1. Executive Summary

In the middle of rising geopolitical tensions and a tech stock meltdown, it is easy for investors to feel there is nowhere to hide. That would be ignoring a sector with an expected yearly growth of 25% from 2022 to 2030. I am talking about the US cannabis industry.

It is an industry still in its infancy, facing complex regulations. It is still very fragmented, even if it is consolidating rapidly. It is also mired in controversy due to the illegal status of this product until recently in many states and until now at the US federal level. To top it all, it is also an industry famous for absurdly high volatility in valuation multiples.

These limitations have reduced the participation in the sector to retail investors only. Most institutional investors are simply unable to invest in the sector legally. This has led to extremely low valuation multiples during slumps and high funding costs for cannabis companies.

Nevertheless, ignoring a sector ready for explosive growth because it is still early can be a massive missed opportunity for investors. If you have the ability and the risk tolerance to invest in it, this could a unique opportunity to buy cheap assets before any large institutional investors can come and plow money into the sector. In this way, it is the opposite of early tech investing: only retail investors are allowed to get in early.

In this report, we will see how the industry works, what its future could hold, and 3 different ways to invest in it: a large recreational cannabis company, a medical cannabis company, and a cannabis-focused REIT (Real Estate Investment Trust).

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2. Extended Summary: Why Invest in Cannabis?

The US Cannabis Industry

The US Cannabis industry has recently moved from an illegal black market to a fully legal and established line of business in almost half of the USA. This followed a massive change in the public’s perception of cannabis. It is also coming as a result of the realization of the flaws and negative impact of the so-called “war on drugs.”

Industry Overview and Legalization

Legalization is a state-by-state business, leading to an extremely complex regulatory landscape. The persistent Federal ban is a constant headache for cannabis companies and creates plenty of extra costs and inefficiencies. The hope of changes in legislation has created a very unstable market, with several cannabis bubbles rising and popping in just a few years.

A Selection of Cannabis Companies

In this section, we cover one of the largest, fastest-growing, and most profitable MSOs (Multi-State Operator) in the cannabis industry, a niche medical cannabis company in protected markets, and a dividend-yielding industrial REIT catering exclusively to the cannabis industry.

3. US Cannabis Industry

From Illegal Drug to Consumer Good

You might have strong feelings about cannabis. People have widely-ranging opinions on the topic: some say it’s an evil, life-destroying drug some say it’s a miracle of nature. This is going to be a report that stirs some controversy, but we’ll try to approach it purely from an investment perspective.

Before we study the industry, let’s look at the plant itself.

Cannabis is a common plant that’s quite easy to grow, hence its moniker of “weed.” The plant is also known as hemp and consists of 2 species: Cannabis sativa and Cannabis indica. Hemp used to be a commonly grown plant all over the world for its valuable fiber, which was used to make clothing, ropes, paper, and much more.

Most of the controversy is due to some varieties having psychoactive effects. These effects have been known for millennia by cultures ranging from classic Roman and Greek to Daoist Chinese and Sufi Muslims. Its usage has been on the rise since its discovery by the hippie culture of the 70s.

The psychoactive effect is mostly due to THC molecules. Another molecule of interest is CBD, which has no psychoactive effect but is nowadays considered beneficial for some medical conditions.

The psychoactive effect is relatively strong, in the range of alcohol, but weaker than so-called “hard drugs” like cocaine. Addiction is possible but seems to be less of a factor than it is with alcohol. While debated, it is generally recognized that consumption at a young age is to be discouraged, and abusive consumption has undesirable effects. Overdose is very rare, again, putting it below alcohol in terms of toxicity.

In the last decade, most Western countries have started to relax regulations around non-psychoactive cannabis-related products. Quite logically, making hemp-fiber shopping bags or anti-convulsion drugs is not that controversial. The same holds true for painkillers, cancer treatment, and anti-convulsive medications.

Full legalization, including for recreational purposes, is currently hotly debated.

The War on Drugs Debate

For many, cannabis is a drug, making it a different category than other milder substances like caffeine. I personally would put it on par with alcohol: a powerful psychoactive substance, but less dangerous and destructive than “harder” drugs like cocaine, methamphetamine, or heroin.

Prohibitionists tend to believe such substances should never be freely available. Remarkably, the same arguments were at the heart of the 1920s Prohibition period. Prohibition’s defenders argued that the destructive nature of alcohol, inducing violence, poverty, and addiction, fully justified its ban from public life.

Here I would fully agree that unlimited and unconstrained consumption of either alcohol or cannabis can be destructive to a person’s life. The problem for me with a prohibitionist stance comes with the social and economic consequences of prohibition.

The truth is that prohibition is rather inefficient at stopping the consumption of illegal substances. People seem to be ready to endure considerable personal or financial costs to keep consuming substances like alcohol or cannabis. Currently, half of adult Americans have tried cannabis in 2021. In 1985, before any sort of legalization was even on the horizon, it was already 30%.

Making desirable substances hard to find and illegal instantly creates a black market that gangsters can use to generate a high-profit margin. This is because the illegality creates scarcity, while the drug itself is cheap to manufacture, leaving a large potential margin for criminals.

