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The Debacle of Wind Turbine Manufacturers

Energy, Global Economy, On the cover, Sin categoría,

(This article was published in Cotizalia.com on August 19th 2010)

I said it three weeks ago. Sell turbine manufacturers and buy wind developers. Turbine prices are plummeting, margins fall inexorably and the demand bubble, artificially created by the debt and subsidies of the OECD countries, has burst. And the only beneficiaries of this are the wind developers that centre on returns and not empire-building growth. They buy more turbines, cheaper and of better quality.

The turbine manufacturing industry is a great industry with great professionals and great engineers. But as an investment it is a disaster. It committed the sin of greed and the industry has been bloated with excess capacity for some time. Since 2006, the market has not seen anything but cuts to their own estimates for orders and margins. The industry positioned itself for excessive growth, undifferentiated returns and the hope that competition would never appear and are now paying the excess.

And it’s not a cheap sector in any shape or form. My readers who have access to Bloomberg can see that the stock market debacle has been entirely justified by falling estimates. And the sector is trading at 20x 2011 PER and average EV/EBITDA 7.5x. Not cheap at all for a sector that has proven to be more mature and cyclical than its managements and analysts would like to admit.

On Wednesday, Vestas, the largest turbine manufacturer in the world, fell 22% after they announced a downward revision of revenue estimates (for 2010!!) from €7bn to €6bn. The analyst consensus, who claimed that their average estimates were “conservative” (€6.7 bn), again had to slash estimates. This has happened six times in three years. The EBIT margin has been reduced by 50%, no less. Let us not forget that Vestas, like all turbine manufacturers, had given estimates for 2010 only a few months ago. And now they cut their estimates for this year … 50%. Then they say that it’s a temporary issue and that 2011 is fine. Again, something they said in 2007, 2008 and 2009. And some say that the market is speculative and short-term. Come on.

When a global leader is unable to estimate properly a year, THE CURRENT YEAR, how can they demand from us to make long-term valuations and investments? Come on. But what’s more important is that we are also seeing the cash flow fall and what is worse, a deterioration of the ratio of working capital/sales, which is what indicates the strength of the sector. Many firms take 20% WC/sales, which it is too risky,and shows that the industry is so desperate that they could be financing their own clients, in a downward spiral of financial weakness.

Gamesa, only a few weeks ago, further reduced, as it is almost a recurrent episode, its estimate of 2,700-3,000 MW of installations to 2,400-2,500, and their expectations for EBIT margin to 4.5-5.5%, compared with 6 -7% in January’s previous estimate. A very difficult process of adjustment to reality after the aggressive expansion plans and ludicrous expectations to compensate the falling Spanish business with Chinese and US growth.

As I told the CEO of one of these companies, who was asking what to do to mak the shares go up: “for once, please beat your own estimates. Simple.”

The turbine manufacturing sector faces three problems:

– The drop in demand, obviously. As I mentioned three weeks ago, the American green dream has faded. Expectations are for about 4 Gigawatt installed in the U.S. in 2010, less than half that of 2009. The European Union has very high electricity reserve margins. And the growth in renewables in other countries of the world is poor at best, and not enough to justify the “high growth sector” multiples. The bubble has burst.

– Production capacity is excessive. Turbine manufacturers themselves confirm that its plants operate at 50-55% capacity. This makes the need to reduce average prices to their remaining customers (10-12% decline in 2010, after a 12% in 2009) and compete aggressively with low margins. And what is worse, not only there have been no cuts in capacity, but it continues to increase both in European and America as well as Asia.

– Competition in the target market of China, which had been ignored with almost xenophobic arguments. “Not enough quality”, “customers do not trust them”, “European turbine prices can not fall and the Chinese have to accept it.” Well, Goldwind and Sinovel continue grabbing the Chinese market with prices 20% lower than European manufacturers, and what’s more improtant, better margins (12%).

The solution for the sector exists. “Shrink to greatness.” ROCE and margins. Easy. Reduce capacity, focus on margins, be less “engineers”, less empire-builders and more managers… And provide the market with realistic expectations. If we return to the bull market for renewable installations, and believe me, do not expect it, they will generate higher margins, better cash and have sustainable and profitable businesses. If the bull market does not come back, and it isn’t, they will be able to generate solid returns and correct the gradual and painful decline that we have seen since 2007. And do not cling to offshore as a salvation, as it’s more costly, less efficient and riskier… But, what’s most important, as replicable and technologically undifferentiated as onshore.

