over several years. We do not make forecasts for an individual quarterly earnings period however we look to form a judgement regarding the likely success of the strategy being employed by the company we are assessing. For UMC, the company scored very well on our broad categories of value, momentum and quality and as noted above we liked their strategy of becoming a specialty semiconductor foundry with the scope to increase profitability. The earnings increase that surprised the investment analysts in the second quarter results was a vindication of the company strategy albeit somewhat earlier than we had anticipated. Figure Three shows that the market is now expecting continued growth of earnings in the next two years with a prospective price earnings ratio of 11.5x. Since we take the view that the company strategy as far from complete, we are retaining our position in UMC.
Figure Three: United Microelectronics Corporation Valuation History and Forward Estimates
Source: marketscreener.com
BayCurrent Consulting Inc. (BayCurrent) (TYO.6532) is a comprehensive consulting firm based in Japan. BayCurrent is engaged in designing and implementing strategies relating to information technology, global growth, marketing, mergers, joint ventures, alliances, governance implementation and turn-around management. BayCurrent has grown rapidly in recent years with the annual results reported to the end of February showing revenue growth of 36% and earnings growth of 91% over the previous year. We started to have a serious look at the business when the valuation dropped below 20x price to earnings in recent months and decided to build a position in early July at an average price of JPY 8,858. We then watched the share price rise by 49% in the space of three weeks to JPY 13,216 at which point we sold the shares. It is very unusual that we have a holding period of just three weeks, more typically we will hold a position for three years. In this instance the 49% share price increase put the valuation up to 31x expected 2021 price/earnings which was more than our tolerance for value. We will be happy to have another look at the company if the valuation drops back to a reasonable level.
Figure Four: BayCurrent Consulting Inc. Valuation History and Forward Estimates
Source: marketscreener.com
In conclusion, while the Asia regional returns have been subdued in the past two years, we have seen some extreme levels of volatility with individual stocks moving as much as 50% month to month. This article has provided three examples of stocks held in our Asian portfolio that have increased by more than 40% during the month of July. Share price movement of that magnitude will always prompt us to review our position, in two cases, China Lesso and UMC we retained our holdings on the basis that our view of the respective strategies remains intact and the valuation isn’t too high. In the case of BayCurrent the 49% upward price move in three weeks pushed the valuation above an acceptable valuation level and we sold our position.
Kevin Smith, also of Delft Partners, is portfolio manager of the TAMIM Asia Small Companies portfolio. Click here to learn more.
This week we go through some of the notes and key highlights from the top end of the market. A disclaimer before reading further, this is the first part of my notes on the top ten securities by market capitalisation.
Author: Sid Ruttala
Please note, this does not necessarily mean that we currently hold any of the top ten, especially given our domestic equities mandates are broadly ASX ex20. Nevertheless, I do believe it pays to keep a track of what is happening in their universe and their balance sheets to get a feel for the overall economy. In addition, given their sheer weightings in a liquidity driven market (we will leave this topic for another week), it is good for investors to keep a track of them whether they own or not.
Commonwealth Bank of Australia (CBA.ASX)
Given the headwinds associated with Covid-19 and the mortgage deferrals, CBA has been pleasantly surprising in its results. The commentary by management has been rather conservative (as would be expected). Numbers-wise, statutory NPAT stands at $9.6bn AUD (up 12.4%), though this is a result of divestments related to the wealth business, while cash NPAT stands at $7.3bn AUD. The cash NPAT gives a better indication of the operating environment for the bank going forward and represents an -11.3% decline. Painful yet better than expectations. The growth in cash rate linked deposits has also provided a buffer.
What is interesting is the maintenance of a dividend at 98c (with no discount on DRP), taking the full-year dividend to 2.98 AUD p/s. This suggests a payout ratio of close to 50%. Despite the payout and provisioning for bad loans, CET1 remains just above 11.3%, significantly better than its counterparts. This is likely to increase to 12.5% after the sale of non-core assets.