The 1920 US alcohol prohibition notoriously created powerful criminal organizations like Al Capone’s. Alcohol consumption might have dropped a little, but the cost in the form of violent crimes and corruption proved to be unbearable for society as a whole.

The current prohibition is similarly funding criminal organizations, which use that money to run gang wars and other criminal activities. In recent years, it has become generally accepted that the “war on drugs,” started by Nixon in the 70s, failed.

Even if you personally disapprove of cannabis usage, it’s worth considering the possibility that moving that income stream away from violent criminals and transferring it to tax-paying legal companies might still be a good thing.

4. Industry Overview and Legislation

The Gradual Legalization of Cannabis

Currently, cannabis is legal in Canada, Uruguay, and several US states. Some US states and countries ban recreational use but authorized controlled medical use.

Several other countries like the Netherlands or Portugal have partially or fully decriminalized all usage of cannabis. Selling and producing are still illegal, but users are no longer prosecuted or imprisoned.

When looking at the US map, the situation is:

• Almost half of the country has legalized cannabis (44% of the population).
• A quarter has authorized medical usage and/or decriminalized cannabis.
• Cannabis is still illegal for the last quarter.

At the federal level, the drug is still fully illegal, putting federal law at odds with most state laws.

Federal law lags behind public opinion. Only 9% of American support a completely illegal status for cannabis. 31% support medical use only, and 60% support full legalization, according to the Pew Research Center.

This is also a bipartisan opinion that transcends divisions in an otherwise very polarized political environment. The only American groups with a majority opposing full legalization are Asian Americans, those 75+ years old, and conservative republicans. Even those groups do not differ that much when it comes to legalizing medical use.

Despite that general acceptance, 40,000 Americans are currently incarcerated for cannabis offenses.

Legal? Yes, But It’s Complicated

Legalization might sound like the endpoint for cannabis companies. They can now sell the product to anyone interested, right? Wrong!

When voting for legalization, state legislations wanted to keep tight control over an industry managing a recently illegal product. So each state has its own set of (somewhat arbitrary) rules, licensing limitations, special taxes, special controls, etc…

This has made the sector very complex, as the ever-changing regulations affect the business models and operation of cannabis companies. It has also affected the ability of the industry to compete with the illegal black market. If taxes and regulations are excessively pushing prices up, illegal supply is cheap enough to defend its market share. Over time, new tweaking of the cannabis laws tends to solve these issues, but recent legalization comes with a lot of legal headaches for cannabis companies.

As a result, the sector is now rather difficult to understand for outsiders. This is partly the reason why we decided to present companies that did not depend on selling on the fully legalized market.

Federal Hurdles

US federal classifies cannabis as a fully illegal Schedule 1 drug, the same classification it imposes on LSD, Mescaline, Ecstasy, and several other drugs.

Notably, banking has been a persistent issue for cannabis companies. This led many companies to sell their products and pay employees and suppliers only in cash. This creates costs and even risks (robberies) for the companies and their workers. It can also make taxes and tax audits extra complicated. Lastly, poor banking access limits the possible sources of funding through debt, leading to sometimes absurdly high costs of capital, sometimes above 10% or 15% rates for secured debt.

Speaking of taxes, there are also “sin taxes” at the state level, but also local municipal-level taxes. So from a taxation point of view, the cannabis industry is similar to the tobacco industry, except with even more complexity.

This is not necessarily a bad thing from an investment point of view, as tobacco has been one of the most profitable industries to invest in for the last decades. Complex regulation tends to protect the largest actor in the industry against the competition, cementing the leadership position by creating an artificial barrier to entry.

In addition to cannabis-specific taxes, regulations block the industry from benefiting from some tax deductions available to any other company. This effectively pushes the effective tax rate of cannabis companies to much higher levels than any other sector.

The Impact of 280E

Example of tax deduction effect –
Source: Green Thumb CEO2021 letter

The SAFE banking act, which would let banks work with the cannabis industry, has been pushed in the US legislature in various forms since 2013 but has never actually reached a vote. When it might happen is anyone’s guess, and the regular setbacks have played a big role in souring the mood of cannabis investors.

Another issue stemming from federal-level legislation is the prohibition of the interstate trade of cannabis, even between or among states that have fully legalized it. This creates a lot of inefficiencies, as cannabis companies are forced to operate in each state as a mini-independent operation instead of being able to scale up. Will that change? Most likely, but it’s anyone’s guess when. When it happens, it will most likely speed up the consolidation of the fragmented industry into a few leading companies, especially as it will let companies export cannabis from low-cost states to high costs states.

Lastly, but maybe of the greatest interest for this report, federal bans have created problems for listing cannabis companies on stock markets. Illegal activity cannot be promoted on markets like the main market of the NYSE or the Nasdaq. For these reasons, all major cannabis companies are listed in the less regulated OTC markets or on the Canadian stock market.

Institutional investors might be prohibited from getting involved in federally illegal transactions or buying companies trading on OTC markets. Many have internal policies against buying penny stock (companies whose shares are below $1). This means that 99% of institutional money is unable to invest in the sector. This, of course, had a negative impact on valuations, as the pool of available money is much smaller. Roughly 80% of US stocks are held by institutional investors.