In an industry where the cost of replacement is reduced in absolute and relative terms every year as the technology is affordable and easy to replicate, basing a business on volume growth is crazy.

Turbine manufacturers should learn from the oil services sector, who suffered the lesson in the 80s when the same “GROWTH FOR GROWTH” and overcapacity issues occurred. Acciona, for instance, has seen this happening for some time. Its turbine manufacturing division is now a mere chain in their renewable business, which allows it to be integrated and manage the total cost in the projects it builds. Indeed, it does not provide the company any higher valuation, but at least they manage the business based on real internal demand, not on unachievable global growth expectations. Gamesa and Vestas have a tough road ahead. But a fascinating one nonetheless. As stocks, still a space to avoid except for very (VERY) short term beta trades. And to me, beta is better found elsewhere.

A Few Thoughts on Brazil E&P, Repsol and BG

Energy, Global Economy, On the cover, Sin categoría

This article was published in Spain’s Cotizalia on o8-06-2010

Eight months ago I wrote from Rio de Janeiro saying how wrong most analysts were in their estimates of development costs of the pre-salt discoveries in Brazil, and time has proved us right. Facts now show between 25 to 30% less than the $40/barrel estimated by consensus. Despite this, the market is not reflecting the incremental value of these reserves in the involved companies’ stocks (Petrobras, Repsol, BG and Galp).

For example, BG Group trades at a 25% discount to its NAV (Net Asset Value), despite being one of the most benefited from the discoveries in Brazil (with holdings of between 25% and 30% in the most attractive blocks, BMS- 9 and 11), showing excellent LNG trading results and being a clear takeover target. Even if we accept the valuation of its remaining assets at “conglomerate” multiples, BG Group at £10.5/share does not reflect in any way reflect the intrinsic value of its Brazilian assets in Tupi, Guara, Carioca, Iara, which, at $77/bbl would be worth about $16 billion. And BG is the only group exposed to Brazil able to finance its development with own free cash flow.

Part of the blame for the loss of interest in Brazil comes from the delay of Petrobras to complete its capital increase ($20-30 billion) and the lack of new information about the pre-salt assets and the improvements achieved.

In this comes Repsol, and says they cannot wait any longer. And it will IPO (or sell to a third party) 40% of its E&P assets in Brazil. Repsol, as Galp and Petrobras, does not swim in free cash flow and thus seeks to raise cash to finance the development program of the fields and diversify into other areas. For Repsol, unlike for BG, Brazil represents too large a percentage of its total E&P assets.

How much are these assets worth? Analysts estimate between $5 to $10 billion, or $8/bbl at the top end of the range for assets that to this day are undeveloped. It seems an excessive price, when BG’s Brazilian reserves are valued at $ 3/bbl, in Petrobras at $3.4/bbl and Galp at $2.8/bbl.

Additionally, Repsol’s assets are the most exposed to changes in the Petrobras development program. If developing the Franco area is the Petrobras focus after Tupi, then Guara + Carioca will not be starting up until 2020, which would severely impact the NPV of the Repsol assets, and put at risk any value above $2-3/bbl.

But let us not forget that out of these companies, two (Galp and Petrobras) are semi-state-owned, and therefore “not for sale”, the third, BG, is a very large leading independent global gas explorer and producer, so maybe Repsol Brazil is the only option for third parties to participate in the pre-salt opportunity. Additionally, the transaction multiples we have seen recently have reached up to $12/bbl (proven and probable reserves). Therefore, it is not surprising that the $8/bbl figure mentioned before would be more than acceptable in a private transaction.

However, it is more difficult to think that an IPO will reach the same valuation from day one due to market risk, the fact that the assets no longer provide an aggressive exploration potential (most of the discoveries have been announced already), and that the market would bear the risk of the previously mentioned delays or difficulties in the development schedule of the assets. And we have seen in Pacific Rubiales or OGX that the attractiveness for the stock market of pure exploration assets is diluted when these move into production. But it is worth bearing in mind the “scarcity value” of Repsol Brazil for other international oil companies, as Petrobras will be the only beneficiary of the new licenses in the country.