Red Flags & Risks: NIM (Net Interest Margins) continued to fall from 2.09% to 2.07%. This might stabilise, assuming the RBA doesn’t change its policy stance with regards to negative rates. Signs of stress are also appearing with credit card arrears ticking up exponentially from 1.02% to 1.23%. There is also uncertainty around the residential mortgage book since the annual report doesn’t take into consideration any loans deferred as part of the Covid-19 support packages in line with APRA expectations. This might have the caveat of nasty surprises if there are any changes to government and regulatory policy.
My Expectations: NIM’s should stabilise at 1.8-2.0% over the next 24 month period. Cash NPAT will be around $7bn AUD and unlikely to grow for the foreseeable future. Management also failed to clearly outline the status and process of cost-cutting initiatives apart from fluff around digital transformation. Personally, I am not expecting substantial strides to have been made via these initiatives. Provisions have been made to deal with the fallout from the Royal Commision, but recent class action from Shine is likely to complicate matters.
Dividend Yield: Current yield of 4.25% (assuming share price at $70 AUD).
Downward pressure likely to take the absolute payout down further. Payout ratio would conservatively be adjusted, contingent upon overall economic outlook and the property market.
Westpac Banking Corp (WBC.ASX)
Revenues were broadly flat through Q3, as is the case with the other majors, along with softer margins, including NIM’s (down by 8 bp). Perhaps of more concern has been deposit headwinds, which acted as a substantial buffer for CBA. This scenario was somewhat mitigated by non-interest income (i.e. predominantly less than expected insurance claims). We believe the wealth business remains a key headache for the bank going forward. The interim dividend was also cut.
WBC is well capitalised with CET1 standing at 10.8% but was an outlier in that this was a slight reduction compared to the other three competitors. Here we were pleasantly surprised on the upside again, with the BDD (Bad & Doubtful Debts) only coming in at around $825m AUD. $30bn AUD in mortgages remain in deferral, this is similar to the bank’s counterparts in my view and was to be expected.
Red Flags & Risks: NIM’s are under pressure and, when compared to CBA, Westpac is slightly lower at 2.05%. Impairment charges on mortgages have been cushioned somewhat with the help of regulators and, somewhat surprisingly, management expects around half to return to payment. 90+ day delinquencies in unsecured consumer lending are also ticking up steadily, now reaching 2.52%, with the NZ business slightly lower at 2.31%.
My Expectations: NIM’s should stabilse at 1.6-1.75% over the next 24 months. Cash NPAT will remain flat for the foreseeable future. The big concern is in regards to legacy business streams, including the wealth management arm, and substantial exposure to commercial property. I remain of the view that we will likely see more stress within these assets. Additionally, I did not get clear signs of how management was likely to reduce costs. This is what will be the key driver within the Australian banking system in the absence of changes to the interest rate environment or mortgage book growth.
Dividend Yield: Current yield of 4.7% (assuming a share price of $17 AUD) and taking into consideration the dividend cut.
Management are likely to be incentivised to play catch up next year assuming an economic recovery. Taking it higher in the year to come, in terms of yield, to 8%. This also assumes no further stress on the balance sheet. However, this would be a one-off and there would likely be downward pressure again given the cash rate and NIM’s. For the more adventurous amongst you, there is a potential short-term play for dividend stripping here.
National Australia Bank (NAB.ASX)
NAB was a genuine surprise, reporting growth in cash earnings from continuing operations by 25% to around $1.55bn (though Q3 earnings were down -7% when compared to 2019). The caveat here is that most of these would have been balance sheet related. To do with reversal of MtM (Mark-to-Market) losses from the previous quarter (related to Markets & Treasury).
Even NAB surprised with the BDD amounting to $570m AUD, substantially less than my expectation of $850m AUD. Management has indicated a clear pathway to separate the legacy MLC business. This should, one would hope, see some cash coming back to shareholders in the next twelve months. NAB is well capitalised with CET1 standing 11.6%.
