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To find undervalued energy stocks that offer upside
and stability, look for utilities with undervalued energy assets. That's Ray Saleeby's preferred method, and the experienced value
investor has shared his top picks in this Energy
Report interview, along with some research pointers. Read
on to find spin-off pearls missed by overspecialized market analysts.
The Energy
Report: Ray, your
firm, Saleeby & Associates Inc., focuses on
identifying companies with turnaround potential—good firms that trade
at a discount, but enjoy a solid customer base in hard-to-enter industries.
Why?
Ray Saleeby: I buy stock in companies that are discounted to the intrinsic value
of their operations. This differs from growth investing, which focuses on
companies that outpace their peers for earnings. It differs from momentum
investing, which attempts to time stocks on a short-term basis. My philosophy
of value is more long term and contrarian. I buy companies when they are out
of favor.
"I
buy a lot of utilities because there are tremendous barriers to entry to that
sector."
I handle
$220 million ($220M) plus, of which about $100M is in the utility and energy
industry. I buy a lot of utilities because there are tremendous barriers to
entry to that sector. One does not find a gas utility popping up every other
week! For the same reason, I like the construction aggregate business. And I
absolutely love the water business. It's a resource that we're going to need
forever. I also invest in defense electronics and oil and gas. There are also
barriers to entry in the drugs and medical device space.
TER: Tell us about your research process.
RS: I have a library of 60,000 different research
articles going back 20 years. I subscribe to about 60 different periodicals
that provide financial reports and different types of information about
various companies. I look at annual reports and presentations by companies.
But before I buy a stock, I call up the management and ask detailed questions.
TER: How do junior gas and oil companies fit into this
model?
"I
like companies that have a first-mover advantage in acquiring developable
property."
RS: With the juniors, I take a very hard look at
management. Does it have a track record of success? Are the managers
personally invested in the firm? Second, I like companies that have a
first-mover advantage in acquiring developable property. Clusters of wells
provide economies of scale where drilling rigs can easily be moved around.
Energy is a commodity business and access to capital is very important. And
being a low-cost provider is crucial when dealing with commodities, as we
never know when the market will fall. And, last but not least, I want
companies that have a good hedging strategy. And for tax reasons, I look
toward MLPs (master limited partnerships).
TER: Let's talk about discounted utilities with
exploration and development arms. Where are the undervalued opportunities in
that space?
"The
typical oil and gas analyst does not generally understand how to analyze
utility operations, whereas the typical utility analyst does not understand
how to value oil and gas assets."
RS: One of the positives about operationally
diversified utilities is that they can spin off resource development divisions.
Now, a utility analyst is completely different than an oil and gas
exploration analyst. With a spin-off, suddenly there are two different types
of analysts following two related companies, and the new firm can get double
coverage. Secondly, the new managers may have more incentive to produce than
they did when they were operating under the parent company's top management.
Also, utilities are heavily regulated; spin-offs are usually nonregulated.
The
negative aspect of a divestment is that utilities are generally financially
stable and can provide a cushion for commodity capital into its development
divisions through boom and bust times. And the flip side of a spin-off in the
analytical marketplace is that the typical oil and gas analyst does not generally
understand how to analyze utility operations, whereas the typical utility
analyst does not understand how to value oil and gas assets. So the double
coverage can turn into a negative, a discount of real existing value.
TER: What are some promising names in this space?
RS: Questar Corp. (STR:NYSE) is a perfect example. Originally, Questar was a utility that also had a gas exploration
business. About two years ago, it spun it off as QEP Resources Inc. (QEP:NYSE), and it's been very successful and is leveraging the resource needs
of its parent. Questar supplies natural gas to a
lot of customers. It is very competitive with electric and it steals
customers that have a choice between electric or gas meters. It is well
diversified; its Wexpro division also develops and
produces gas for the utility and it is very attractive on its own merits.
Another factor to consider is that a lot of natural gas companies are not
able to make a profit in the current price environment, unless they are
hedged. Some are starting to shift their exploration dollars toward oil,
rather than gas, because oil is holding up relatively well relative to gas
prices. QEP Resources is well positioned in gas but has recently made a
couple of acquisitions in the oil business to help balance things out. It's
even buying back its own stock.
An example
of a well-diversified company that has not split is National Fuel Gas Co. (NFG:NYSE). It is a combination of utility, pipeline, storage and explorer and
producer (E&P) company with, I believe, some of the best assets in the
U.S. It has 800,000+ acres in the Marcellus fields close to the New York
consumer markets. It's been around for 100 years, it has a good balance
sheet, and it has a history of paying increasing dividends. Looking deeper,
it had some problems with executing on oil-producing land it owns in
California. And it was not able to get a joint partner for its Marcellus
field after natural gas prices went down. If gas prices start popping up
again, National Fuel could be a takeover target. The Marcellus acreage is
extremely valuable and it can be better exploited if natural gas goes higher.
Mario Gabelli has a position in the company, as do
I.
TER: How hard is it for an exploration company to switch
over from natural gas to oil?