The Many Types of Cannabis Companies

Here are the main business models that form the cannabis industry ecosystem:

Bulk Growers

These companies focus on growing a lot of cannabis efficiently at the lowest possible cost and selling it in bulk. This assumes a strategy where the buyer buys it like a commodity instead of as many differentiated products.

Initially successful, this model worked when there was a shortage in production. But it contradicts the nature of the product, which is more akin to tobacco (with strong brands and taste fidelity from consumers) than (for example) potatoes, a commodity where branding is nearly impossible.

Multi-State Operators (MSOs)

Multi-State Operators are companies selling cannabis in more than one US state. This gives them the scale to spread administrative, regulatory, and operating costs over larger operations. They will be the first to benefit from the lifting of restrictions on inter-state trade by, for example, centralizing their growing operations in the most efficient locations.

Medical Marijuana Companies

These might be focused only on non-psychoactive products (notably CBD) or on cannabis products in general. The difference with other MSOs is a focus on specific formulations aiming for a specific therapeutic effect. They are overall much less controversial than cannabis for recreational use and rely on medical prescriptions to support their sales, operating much like pharmaceutical companies. They are less dependent on full legalization.

Service Providers

The explosive growth of the industry has created an opportunity for other companies to help provide service to the industry. This can include companies selling farming equipment (including vertical hydroponic indoor farming), packaging, SaaS software for handling sales and operations, funding and financing, or, like one company below in this report, REITs building and operating the real estate infrastructure required to grow cannabis.

Future of the US Cannabis Industry

A Brief History of Cannabis Investing

The first rush in cannabis investing followed Canada’s full legalization of cannabis for recreational uses in 2018 (medical use has been legal in Canada since 2001). Market reaction was a “green rush,” leading to massive gains, followed by the bursting of this “Cannabis Bubble 1.0” in 2019. At that time, the supply chain was far from established, and investor enthusiasm was certainly premature.

The second wave followed a series of individual US state legalizations. The narrative was that this would trigger quick legalization at the federal level. This would have grown the market dramatically, increased profitability, and allowed institutional investors to push stock prices higher.

This did not happen. As a result, the US-centric cannabis bubble 2.0 burst as well in 2021. We can see this from the chart of the AdvisorShares Pure US Cannabis ETF (MSOS), a fund devoted exclusively to cannabis stocks:

After 2 bubbles in less than 4 years, early cannabis investors are rather burned out and despondent. I think the key part to surviving such a volatile sector is to adopt one of two strategies:

1. Act like a trader and know when to take gains off the table
2. Act like a long-term investor and ignore the short-term volatility.

In both cases, being aware of where we are in the cycle is important. After a drop of 80% in stock prices, we are likely closer to a new bottom than a top.

Long-Term Changes in the Cannabis Business

Positive events:

• SAFE banking act finally voted, allowing the cannabis industry to be banked “normally” and access capital at a lower cost.
• Interstate trade regulation allows for the transfer, at least of raw materials, at best of finished products, between states that both have fully legal recreational use.
• Generalization state by state or at the federal level of medical usage.
• More prohibitionist states decriminalize or authorize some usage.
• More medical-uses-only state switching to full legalization.

Some negative events might occur as well and this should stay in the mind of cannabis investors:

• Restrictions on products with very high concentrations of THC or CBD.
• Restrictions on products that are suspected to be too easily used by minors, like what recently happened to vape products.
• An increase in taxation by cash-strapped municipalities and states.

Any of these could add additional headwinds to the sector.

5. A Selection of Cannabis Companies

• Strong demand for a product that has lost its stigma with most of the population and is regularly used by tens if not hundreds of millions.
• A substance as addictive as tobacco and alcohol.
• A sector where premium branding can create significant barriers to entry and higher margins.
• Non-recreational use cases (medical cannabis) are almost fully normalized today and are increasingly accepted by the medical community.

These factors explain the strong growth projections for the US market.

Because of these strong fundamentals, I have selected 3 companies offering different risk levels as possibilities for exposure to the industry.

5.1. Green Thumb Industries (GTBIF)

Quick Stock Overview

Ticker: GTBIF

Source: Yahoo Finance

Key Data

Industry	Cannabis/MSO
Market Capitalization ($M)	3,119
Price to sales	3.1
Price to Free Cash Flow	–
Dividend yield	–
Sales ($M)	998
Free cash flow/share	$-
Equity per share	$7.22
P/E	33.6

The company offers a wide range of cannabis products, from “classical” cannabis to burn (including pre-rolled like a cigarette) to vaping concentrate, edible candies, and pastilles. It also has a line of medical cannabis in the form of essential oils, balms, creams, and concentrated extracts.

The company operates 77 shops in 15 states, covering 50% of the US population, with 4,000 employees, making it one of the largest MSO companies.

The company is looking to acquire licenses and expand in both legal markets where it is not yet active (Oregon, Washington, etc…) and is entering or has just entered states with newly opening markets (Virginia, Rhode Island). It also entered Minnesota through an acquisition.