The IPO of Repsol Brazil, if it happens, would be great news. To begin with, because it would crystallize value and would allow investors to choose the part of the integrated group that interests them the most, without having to take the risk of refining, which terrifies me, or Argentina. But it is also a double-edged sword. If the listed subsidiary fails in the secondary stock market, it will de-rate the Repsol stub agressively. It is inevitable to see the “de-rating” of the parent when the subsidiary goes public, but even more if it loses value, and this has been seen in 100% of the cases of spin-offs, IPOs, or rearrangements of divisions priced “greedily”. Repsol Brazil also has to compete for investor interest against BG, Petrobras, which trades at a 15% discount to its peers, and OGX, its largest competitor in Brazil as a “pure play” in E & P.

For now, the commitment to crystallize value, re-organize the company and reduce the conglomerate discount has made Repsol trade at a deserved 11% premium over its peers (ENI, Total, Shell, OMV). For Repsol it is now time to make its Brazilian division a “must own” stock for investors. And that has to come from a good pricing and solid catalysts.

In Memory of Matt Simmons

Energy, Global Economy, On the cover, Sin categoría

This article was published in Spain’s Cotizalia.com on 08/12/2010

Last Monday I received a short email from Matt Simmons’ institute. Mr. Simmons, oil guru, visionary of clean energy and author of one of the most fascinating and controversial books of the recent past, “Twilight In The Desert”, had passed away at the age of 67 years old. I was shocked.

For those of us who study oil and energy, Matt Simmons was always an essential reference to understand the complex world of energy. To me, he was an amazing personality and an absolute master in his field. Matt was humble, open, always ready to discuss different theories and innovations in the field of energy, and what’s most important, always interested in other people’s opinions. Matt didn’t speak from an altar to share his wisdom. He engaged in dialogue and open debate. And listened. Patiently. To everyone.

His loss is immense but his legacy is outstanding. Let me centre this article on some of his many achievements.

On one side, his analysis of the oil fields in Saudi Arabia was groundbreaking not only for the wealth of detail and clarity of the arguments, but also because it was the first time that someone had questioned official information with solid data. It might seem strange to my readers, but before “Twilight In The Desert” no one really questioned the official figures of reserves provided by the producing countries. Only a few years before Matt’s book Newsweek was warning of an “oil glut” based on precisely those official numbers!. Today, all of us who study oil and gas try to make an effort to challenge official numbers and study the issues that might impact the figures of proven and probable reserves in countries like Saudi Arabia, Iran, Iraq, Brazil, Russia, etc. Thanks to Matt Simmons we are all a lot more cautious with predictions of new production and, most of all, in estimating decline curves. And this caution has proven to be right when, delay after delay and revision after revision, we can all see that global oil production does not reach the 89mboepd mark even counting with Iraq and Tupi.

It is true that some of the predictions of “Twilight in the Desert” have been delayed, mostly due to the global recession’s impact on oil demand. But even the Kingdom of Saudi Arabia is now showing an unusual level of transparency and recognizing the need to preserve current reserves and monitor the declines of Ghwar, Khurais or Khursaniyah.

Many have criticized the “Peak Oil” theory, but reality has proven that supply issues are only growing and even those who criticize the theory must admit that it has been essential to help promote innovation and alternatives. Even the IEA admits that the “deficit of discoveries” is so large that the world will need investments of $26 trillion to replace consumed reserves by 2030.

But Matt Simmons also left us a tremendously interesting analysis of the opportunities provided by shale gas when analysts and companies said it was uneconomical at $10/mmbtu. Matt was proven right when he mentioned that costs would drop aggressively and proving that profitability of shale gas in Marcellus, Barnett or Haynesville was solid at $4.5/mmbtu.

Mr Simmons’ analysis of the new paradigm of natural gas as a clean, abundant and profitable source of energy and his studies of other alternative sources were also essential for the US administration’s advances in energy policy.

The last time I spoke with Matt Simmons he came for a chat at my fund. We spoke about the challenges of the electric car as a viable alternative to traditional vehicles, the difficulties to develop a coherent and sustainable energy policy in the US and the Macondo oil spill, where Matt was right as well when he warned of a much worse spill at a time when most analysts and experts still spoke of 5-10kbpd. His last comments to me were about the work he was doing on alternative energies that would be efficient and viable without massive subsidies. I am sure his team will continue the good work.

To all my readers, I recommend you to read or re-discover “Twilight in the Desert”, and if you can, read some of his papers from the Ocean Energy Research Institute in Rockland, Maine. I will remember the chats and debates and his lively and open personality, and as soon as I can, I will enjoy a wonderful Maine lobster in his memory. Rest in Peace.