Red Flags & Risks: Again NIM’s are under pressure (there appears to be a theme emerging here), we estimate them to be around 1.78% and likely to stay around this level for the foreseeable future. Much depends on management in streamlining the business through the sale of MLC (or spinning off) and placing focus on the SME lending business, a segment in which they have a substantial edge comparatively. There has also been a 2% increase in the costs, to do with remuneration and annual leave accruals, but Covid-19 has meant that the cost-cutting process is now seemingly taking a back seat. Nevertheless, the stock does trade at a significant discount to its peers.
My Expectations: NIM’s to stabilise at 1.4-1.55% over the next 24 months. Cash NPAT to remain flat for the foreseeable future. The big concern is the backseat the cost reduction initiative has seemingly taken. The fact that NAB has the SME portfolio is also a big plus when compared to the others as, in my opinion, the market is mispricing the amount of collateral that is actually put up for SME lending.
Dividend Yield: Current yield of 7.2% (assuming a share price of $18 AUD).
Likely to stay stable overall, assuming that we are right on the SME lending arm and given its relative undervaluation. In absolute terms, likely to stay consistent.
Australia and New Zealand Banking Corp (ANZ.ASX)
ANZ also surprised on the upside with BDD’s standing at $500m AUD. The earnings update was solid with an unaudited profit of $1.3bn AUD. Management has also been exceptionally disciplined in its cost reduction, maintaining a 1% decrease while also increasing capex and seemingly going through with their transformation initiatives. Dividends, thankfully for the investors, were 25c per share for H1 2020.
The caveat, and the one thing that stood out, was the substantially lower net interest margins when compared with the other three, standing at around 1.69%. We expect the bank to maintain this going through the next 24 months while the other three catch up on the downside (catch down is perhaps a more appropriate way of putting it?). The flip side is that, comparatively, ANZ has a greater proportion of fixed-rate loans and disproportionately high liquid assets (13bn). Deposit growth of 2.1% in this environment is to be applauded.
Red Flags & Risks: The NIM’s are by far the biggest concern when it comes to ANZ. The institutional business is stagnant and needs momentum behind it. The commercial business might get rather messy, especially Victoria. Currently, the commercial deferrals stand at approximately 14% of the book. That said, only 6% of this exposure is currently unsecured.
My Expectations: NIM’s will stay flat over the next 24 months, as will cash NPAT for the foreseeable future. However, the upside is that a quicker than expected recovery would see ANZ benefit given its institutional and commercial business, as well as well-diversified portfolio.
Dividend Yield: Current yield of 5.8% (assuming a share price $18.54 AUD).
Likely to stay stable given that absolute payout has already taken a hit. On the upside, increased momentum in the institutional/commercial business and cost reductions could provide some upside. Payout ratio expected to stay at these levels.
Takeaways
Leanest and meanest of the lot: CBA
But look at it like buying investment property… but with leverage given the balance sheets exposure to that particular segment.
Cheapest of the lot: NAB
The market is mispricing the collateral that SME’s put up for the loans.
The laggard of the lot: Westpac
Reading through the reports, I didn’t see any real indication as to how the business was to be taken forward and what the future might hold.
The one I can’t put a finger on: ANZ
NIM’s are the biggest concern but it remains the only one that has a substantial institutional business and seems to be the quiet performer in terms of its cost-cutting measures and vision.
Which one would I buy?
Rationally, either NAB (in need of a substantial re-rating) or CBA (safest bet). That said, I’m a little too scared to own any given I spend too much time reading about what happened to the financials in Europe and Japan in a prolonged low interest rate environment.
Endnote: CSL along with BHP, Wesfarmers and FMG will be next week.
Ron Shamgar provides an update on a number of the companies held in TAMIM’s Australian equities portfolios.