Most of the expansion to new states seems to be using a strategy of buying a smaller license-holding competitor in a state where Green Thumb does not operate yet. Once the license is acquired, they expand by progressively opening new shops in that state. So far, Green Thumb has been mostly focused on states where cannabis is fully legalized.

The company’s main revenues come from smokable products (vape + flowers). Consumers’ tastes are evolving beyond the usual “joint” to other product categories previously unavailable from illegal street vendors, with flower sales growing at a slower pace than the rest of the product selection.

Beyond the growth from new legalizations, same-store sales are growing by 10% per year. This is unlikely to reflect a rise in total consumption, as most studies show little overall increase in consumption after legalization. This is more likely to reflect a growing trend of replacing illegal supply with established legal brands and increased customer fidelity.

Green Thumb has sold and leased back its growing facilities in 2019 and 2020 (more on lease-back when we discussed the third company covered in this report).

The rationale behind this move was to have a more flexible production capacity and to move toward an industry structure where MSOs require less capital for expansion (leasing instead of paying directly for new greenhouses). Growing and manufacturing are still handled internally.

Financials

When looking for a good MSO to feature in this report, I was surprised to notice how many failed to be profitable. Green Thumb consistently turns over a profit, which was a big factor in picking this company over its competitors. This way, if federal legalization takes a lot longer than expected or if capital markets close up (recession, financial crisis), the company would not be put at risk the way its cash-burning competitors would.

85% of the company stock is floating, and insiders’ stock options and warrants are not a risk of significant dilution (less than 5% of total stocks).

The company grew its revenue by 15% year-to-year with a stable income per share. EBITDA margin has been somewhat stable in the 25%-35% range.

Its P/E ratio is 33. Free cash flow is negative at -$91M due to a large $214M in CAPEX. The company has $145M in cash for $253M in debt. Total assets, excluding goodwill and intangibles assets (from acquisitions), are $1.17B, compare to $0.75B in total liabilities.

Debt was secured at an industry low of 7% rates (which tells you a lot about how bad it can be for Green Thumb’s competitors) and has been recently refinanced in 2020.

At this cash spending level, the company is not at any immediate risk but might be forced to slow down expansion or raise more money (through stock sales or debt) in the next 2 years if cash flow does not improve.

Conclusion

Green Thumb has a good business position and product/brand selection, combined with a solid balance sheet. It has a rather typical profile for a growth stock (rather high P/E, high CAPEX to fund growth), with the bonus of being already profitable and having cash flow-positive operations and positive free cash flow.

This puts the company in a relatively safe position regardless of the pace of legalization and of normalization for the cannabis industry. Would this happen slower than expected, the reduced need for CAPEX would likely turn it cash flow positive. It would even give a good opportunity for further acquisition of distressed, less profitable, or less cautious competitors.

Alternatively, would the SAFE banking act be voted or interstate trade authorized, the company, with its established network, should be able to optimize its operation even further.

Overall, Green Thumb seems like a reasonable way to bet on the major MSOs consolidating the sector into a profitable oligopolistic industry.

5.2. MariMed (MRMD)

The Healing Virtues of Cannabis

MariMed is a cannabis MSO focused on wellness and health rather than the recreational side of the industry. The Company has been active since 2012. It operates as a vertically integrated business “from seeds to sale,” operating 300,000 square feet of cannabis facilities.

The company aims to be more technical, scientific, and technology-driven than its competitors. It is also more centered around medical and food products compared to traditional cannabis for smoking.

Quick Stock Overview

Ticker: MRMD

Source: Yahoo Finance

Key Data

Industry	Medical cannabis
Market Capitalization ($M)	183
Price to sales	1.6
Price to Free Cash Flow	97.2
Dividend yield	–
Sales ($M)	129
Free cash flow/share	$0.01
Equity per share	$0.14
P/E	–

MariMed’s Operations

The company operates in 6 states, with only one dispensary per state, with the exception of 4 dispensaries in Illinois. This put MariMed at a much smaller scale than some of its larger MSOs competitors (like Green Thumb).

MariMed is focused on states with limited licenses, which allows it to be one of the dominant actors in these areas. It also means the company is less dependent on rapid and generalized legalization for its immediate future. Instead, the limited licenses provide it with protection through high barriers to entry in these markets.

Each state has a maximum number of dispensaries authorized for one company. This means MariMed can be authorized to triple or quadruple the existing number of dispensaries, depending on the state.

Besides the focus on limited licenses, the smaller scale comes from a focus on profitability, with careful and slow CAPEX and acquisitions.

MariMed has made extra efforts to develop its own varieties of cannabis plants. This was done by building a large library of cannabis plant genetics. Improved proprietary horticultural methods are also part of the company’s assets.