RS: Some fields are more attuned to gas, some to oil. It
is hard to get out of leases to switch over from one to the other resource.
And drilling crews have to be shifted around, which is expensive. But there's
a glut of gas right now in a lot of different markets. And that's one of the
reasons why the MLP sector is a very attractive sector going forward.
TER: How do MLPs work?
RS: Master limited partnerships are structured so that
income flows directly to the investors. It is not double taxed at the
corporate level. Investors receive K-1 forms versus 1099 forms for their IRS
tax returns. However, it is advisable that you really know what you're doing
before diving into a complicated MLP arrangement. MLPs may not be suitable
for all investors.
TER: What other utility-centric natural gas companies
provide good value for investors?
RS: Enbridge Energy Partners L.P. (EEP:NYSE) is an MLP. It operates one of the largest pipelines and brings
Canadian tar sands oil into the United States. It enjoys great access to
capital. It is a very well managed company. It has
I-units, which allow investors to reinvest dividends and receive a 1099. It's
a unique investment for the long term.
Energen
Corp. (EGN:NYSE) is a small utility in Alabama that runs a large
exploration company in the Permian Basin. It is currently out of favor in the
market—discounted to its asset value. It is very conservative. It
hedges a lot, and has 30 years of dividend growth. It uses the dividend
income from the utility to grow the oil and gas exploration and development
business. It's a good value find.
TER: Why is Energen
discounted?
RS: As a combined utility and oil and gas exploration
company, it is subject to the kind of analyst misdiagnosis I explained
earlier. But Energen's cash flow and its EBITDA are
cheap comparable to its peers. It has proven reserves. Management is
competent, even though it just reported a disappointing quarter: gas prices
plummeted and the firm was not as well hedged as it had been previously due
to expirations.
TER: Is there a limit on the supply of natural gas?
"Some
say that the U.S. is the Saudi Arabia of natural gas. But the real question
is: Is the existing supply an economic supply?"
RS: Some say that the U.S. is the Saudi Arabia of
natural gas. But the real question is: Is the existing supply an economic
supply? Companies simply cannot make money exploring for gas at the current
price. Capital is moving into oil. Sufficient cash is not spent on the
necessary infrastructure, such as storage and transportation, to take the gas
to the domestic consumer and to international ports for export. The other
problem is that it takes a while for utilities to shift over from coal to
natural gas. Facilities are being built, but it takes time. On the upside,
there are transportation uses for gas, especially for heavy trucks and
commercial vehicles and government vehicles. Incentives are needed to support
that transformation. The more these gas-dependent industries develop, the
higher the price of gas will rise, providing more capital for more
infrastructure and development. But a lot of E&P firms are keeping the
gas in the ground for now.
TER: Are there any energy holding companies that reflect
your investment model?
RS: MFC Industrial Ltd. (MIL:NYSE) is a company that has done phenomenally well. A $1 investment in MFC
a little over 10 years ago is worth $6.50 today. It's averaging a 20%
compounded return. MFC is a true value investor. It turns energy and resource
companies around and monetizes them. It recently bought Compton Petroleum.
The management is very shareholder oriented; executives own a large stake in
the company. It is a small firm, but it sources and delivers commodities and
resources throughout the world.
South Jersey
Industries Inc. (SJI:NYSE) is a utility in New Jersey. But probably 30% of
their business is nonregulated. An investment of
$6,000 in 1985—with reinvesting the dividends—would now be worth
$720,000. Management has just been top notch in creating shareholder value.
TER: To conclude, are any of these firms looking at
renewable energy development?
RS: South Jersey is involved in solar. But with the
revolution in cheap natural gas, a lot of the solar and wind ventures have
been put aside. A few decades down the line, solar is going to be the
solution. The world has an abundance of sun! There are, however, cost and
efficiency problems with solar and wind due to storage and transmission of
power. Alternatives have a role in the future, but we have an abundance of
natural gas at this time.
TER: Thanks for speaking with us, Ray.
RS: Likewise.
Ray Saleeby formed Saleeby &
Associates Inc. in 2001 after 15 years working with brokerage firms such as
R. Rowland Co. and Forsyth Securities. Saleeby
published a newsletter between December 1987 and May 1996 that received
national attention. Articles written about him and his recommendations have
been published in USA Today,
The Wall Street Journal, St. Louis Post-Dispatch, St. Louis Business Journal and
other periodicals.
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DISCLOSURE:
1) Peter Byrne of The Energy Report conducted this interview. He
personally and/or his family own shares of the following companies mentioned
in this interview: None.
2) The following companies mentioned in the interview are sponsors of The
Energy Report: Enbridge Energy Partners L.P.
3) Raymond Saleeby: I personally and/or my family
and/or Saleeby & Associates Inc.' clients own
shares of the following companies mentioned in this interview: Natural Fuel
Gas Co., Questar Corp., QEP Resources Inc.,
Enbridge Energy Partners L.P., Enbridge Energy Management LLC, Energen Corp., MFC Industrial Ltd. and South Jersey
Industries Inc. I was not paid by Streetwise Reports for participating in
this story.
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