Pain in Oil Not Likely To Subside Soon; Alibaba Disappoints
publication date: Jan 29, 2015
author/source: Brian Nelson, CFA
Just how bad are we drowning in crude oil? Yesterday’s inventory report showed the largest weekly supply increase in over 30 years, since 1982. That’s how bad.
Yet, knowing that crude oil prices are driven by supply and demand, pundits continue to be optimistic, perhaps overly so, about the timing of the recovery in the price of the black liquid (USO). Let’s first start with OPEC, and the Secretary-General Abdullah al-Badri, who said Tuesday that oil prices have bottomed as he “warned of a risk of a future price spike to $200 a barrel.” With inventories as they are and OPEC not ceding market share to US shale-based plays, we think the Secretary-General is drinking a bit too much Kool-aid. As they say in this business, Mr. al-Badri is just talking his book, and there’s not much more there than that. OPEC nations are dependent on production, and scaling back would only play into domestic producers’ hands, much like what has happened in previous cycles. OPEC is playing a different game today than in years’ past.
How about Continental Resources’ (CLR) CEO Harold Hamm? The well-respected industry leader, who seems to have unfortunately received more press about his ~$1 billion divorce settlement in recent months than anything else, believes that oil prices “could rebound faster than many observers expect.” Though there is some merit to his statement in light of the fact that exploration and production firms have slashed capital spending for 2015 almost across the board, we’re not sure that OPEC’s future actions can be predicted with a high degree of confidence. For one, the market had thought OPEC would be reasonable and scale back production to halt the decline many months ago and at materially higher prices. But the cartel did not.
From our perspective, OPEC is playing for keeps, and we think it won’t ease the pain until key players in the US fold, or at least global production is slowed to the point where its market share is retained. Hamm, himself, admitted that many exploration and production companies can’t afford to borrow money. The problem is that in regulated capitalism, particularly in the US, companies cannot collude, and therefore, cannot act uniformly to fix or prop up prices. President Teddy Roosevelt busted the trusts a long time ago.
It’s possible that Hamm may just be signaling to other participants that he’ll be rational, and hope that other firms will follow along (“play nicely in the sandbox”). After all, someone has to lead. However, we know all too well that each oil and gas firm has its own shareholders to serve, and each will use its own advantages to carve out any economic gains possible, even if it shrinks the PIE (potential industry earnings). Frankly, there’s not a long enough history to ascertain whether all will act rational, and as we know from pure economics, all it takes is one large, irrational player to disrupt the market. OPEC is doing that right now.
We think it may be best to steer clear of the most leveraged US-based exploration and production companies until the dust settles. It is not outside the realm of possibilities that equity holders in some leveraged entities could see their investments completely wiped clean in the event of sustained oil prices below the $40 mark. Creditors are waiting to strike, and tightening the noose. Management teams simply have not planned for this adverse event, despite, as we mentioned before, the well-known dynamic of volatile crude oil prices. The only thing executive suites can do at this point is scale back spending to preserve liquidity, meaning the entire energy sector is playing a game of survival. ConocoPhillips (COP) and Shell (RDS.A, RDS.B) announced more capex cuts today.
Even some of the best economic value generators in the energy sector in the likes of Core Labs (CLB), for example, are struggling. This very attractive Netherlands-based Economic Castle has revenue-to-free cash flow conversion that is top notch and generates economic profit at a pace several times that of peers. But more than 80% of Core Labs’ revenue comes from oil-related projects, and even it hasn’t been spared from the precipitous price decline. Core Labs’ fourth-quarter results, released January 28, were in-line with expectations, but the firm guided below consensus for the current period.
Strong management and solid execution is not enough to offset falling North American land rig counts and slowing Gulf of Mexico activities. Share leader in the US land drilling market, Helmerich & Payne (HP), warned that its customers are cancelling long-term contracts early and that results would be pressured, at least through the end of 2015. There’s simply no place for participants to hide, and the news in the energy sector may get worse before it gets better.