Authors: Ron Shamgar
Cardno (CDD.ASX) is an environmental, government and community consultancy firm which operates with over 4,400 staff globally. The company has been overlooked by the market recently as it has been in turnaround mode for the last few years and also demerged its lab testing division, Intega (ITG.ASX), more recently, making it too small for some index funds to hold. We took advantage of this to build a position around 23 cents ($100m market cap) recently.
CDD released a strong trading update in July with the business not being impacted by Covid, benefitting in fact, as governments and corporates require help with community planning due to Covid restrictions. CDD is guiding to EBITDA of $41-$43m in FY20 and a positive net cash position. Operating cash flows were also strong and we believe there’s a good chance of dividends being reinstated. We estimate that FY21 will see further earnings growth as management has indicated a strong backlog of work. CDD is trading on a 6x PE multiple and we value it at 55 cents.
iSelect (ISU.ASX) is a price comparison site that helps consumers compare and save on Health insurance, energy and telco bills. The company has a strong and recognisable brand along with a valuable commission trail book worth 53 cents a share. We have been quietly building a position in the company at the 20-cent mark as we like the new management team and their strategy to simplify the business and cut costs.
ISU announced in July that its largest shareholder and competitor, Compare the Market, has lobbed a cash takeover offer of 40 cents. Unfortunately, the companies could not agree on some clauses related to Covid, and so the bid was cancelled for the time being (even though the price was not the issue). We think the bidder will eventually come back and may end up paying more.
In the meantime, ISU divested its loss making iMoney Asian business which will remove $4-5m of annual losses. During July, ISU grew profit substantially to $1.5m EBITDA or 65% growth on July FY19. This bodes well for profitability next year which we think can be about $15m in EBITDA. At the very least, we think ISU is worth 40 cents with potential for much more.
Tesserent (TNT.ASX) recently announced the acquisition of Canberra based cyber security firm, Seer. This now transforms TNT into the largest cyber security firm in Canberra. Seer services the federal government and defence department agencies and strengthens TNT capabilities to the government sector. More importantly, Seer is a high growth business that generated revenue of $7.6m and $2.2m in EBIT in FY20. We expect strong growth to continue next year.
In addition, TNT announced FY20 milestones of a $40m of annualised revenue run rate and reaching cash flow positivity in June. The company is now well funded with a newly established debt facility to acquire more cyber security firms in the short term. We expect at least one “bolt on” during August and a larger one thereafter. The shares reacted favourably since the deal was announced and TNT has now officially made us 5x our money since we bought the stock at 5 cents last year. We have taken some profits but still retain a sensible position.
Source: ST1 company filings
Spirit Telecom (ST1.ASX) is a modern national telco provider to businesses. The company has been transformed by their new CEO, Sol Lukatsky, who joined last year. They have blossomed from a sleepy fixed wireless infrastructure provider to an aggressive, high growth and modern national telco. ST1 has made several successive acquisitions over the last twelve months in order to offer not just a fast internet service, but also other IT services such as cloud and cyber security services, virtual hosting and IT hardware and support.
The company’s strategy revolves around their SpiritX platform which allows both business customers and telco dealers to use the online platform and see which is the best data connection for their location. ST1 offers not just its own fixed wireless network but also NBN and other provider’s fibre services. Overall, this increases the market size opportunity for ST1 and has resulted in strong growth.
FY20 2H revenues grew 80% to $22.4m, with 14% revenue growth from Q3 to Q4. The recurring revenue base of B2B customers grew 82% in 2H. EBITDA for FY20 is approximately $3.8m. The company also recently made an acquisition of VPD which will add further growth in FY21. We see SpiritX as a strong lead generation tool with 12,000 addresses qualified through the platform in 2H. This provides visibility on customer demand and is valuable IP that the company is building.
Source: ST1 company filings
We expect ST1 to continue their acquisition of other providers in order to ensure national coverage and access to 300 telco dealers across Australia. We envisage ST1 to have an exit run rate in FY21 of over $100m in revenues and $15m of EBITDA. ST1 is currently our largest holding in the All Cap portfolio. We took our position at 21 cents and we believe that ST1 is worth 45 cents in the short term but potentially double that on successful execution of their acquisition strategy by management.