Careful: The Five Risks Of Big Oil

Energy, Global Economy, On the cover, Sin categoría
(This is a November update of an article published in Cotizalia in Spanish)

I have read several analysis reports recommending to buy large integrated oil companies versus the market because they have underperformed. Careful.

Yes, in the last weeks the market has risen considerably and the brokers dust off the “Buy” recommendation machine and recommend laggards. I have nothing against it. But I, just in case, would list the reasons why Big Oil, as stocks, generate more risk than return.

1) Big oil is not a good way to play the oil price. The average price realization of their basket of crudes has fallen inexorably to stand at an average of $65-68/barrel, while oil contracts and licenses underpinning the future growth are very restrictive in terms of taxes and profit sharing between the producer and the company (production sharing contract). Moreover, most of Big Oil’s mid-term growth is heavily weighted to gas. This has led to most of Big Oil to generate returns of 33% in “legacy assets” and much lower, close to 15% on new projects. Therefore, to reinvest cash generated at 33% in projects that generate 15% returns destroys shareholder value, even if it’s a decision of business survival.

2) An industry that invests 33% of its capitalization to replace less than 100% of its reserves. One reason why the sector “does not work” is that multiples seem cheap (PE 8.5 x, Dividend yield 6%), but what really matters is the cash flow generation in a sector as capital-intensive as this one. Free cash flow yield has fallen year after year from 7% in 2003, with oil at $30/barrel to a very poor 3.6-3.8% in 2010 with oil at $80/barrel. Since depreciation of assets is still lower than the capital invested, the real PE (the “Economic PE”) is much higher, close to 9.5x … no longer so cheap, right? If we add that such investments can hardly replace the reserves consumed, it adds to the sector problem: “running to stand still”.

3) Diversification does not add value (to shareholders.) Another typical argument is that mega oil companies are trading at prices far lower than their sum of parts. As we have discussed other times, the conglomerate discount of about 30% is justified when the generation of returns of some of the parts is much lower than the core business. For example, one of the major listed companies invests 15% of their capex in areas (refining and power) that generate a return on capital employed of 5.5%. Then it is justified that the valuation of such activity does not add up, but substracts to the remainder of the valuation of other activities.

4) Lots of reserves does not mean value. The valuation of big oil based on reserves is not valid, unless the company, like E&Ps, was for sale. If, in addition, it appears that these companies do nothing more than buy new reserves to replace those consumed, the value of the conglomerate does not exceed $4/barrel (proven and probable) until they start generating cash. That is the reason why Big oil trades on traditional PE multiples, EV/DACF and free cash flow yield.

5) Beware of dividends. The last argument is that Big Oil pay a great dividend. Right. But it is also true that since the fall of free cash flow we have discussed, much of that dividend is paid with additional debt. So it is difficult to see that dividend as increasing in US$ terms, unless we consider that debt is too low. And at first glance, it seems like it. With 20-30% debt to capital (equity) on average, companies seem to have very little debt. But if we add working capital requirements, and turn to the equation “free cash-capex-dividend “, it is difficult to be positive, as these enormous dividends are not sustainable in a cyclical environment. Additionally, with a Free Cash Flow yield at around 3.6-3.8% for 2011 for US and Euro names and heavy requirement to ramp up capex on exploration, high dividends should not be considered as sacred.

Integrated oil companies appear attractively valued on 12-month forward P/Es relative to the market. However, once we adjust for the sector’s under-depreciation, they no longer look as attractive. The 12-month forward P/E adjusted for under depreciation shows US and European majors trading above historical norms relative to the market. As I mentioned before, the adjusted 12m forward P/E of Euro Big Oil, for instance, at 9.2x, is in line with that of the market, not 20% cheap, as the unadjusted number suggests.

In my opinion, Big oil does not provide defensiveness vs market turmoils. So, you can only buy for the very short term. A typical case of “value trap” of stocks that seem cheap, but they are not. After a 17% stock market crash in 2010, the surprise is that they are not cheaper looking at forward estimates. I am more interested in “restructuring story” stocks such as Repsol (July 2010), so disliked by my readers and by analysts and, like the national team, rocking, driving value through the simplification of business, or in independent explorers. In my opinion, to invest in oil, it seems obvious, we must invest in companies that have real exposure to oil. Or not invest at all. Washed down hybrids are only a waste of capital and a headache.