We’re planning for upstream master limited partnership Legacy Reserves (LGCY) to slash its distribution, and the likelihood of Transocean (RIG) and Noble Corp (NE) doing the same has increased. Linn Energy (LINE) and Seadrill (SDRL) have already cut their dividends to shareholders, and the probability of default for both of these equities is still on the rise. Weatherford (WFT) and Nabors Industries (NBR) are also worth watching closely for signs of not meeting upcoming debt obligations. Several oil equities are increasingly factoring in a probability of default (i.e. a probability of shareholders being wiped out), which, despite being a credit consideration, is weighing on their equity prices.
The intrinsic worth of any company will always be based on the weighted average price of a calculated probable range of fair value outcomes, which itself is based on a company’s net balance sheet and future risk-adjusted free cash flows. With the probability of a $0 fair-value event increasing for many companies in the energy sector, equity prices themselves are falling. Use this framework to your advantage. The balance sheet is incredibly important, and in times of stress, it is infinitely more important than the income statement where accounting earnings per share (EPS) can be found. Equity analysis and credit analysis are forever linked.
At the time of this writing, crude oil has tumbled to a six-year low, now under $44 per barrel.
In other news, we’ve been disappointed with the performance of some of the tech companies in the newsletter portfolios as of late. We had removed half of the position in Microsoft (MSFT) in the Dividend Growth portfolio as a result of its poor revenue outlook, and we can’t say we were pleased with Chinese e-commerce giant Alibaba’s (BABA) calendar fourth-quarter numbers. Shares have fallen to roughly in-line with the cost basis in the Best Ideas portfolio, and frankly, we’re disappointed with the firm’s trading activity following its IPO. We’re still waiting to get a definitive read of its long-term technicals, but right now, its chart appears vulnerable.
On an operational basis, we don’t see anything wrong with Alibaba. Revenue grew 40% in the calendar fourth quarter, while mobile revenue increased more than 5-fold! Non-GAAP EBITDA advanced more than 30% in the period, while non-GAAP net income followed with a 25% increase. Non-GAAP diluted earnings per share advanced 13% in the quarter, to $0.81 (which was better than consensus). Alibaba’s earnings potential is far greater than its present ~$3.24 per share annual run rate, and we continue to peg its intrinsic value north of $100 per share on the basis of its prospects for continued strong growth.
Alibaba’s stock price momentum, however, has soured, meaning the market, via its share price, is telling us that we’re wrong about our thesis in the firm…at least at the moment. Still, we’re going to remain patient, as I’m sure you’re aware, the market is often wrong over short periods of time. In light of the market’s reaction to Alibaba’s performance, Yahoo (YHOO) is also facing selling pressure. I talk about the increased uncertainty related to Yahoo’s tax-free spin-off of its Alibaba shares in this video here.
In yet more news, two familiar names in the likes of Ford (F) and aspirational handbag maker Coach (COH) issued calendar fourth-quarter results January 29 that can best be described as better than feared. Though it has been removed from the Best Ideas portfolio, Ford has been a key contributor to outperformance, and we highlighted the firm’s upside potential to $20 per share in the latest edition of the Best Ideas Newsletter. The automaker’s revenue and earnings per share fell in the fourth quarter, but Ford’s results beat depressed expectations, and management maintained its 2015 outlook for pre-tax profit in the range of $8.5-$9.5 billion. We’ll be looking for a “re-entry” point below $14 per share, if Mr. Market should ever be so kind.
We thought Coach was setting up for a disappointing calendar fourth quarter after rushing to put its cash to work in scooping up the Stuart Weitzman brand. We just weren’t very excited about the deal. For one, Coach is a hefty dividend payer (a near-4% yield), and we liked its robust cash balance because it offered enhanced security to the dividend. With most of its excess cash now absorbed in the Stuart Weitzman transaction, we’ve become less-enthused about including the aspirational handbag maker in the Dividend Growth portfolio, despite its bargain-basement valuation. However, a 12% constant-currency decline in revenue and a 30%+ drop in earnings per share during the period were better than feared, and the company is rallying on the news. Management is talking of “green shoots,” and a turnaround in its North American women’s handbag business could finally be getting traction. Sales in China rose 14% on a constant-currency basis. Shares are now approaching $40 each.
All told, we’re still expecting market headwinds to impact portfolio returns. Stay tuned!