City Chic (CCX.ASX) is a leading online plus size women’s retailer. During July CCX announced the acquisition of the e-commerce assets of US based plus size retailer Catherines from bankruptcy proceedings. The deal, when successful, should add up to $90m in online sales in the US. To support the acquisition, which we estimate will cost $30m, CCX raised $90m in new equity. We have participated in this at $3.05 a share.
Management also provided FY20 financial results of 30% growth in revenues, to $195m, and about $29m in underlying EBITDA. The company finished the year with a net cash position and, together with the proceeds of the raise, should have over $60m to deploy on future deals. We expect 80% of group sales next year to come from online. The global opportunity in North America and Europe provides CCX a long runway for growth and management are astute in their opportunistic buying of other businesses. We value CCX at over $4.00.
Source: CCX company filings
Source: CGR company filings
CML group (CGR.ASX), which provides invoice financing to small and medium businesses, provided both a business update and a technology acquisition during the month. Pleasingly, CGR financed over $1.7bn in invoices during FY20 and achieved EBITDA of $20m and $8m NPAT. The company will also pay a 1.75-2 cents dividend which is an attractive yield. FY21 outlook is positive with demand increasing in June and July.
During tough economic times, invoice payments get delayed, and we are already seeing this with industry data showing invoice payment delays in June now at 49 days (compared to 15 days last year), with some industries seeing delays of over 60 days. This bodes well for CGR. The acquisition of Skippr in July provides an automated technology platform for the company to acquire smaller customers at a lower cost and thus increase their market size opportunity. We think investors will gradually begin pricing CGR as more of a fintech rather than a traditional finance company. CGR currently trades on 7.5x PE and a 6% ff yield. We value the company at more than 50 cents.
National Tyre & Wheel (NTD.ASX) is a leading national distributor of branded tyres and wheels. NTD announced the acquisition of Tyres4U for $50m in July. The acquired business is not profitable but presents an attractive opportunity for NTD to extract synergies and bring it to similar profit margins. The combined group will have over $450m of revenues and significant scale.
The deal will be financed partly through cash and a new debt facility structure with CBA bank. Following the deal we estimate net debt of about $30m. This deal presents good upside, as the group can double earnings through cost outs, but also adds further risk as the debt levels are now high. Overall we think management have shown themselves to be conservative and we think the risk reward proposition is still attractive. We value NTD at 70 cents.
Note: All stocks summarised above are held in either the TAMIM Fund: Australian All Cap or Small Cap Income portfolios.
Infrastructure companies are essential providers of facilities and structures for the effective operation of a business, state, or economy. They are indispensable to sustainable growth and enjoy stable demand, growing profitability and provide above average yields to equity investors. Robert Swift explores one such stock.
Author: Robert Swift
Listed infrastructure companies are currently very attractive investments. Many pay high sustainable dividends and their revenue streams are consistent and secure. Our estimate of the Beta of the infrastructure universe is 0.8 relative to the broader global equity universe. This means that the listed equity infrastructure category will not fall, nor rise as much as the general market. At a time when government bond yields have been suppressed to virtually zero and when equity market volatility is likely to rise, this means that the listed infrastructure ‘asset class’ offers yield and safety. Something which used to be the role of bonds, but which now appears to be beyond them?
We have termed the global infrastructure opportunity as one defined by:-
Renovation – the need to move infrastructure from 3rd World to 1st World status in the USA and much of Europe
Reinvigoration – expanding infrastructure will raise productivity and provide a fiscal multiplier boosting sustainable economic growth
Restitution – the adoption of cleaner renewable and recyclable will raise the quality of economic output.
This is a brief article on a company which fulfills all 3 criteria. It is a core holding in our Global Infrastructure strategy.