The company operates an array of brands catering to different needs and market niches:

• Heritage: for the more green and nature-focused consumers.
• Betty’s Eddies: Candies and ice cream with compound mixed specially to help with stress, pain, or sleep problems.
• Bubbies Baked: Organic brownies with cannabis.
• Vibations: Hydrating energy drink with caffeine and cannabis, quite far away from the usual “stoner” image.
• K Fusion: low-dose chewable tablets.
• Florance: non psychotropic CBD based pills and medicine
• It is also reselling partner brands: Healer, a supplier and training platform for doctors willing to learn about cannabis-based treatments; and Tikun Olam, the leading medical cannabis product in Israel.

That variety allows the company to tap different niches within the medical cannabis market.

Financials & Valuation

MariMed’s EBITDA margin stands at 35%, among the highest in the industry, something that played a large role in picking the company. (Green Thumb’s EBITDA margin is 25%-35%).

Revenues grew to $121M in 2021, up 142% year-to-year. EBITDA grew similarly by 142% year-to-year. Growth is expected to slow down for 2022 to the 5%-15% range.

Regarding valuation, some dilution needs to be incorporated in the price calculation. This comes from preferred stock, options, and warrants, which are equal to 30% total basic shares outstanding. In addition, the company has the right to issue more stock (up to double the current count, see page 15 of the annual report). So while strong dilution is not certain, it is a risk to consider.

The company has $29M in cash, matching the $27M in current liabilities. The $59M in long-term liabilities are split between $22M in debt and $37M in preferred securities.

The company is free cash flow positive ($2M), even with an $18M CAPEX. P/E is high at 51, with the company having turned a positive net income only since 2020.

Conclusion

MariMed has strong brands, efficient vertically integrated operations, and positioning in selected markets with high barriers to entry. It is profitable, though not as much so as Green Thumb. It is also not growing as quickly.

The main strength of MariMed is its positioning in the food supplement and medical markets instead of the more classic recreational uses. This gives it a hedge in case legalization takes a slow pace and medical cannabis stays the main market for half of the US.

The opposite is also true. A speed-up legalization could threaten MariMed with the arrival of bigger competitors in its (for now) protected markets.

The medical angle also makes it an investment more friendly to people reluctant to invest directly into recreational marijuana but acknowledging its potential as a medical treatment for pain, stress, sleep disorders, PTSD, spasms, etc… (9 out of 10 Americans support medical cannabis legalization).

Lastly, its valuation is not high when considering the price-to-sale ratio but includes a lot less built-in growth than for larger, more aggressive MSOs. The company is somewhat profitable but will need to cut CAPEX to really turn cash flow positive.

5.3. Innovative Industrial Properties (IIPR)

The boom in cannabis sales has created an entire ecosystem for service providers to cannabis-selling companies. Industry-specific software or marketing services are difficult to judge, as this is a sector evolving very quickly.

More constant is the basic requirement of any cannabis operation: growing the plant itself and in industrial quantities. Some companies like MariMed have insisted on keeping all their operations integrated, allowing them to focus on unique plant genetics.

Others, like Green Thumb, are happy to keep their sparse and expensive capital to feed growth, licensing to newly legalized states, and acquisitions to open new markets. This is the core of IIPR’s clients, as it builds and operates greenhouses dedicated to cannabis cultivation.

Quick Stock Overview

Ticker: IIPR

Source: Yahoo Finance

Key Data

Industry	Cannabis REIT
Market Capitalization ($M)	3,196
Price to sales	11.7
Price to Free Cash Flow	14
Dividend yield	6.3%
Sales ($M)	248
Free cash flow/share	$0.84
Equity per share	$69.81
P/E	22

REIT structure and dividends

IIPR is structured as a REIT (Real Estate Investment Trust). This means it essentially deals with real estate properties, in this case, industrial properties dedicated to cannabis cultivation.

To learn more about REITs, you can consult my article about them here.

As a REIT, IIPR has to distribute at least 90% of its taxable income to its stockholders. This means that this is one of the only cannabis industry-focused investments that also gives away a strong dividend yield. The company started giving growing dividends in 2017 and is now distributing a yield of 6.5%.

The company is one of very few following this business model. IIPR stands at $3.2B in market cap. Its two next competitors are NewLake Capital Partner ($320M capitalization), and Power REIT ($30M), which is not exclusively a cannabis-centered business.

IIPR was founded by Alan Gold, previously the founder and manager of BioMed Realty Fund, which was, until its sale in 2016, managing laboratories and production facilities for the biotech industry.

IIPR Assets & Clients

IIPR operates 110 assets all over the USA. This includes both greenhouses and laboratories to extract the active compounds.

Because every plant variety has different requirements, with different goals in terms of THC, CBD, and other chemical compound production, plant growth has to be done in a very regulated environment.

So IIPR focus on delivering optimal growth conditions for all the possible requirements of its clients. Indoor cultivation allows for the perfect mix of nutrients, light, temperature, and humidity to obtain a more potent product and much higher cultivation yields all year round.

Due to its scale, IIPR can also build the greenhouse facilities at a cost advantage, as it has a massive scale and negotiating power when it comes to sourcing equipment like sensors, piping, electrical (lamps, heater, etc…), ventilation, security, etc… Being a REIT and not a cannabis MSO, it also has access to capital at lower rates than its (still unbanked) clients.