Electric utilities are key infrastructure companies, and while not the most exciting of companies to read or write about, it is often the case that boring companies can be great investments.
Nextera Energy (NEE.NYSE) in the USA has been a great investment despite just being an electricity producer, but it is interesting how it actually achieved this because it may help us to find the next “Nexteras”.
It is now the largest utility company in the world by market value and the largest producer of wind and solar energy in the world. It has certainly done well for its shareholders. Over 15 years its annualised earnings growth has been 8.4% and its dividend growth has been 9.4%. But even more impressive has been its share price rising 10x over 15 years at an annualised rate of 17%!
Given its good operational performance of earnings and dividend growth it has certainly been well managed with judicious use of capital and M&A activity. It has also played in to two key themes.
It has significantly increased the proportion of its electrical production from renewables – wind and solar power – and
has also significantly increased its battery storage technology and capacity. So, it now has the largest battery storage capacity in the world.
These have played well with institutional investors that have been under pressure to invest in a more environmentally conscious way.
A cynic may say that it has also been very good at marketing itself too and communicating all the right messages to the investment community. You won’t find much mention of the fact that it still has some of those nasty carbon burning power plants in its investor presentations!
Nextera has also explicitly targeted raising its ESG (Environmental, Social, and Governance) scores in other aspects. So Nextera has been ticking a lot of the boxes for investors. As a result, Nextera now trades at a significant valuation premium to other electric utilities at 30x PE for 2021. So, while it is likely that its best returns for shareholders are behind it but it could yet still outperform its peers; and provide a stable source of income and capital return in a world where government bond yields have been suppressed to virtually nothing.
As we move increasingly to electric vehicles (EVs) then this is likely to be a significant boost for electric producers and lead to significantly better growth prospects. So, it should become a more attractive sector with rising valuations, and we should see more M&A activity particularly in more fragmented markets like the USA. So, it’s a sector we prefer within the Global Infrastructure universe right now, with good earnings and dividend visibility in this Covid-19 economic environment.
Many countries are likely to run in to electrical capacity constraints – indeed lots of emerging economies already have capacity issues. As countries decommission oil, gas and nuclear plants so there will be a significant demand for wind turbines, solar panels, hydro electric turbines and other capital goods related to the electrical power generation industry.We are in the middle of a low carbon industrial revolution as companies commit themselves to lowering their carbon footprint. Although Covid may curtail some companies from spending money on capex to be more environmentally friendly it is unlikely to be the electrical producers where project times are long, and they usually have regulatory commitments. Key beneficiaries from project work like this would be Schneider Electric, Mitsubishi Electric, Siemens, GE, Honeywell, ABB and Vestas Wind Systems. We will write about these in the months ahead.
This week we continue our exploration of the energy thematic and look at another (perhaps misunderstood) sector, nuclear, and the potential for uranium as an investment.
Author: Sid Ruttala
First let me start with a disclaimer, since I am particularly passionate about this topic it might cloud my judgement from taking a purely rational view. Put simply, I am of the belief that nuclear energy should play a crucial role in the energy mix of the planet going forward, despite the perhaps misguided murmurings of some lip-service environmentalists. This is even more important if one considers the very real possibility of negative emissions targets that are being set forth most recently by House Democrats in the US. As if that wasn’t enough, after years of a depressed market since the Japanese fiasco, the yellow cake has been the quiet performer this year moving from 24 USD/Llb to 34 USD/Llb at the end of June. Not a bad return in this year’s markets, especially since it didn’t seem to have any correlation with the broader market during the sell-off (an important point which we will come back to later on).
Source: Katusa Research
Some Context: Why Nuclear?
The immediate thing that comes to mind when one mentions “nuclear energy” isn’t necessarily one that makes it amenable to be bullish on the sector. Images of Chernobyl and Fukushima come to mind immediately or at best The Simpsons shenanigans regarding it, with Homer making a cake of himself at the Springfield Nuclear Power Plant or countless meltdowns and accidents over the show’s thirty year tenure (think about that, one of the most popular and widely circulated pieces of media of the last three decades consistently associates nuclear with bad things/accidents, all lorded over by an evil billionaire in Mr Burns). But the reality, in this author’s opinion (not necessarily TAMIM’s), is rather different. Nuclear energy has provided, and continues to provide, the world with stupendous amounts of clean, emission-free electric power. After all, how many people are aware that coal has killed far more people than uranium?
Perhaps most importantly, nuclear energy is a zero-emission alternative. For those of you who don’t understand the actual process, it uses fission (i.e. the splitting of atoms) to produce energy. The heat created through the fission process is turned into steam that then goes on to turn turbines. If we take the Nuclear Energy Institutes (NEI) data at face value, in 2019 the US’ use of nuclear power generation avoided the emission of more than 476m metric tons of CO2 into the atmosphere. Let me put this in context, it is the same amount released by around 100m cars and more than the combined output of all other green energy put together.
As emerging markets such as India, and others across Asia, continue to grow their economies and thus their energy consumption, it will become imperative for them to build upon their nascent power generation sectors. This is especially so as energy deficient nations such as India need to sustain their middle class and increasingly urbanized population. For example, 60% of the Indian population still lives in rural areas and will continue to shift to urban areas as the economy transforms from its agrarian roots, putting upward pressure on energy demand.
The only currently viable economic alternative for nations like India and China is coal. Given the aversion to fossil fuels and increasing pressure to reduce emissions, there will be a marked incentive for such nations to develop their nuclear footprint. This is because in densely populated nations, the most important factor when it comes to energy production is not only cost but also land footprint. It is not only expensive but downright irrational to build wind-farms where land scarcity is a significant issue. A typical 1000 megawatt nuclear facility for example requires less than 2.5 square kilometres whereas you would require 360x that in order to get the same magnitude of power generation from wind farms or 75x that space for solar photovoltaic plants. While this might change with advances in battery technology (harvesting power in land-rich nations such as Australia and exporting capacity) and increased efficiency across renewables, the scale and magnitude of the increased energy demand does not make this a viable alternative. For example, recent research from BP forecast India’s energy demand alone to grow by 156% by 2040 and if current trends are any indication, then over 58% of this will be met by coal with a subsequent increase 116% in CO2 emissions. In order to find credible alternatives we are likely to see Indian governments looking to nuclear for energy production, something that Australia was grappling with during the final years of the Howard government where the potential for uranium exports to India was effectively shelved by the election of the Rudd government.
A common argument against also stems from the waste produced but this is also completely misunderstood. One gram of uranium produces about as much energy as a ton of coal or oil and correspondingly, the actual waste is about a million times smaller, and only about 3% of the fission products are vitrified, the rest reused and recycled. For example, all of the waste produced by the US nuclear energy industry could in fact fit onto a football stadium at a depth of less than 10 meters.
Source: US Department of Energy, US Energy Information Administration
But what about the radiation? This is another rather moot point since it is a rather mistaken interpretation of the actual studies and using instances like Hiroshima/Nagasaki, Chernobyl and Fukushima is not an overly valid point. Firstly, the atomic bombs used on Hiroshima and Nagasaki and the subsequent radiation was an intentionally weaponized case. Second, there are currently 440 reactors in 30 countries while there have only been three significant meltdowns since 1957 (Source: International Atomic Energy Agency, Incident and Tracking Database), two in the Soviet Union (technology has moved on a bit since they were a thing) and the other was built on a fault line (that just doesn’t seem like a good idea in the first place). The somewhat over simplified point being? In regard to most things in my life, I would be ecstatic with a 99.3% success rate… Additionally, a moderate amount of radiation is actually essential to life. We’ve been bathing in it and radioactivity is as old as time, since our earth and the sun itself are remnants of a giant explosion, supernova. In fact even your own body is radioactive since it contains 8000 atoms disintegrating every second, half of which are potassium-40 and carbon-14. The reality is, we have identified harmful types of radiation and there are ever improving processes and technologies in place to shield us from it. Radioactivity in its broad sense is not the boogeyman it is often made out to be.