Difference between indoor and outdoor cannabis cultivation –
Source: IIPR presentation: U.S. Cannabis Sector Primer

Profitability and Risks

Industrial cannabis facilities command a higher average rent price per square foot than traditional industrial facilities ($30 versus $10). The leases are also very long (15-20 years) compared to the average 5-year length for classic industrial leases. All maintenance, capital repair, and replacement costs are paid by the tenant during the full length of the lease (triple net leases).

This high profitability compensates for the inherently more risky profile of the cannabis sector. Most MSOs are not yet profitable, focusing their money on quick expansion.

This makes IIPR tenants inherently riskier than tenants of other, more traditional REITs. Currently, no tenant represents more than 14% of the total portfolio, which at least diversifies the risk of a specific tenant not paying its rent.

IIPR’s yield on invested capital stands at 13%, down from its historic highs of 16% in 2018. The company expected this yield to decline over the next decade to stabilize in the 10%-12% range. This would still put it way above the average REIT’s yields of 6%-8%.

The high degree of customization of IIPR’s assets to its client’s requirements is a bit of a double-edged sword:

• On the positive side, it makes substitution costs very high for IIPR’s clients and puts high barriers to entries for potential competing REITs.
• On the negative side, it reduces IIPR pricing power. The pool of cannabis operators is limited and shrinking quickly, with the sector consolidating through M&A. In addition, new cultivation techniques or changing products requirement could make some details of the greenhouses obsolete earlier than expected.

One strong sales argument of IIPR is the Sale/Leaseback, business model. Essentially, IIPR buys facilities from established MSOs and leases them back. By doing so, IIPR act as a provider of liquidity to the MSOs, freeing money to redeploy toward accelerating expansion. Stronger growth, in turn, increases the need for more of IIPR’s greenhouses by the MSOs.

IIPR Valuation

IIPR real estate is worth $2.2B at cost, slightly less than its current market cap of $3.2B. Other assets are equivalent to all liabilities, including long-term debt. So would put the Market Cap to NAV (Net Asset Value) ratio at 1.45. This ratio would make IIPR appear overvalued, as REITs should trade close to their NAV.

However, we need to consider the real value of the properties instead of how much they cost years ago. Inflation has been especially strong on both real estate prices and base materials. So I assume the replacement costs of the greenhouses are much higher than what they cost a few years ago.

Prices for machinery, steel, aluminum, piping, glass, ventilation systems, etc… have gone up radically, sometimes up 100% for some components of greenhouses.

As a result, I suspect that IIPR’s market cap to NAV is slightly below 1 (maybe 1 to 0.8).

Remarkably, this also means that the company was grossly overvalued at the end of 2021. It is pretty rare to see REITs drift far apart from their NAV. Normally these are rather “boring” investment vehicles that fluctuate little year-to-year.

But it seems the company was caught up in the general cannabis bubble enthusiasm. This should be something to remember for investors in IIPR in the future. Any significant rise above the NAV should be a warning and might justify selling the stock until the valuation comes back in line with the valuation of a “normal” REIT.

Conclusion

IIPR is an interesting way to bet on the cannabis industry for conservative investors who are unwilling to take chance with the more risky MSOs. It also provides a steady income in the form of dividends.

The current valuation seems roughly in line with NAV, especially when taking into consideration recent inflation and the real replacement costs for the company’s extensive network of greenhouses and cannabis extraction facilities.

As an extra bonus, it seems markets have in the past been willing to pump up IIPR’s stock price in tandem with the rest of the industry, despite its REIT status. So there is a chance that IIPR provides upside optionality in addition to the relatively “safer” downside protection from its real estate assets.

Lastly, investors in IIPR should stay aware that its industrial real estate properties are less fungible than for simpler REITs dealing – for example – in apartment buildings. The properties are highly specialized and would need extensive (and expensive) refitting to be used for another purpose than cannabis growing.

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6. Conclusion

The cannabis industry is still a very young sector. As a result, it is also highly unstable and subject to abrupt changes in both regulation and market conditions.

It is also one of the fastest-growing industries, replacing an enormous but previously illegal market. In the last 10 years, public opinion has radically shifted, with the legalization of at least medical cannabis now an almost society-wide consensus.

Evolving public opinion combined with the appeal of a new source of tax revenues is rapidly changing the political trend regarding the drug. Most likely, it is a matter of when, not if, for cannabis use to be at least decriminalized and likely fully legalized. So the prospects of the industry in a long enough timeframe (5-10 years) are good.

The timing of these changes is more uncertain. Cannabis promoters have a history of being over-optimistic about “imminent” legislative reforms. This has led to no less than 2 successive bubbles popping in less than 4 years. So any potential investor in cannabis should be ready to adapt to extreme volatility and act as much as a trader as a long-term investor.

We are likely to see cannabis operators continuing to consolidate the industry. This would mean the sector might end with an oligopoly of a few companies, something to be expected when an activity is extremely regulated. This trend would benefit Green Thumb.

Even extensive consolidation could still leave space for profitable high-end niches, especially in the non-smoking segments of the market, foodstuff and medical especially. This trend would boost MariMed.