Where Is The Money?
So now that I have got that particular rant off my chest, let’s move onto the actual numbers. The debate around nuclear has seen a resurgence in recent years only as a result of the Tweeter-In-Chief’s investigation into Section 232 of the Trade Expansion Act, the short story of which is the reliance of the US upon uranium imports as opposed to domestic production. The very reason that some of the better recent performers in the space have been companies like GTI Resources (GTR.AX) with projects across Utah.
In terms of the actual numbers though, the prospect of nuclear energy is out of fashion at this point with planned increases in reactor capacity declining and many of the existing and operating reactors likely to be decommissioned without replacements over the next fifty years.
Source: Katusa Research
However, it is likely that we will see a reversion back to the mean as has always been the case with these issues. India has, in fact, committed itself to the path and China is likely to increase its own ambitions within the sector. The decommissioning and decreased building of new generation capacity is predominantly a result of public perceptions (mis!) in France and the OECD nations. We are likely to see substantial changes to this graph predominantly due to emerging markets. There is simply too much of an incentive from an efficiency perspective, for example, even though energy generation from nuclear since the 1980’s has increased by a factor of 2.5 actual input requirements in terms of fuels required only increased by 1.4.
Why Can One Be Bullish?
For one thing the supply-side gets rather interesting. Due to massive under-investment into the sector, we have seen consecutive quarters of decline in the actual production of both uranium and plutonium. Most of the global supply is dominated by Kazakhstan at 30% and Canada second. Australia is a very distant third despite this country being endowed with 30% of the proven global reserves (seems like an unexploited opportunity, doesn’t it).
Source: Paladin
Source: Paladin
In terms of the companies, the largest producers are dominated by companies in Russia, Kazataprom and the likes of Uranium One with connections to the Kremlin. As we continue to see aggressive stances made between Russia and the US we are likely to see downward pressure upon the actual supply, much the same way as sanctions against Iran and Venezuela suppressed supply in the oil markets. The Khazhak supply is likely to be re-oriented towards China (I would hazard a guess that western economies will turn to Australia’s largely untapped reserves in response). And so, while one need not be overly-bullish in the short-term based on the demand picture, the changing geopolitical picture will (we feel) lead to a gradual disentanglement of the actual prices. On-the ground prices in China, for example, are likely to be less than the global spot price.
This also creates rather good incentives for miners listed on the ASX with US assets and/or Australian exports of the finished product (with, one would hope, export restrictions to India lifted, the logic of exporting to China but not India defies us).
How To Play This?
For the conservative investors, BHP and Rio continue to have significant Uranium assets that look set to benefit from any advances in price and the capacity to increase production should prices move higher. BHP, by the way, produces around 3364 tonnes while Rio produces 1016. For the more adventurous, the old market darling Paladin (PDN.ASX), with 35m USD in cash reserves, requirement for less than 10m USD in spend and the restarting of their Namibian operations, looks attractive. The cost of production for its operations is also around 27 USD/lb and assuming a 45 USD/lb short-run (12-24 month) target we will likely see the share price more than double to 25c. For the exceptionally adventurous, GTI Resources (GTI) has been kicking goals in its exploration projects across Utah and is likely to see support from policy makers to get the projects up and running over the next 24 months.
While it would be fantastic if solar, wind and battery technology advanced enough and became cheap enough to cater to humanity’s energy demands, the reality is they currently don’t. Some additional clarification around this investment thesis too, Uranium as an investment is something I consider to be higher up in terms of the risk profile at this stage. But, should prices come back to economic equilibrium, it should reward the patient investor disproportionately.
Source: ST1 company filings
Source: CGR company filings