In both cases, there will be a constant demand for highly professional cannabis growing facilities, IIPR’s specialty.

Because of the incertitude about the future structure of the cannabis sector, it is best for investors to diversify their exposure to the industry.

For this purpose, I think it might be interesting to look beyond the companies featured for building a diversified portfolio. So contrary to other reports, I will give a passing mention to other actors in the sectors:

The big 4 beside Green Thumb are CuraLeaf, Trulieve, Verano, and Cresco Labs. They have been aggressively acquiring their smaller competitors in the hope of turning into THE dominant actor in the industry. Of this list, only Green Thumb and Verano are currently profitable.

Other MSO options are the ETF MSOS (providing built-in diversification), Tilray, Aurora Cannabis, or Canopy Growth.

If you are more interested in a “pick and shovel” option similar to IIPR, you might want to give a look at GrowGeneration, the largest hydroponic supplier in the US, and AFC Gamma, a loan provider to the cannabis industry.

The post Looking for New Highs: An Analysis of the Cannabis Industry and Selected Companies appeared first on FinMasters.

Quick Stock Overview

Ticker: JOUT

Source: www.stockrover.com

Key Data

• Sector: Consumer cyclical  
• Sales ($M): 632
• Industry: Leisure  
• Net Cash per share: $15.49
• Market Capitalization ($M): 1,530  
• Equity per share: $39.42
• Employees: 1,200  
• Debt / Equity: 0.1      
• Interest coverage: 651.9

Summary

Johnson Outdoors is a manufacturer and seller of outdoor sports equipment, with a strong focus on fishing gear. It is a solid brand in its main sector, and also branched out in other outdoor sports. This is a family firm, with 3/4 of the shares still owned by the Johnson family. By far its main activity is in the fishing segment, with a presence in other water- and fishing-related sports like diving and kayaking. It is also active in camping (cooking accessories and tents).

GD sectors of activity (source: johnsonoutdoors.com)

Strategic Analysis

Johnson Outdoors (JOUT) is steadily growing in a sector with increasing popularity. Quality of life in large cities has taken a severe hit in 2020 with the COVID-19 pandemic. So outdoor sports, especially out at sea or lake, away from sanitary restrictions, have prospered.

As you will see in the quantitative analysis, the company has experienced very strong and steady growth over the last years even before COVID-19.

A Large Addressable Market

The addressable market is massive, with 50 million Americans participating in fishing activities in 2019 for a $13.4 billion global market size. While Johnson is mostly selling in the US, it has room to expand to overseas markets and other markets like the camping sector. Americans are spending no less than $887 billion per year in outdoor sports, according to the OIA (Outdoor Industry Association). This includes $14 billion in water sport gear and $20 billion in nature trail gear in 2017.

Outdoor sports gear is a highly fragmented industry ripe for consolidation by strong and recognized brands. As a leader of the segment with strong brands and intellectual property, Johnson should be able to keep growing and expand into new segments. With only $600 million in sales in 2019, this leaves plenty of room for Johnson Outdoors to keep growing, even if it stays in the water sports and camping sectors only.

It is also worth noting that while Johnson Outdoors sells mostly through retailers, it also has direct e-commerce channels, and that these channels have been performing well during the pandemic and lockdowns, with malls closed.

Source: mordorintelligence.com

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Qualitative Analysis

Business Analysis

Johnson Outdoors has been operating for almost 50 years, and is controlled and operated by the descendants of the founder, Sam Johnson.

Sector Products Sales ($M) in 2020 Percentage of total revenue in 2020 Operating margin in 2020 Fishing Anchors, water radar, motors, maps 449 75% 21.3% Diving Dive computers, divewear, regulators 60 11% -4.2% Watercraft Kayaks, fishing craft, accessories, personal flotation devices. 41 7% -0.7% Camping & Hiking Tents, sleeping bags, cooking burners 41 7% 10.6%

It is worth noting that in 2019, diving was with a profit margin of 3.9% instead of a loss. This is an effect of the pandemic as travelling to diving destinations stopped, and should allow Johnson’s diving sales to get back to generating a profit of $2-3 million when the situation is back to normal.

Source: johnsonoutdoors.gcs-web.com

Geographically, JOUT is not really diversified, with only 12% of revenues out of the USA, of which 5% in Euros and 5% in Canadian Dollars and only 2% in other currencies. This obviously means that the company is mostly exposed to the American consumer spending, but also gives a large space to grow abroad, even if the American market was getting saturated.

Economic Moats

In value investing terms, Johnson Outdoors has several economic moats:

Brand

Sports and outdoors enthusiasts are ready to spend large sums to get good quality, reliable, sturdy and durable equipment to enjoy their hobby. Ask any hiking or fishing enthusiasts about their gear, and they will be delighted to discuss for hours the respective merits of different brands and designs. Outdoors activities are tough on devices and tools, as they are exposed to extreme hot or cold, salt water, tears and shock. This means that any serious hobbyist will have learned to prefer branded, reliable goods to cheap knockoffs. And when they find one they can trust, they stick to it for years or even decades.

Johnson’s financial results and price range seemed to indicate they are positioned in the upper part of the market, but not the most expensive either. I still checked their online reviews, and the typical listing shows the product quality as well as the money Johnson consumers are ready to spend. For example, these two frequently sold together products on a retail platform I am sure you will recognize.

Source: amazon.com

On top of being a brand known for the quality of its products, Johnson also cultivated a friendly, non-corporate, family-owned image that aligned perfectly with the value of its customers. After all, how many $1 billion companies are communicating this way?

The team member page showing them in shorts, backpack and wearing video game T-shirts
Source: johnsonoutdoors.com

A perfectly serious and normal head image for a corporate website
Source: johnsonoutdoors.com

Interestingly enough, the product quality speaks for itself in another way. While Johnson is essentially a B2C brand, it also supplies the US military with tents and other outdoors equipment, for a total of no less than $200 million in 2015 (with deliveries spread over several years), after multiple other successful tenders in 2004, 2005 and 2009. This is an area that the company has identified as a possible growth segment since at least 2017. This is the kind of positive surprise the shareholders of a quality company, selling sturdy and reliable products, can expect.

The military sales have decreased in 2020 compared to 2019, but this does not mean that further tenders will not be won down the road, just that government contracts tend to be irregular and do not fit the neat quarterly expectations of Wall Street.

Intangible Assets

Johnson Outdoors is re-investing a significant part of its profits into R&D, which produces valuable patents, supporting the performance and quality expected from a high-end brand.

For example, there are thousands of different designs of camping burners. But how many can – like the Jetboil – promise to boil water in just 100 seconds, while staying light, compact, efficient and durable? I would bet that once a camper got used to this kind of performance, he will never settle again for anything less. Especially if the price is still reasonable.

Source: johnsonoutdoors.com

R&D has been $24 million in 2020 (compared to a net income of $54 million), up from $20 million the previous years, so JOUT is definitively investing in the future of its product line and is likely to stay ahead of the competition.

Management

Being a family-owned business, Johnson Outdoors’ management is naturally expected to have the interest of the company at heart. The steady growth and attention to quality and branding reflect this, so this should not be a concern for an outside investor.

However, this also means that minority shareholders (so everybody but the Johnson family) might be at risk of the majority shareholders handling the company for its own profit, instead of benefiting all shareholders. This is commonly happening through excessive management compensation, stock options and other rewards for management from the pocket of the other shareholders.

For all practical purposes, the Johnson family’s control of the company is absolute,  and this is something the other shareholders will probably have to accept permanently.

Source: johnsonoutdoors.gcs-web.com

At the moment, there are around 10 million outstanding A and B-class shares. The long-term incentive plan for management and employees over the last 11 years have represented around 100,000 options and warrants, and 725,000 other shares available for future issuance. If they are all issued, it would represent a total of approximately 8% dilution over 11 years. So nothing out of the ordinary in management rewards for a company that has experienced an exceptional growth and financial performance.

Obviously, a reduction of the share compensation and an increase in dividends would be preferable for non-controlling shareholders, but this is also not a situation where the founding family is funneling all the company money out into their personal wealth.

Source: johnsonoutdoors.gcs-web.com

As you can see, the company did not either make a habit of emitting new shares that would dilute existing shareholders.

Source: www.finbox.com

One last management risk associated with family-owned companies is nepotism and being unwilling to bring managerial talent from outside. This is not the case here, as some examples below can show, from the board of directors:

• John M. Fahey Jr, retired chairman and CEO of National Geographic Society
• Richard Sheahan, former president of Patagonia.
• Edward F. Lang, CFO of New Orleans’ NFL and NBA teams (Saints and Pelicans)

Competition

The markets in which Johnson Outdoors operate are not very concentrated, so there are a lot of different competitors. JOUT itself identifies them clearly in its annual reports (SEC filings). I have put at the end of this section the complete description of the competition by Johnson itself, but I will also look deeper into some of the larger and more serious competitors.

Many of them are private corporations, so it is not as easy to assess their strategy or strength as with public companies. JOUT is not giving publicly their assessment of their competitors, in order to not weaken their own position, so I will have to make an educated guess on it.

Garmin

Garmin, more known for its GPS devices, is a competitor of JOUT for the trolling motors, the marine cartography and the on-boat electronics. As a 22.4 billion dollars company, it definitely has the firepower to be a serious competitor to JOUT’s electronic fishing equipment. Garmin’s origins are actually in the marine market, when it started in the 1990s to sell a $2,500 GPS receiver for sea going ships.

I could not really decide how big of a threat Garmin is for the core sector of JOUT, its fishing sector (still representing 75% of sales) in terms of quality, as both have excellent reviews.

Garmin as a company seems mostly focused on competing on the general electronic segments (a MUCH larger market after all), with very strong focus on wearables like smartwatches and personal trainers, but also GPS (car and outdoors) and even avionics.

The only segment that seems a focus of Garmin which overlaps with JOUT’s core products is their marine section. It includes sonars, ice fishing kits, trolling motors and marine maps.

Johnson products seem quite a bit cheaper than Garmin’s, but frankly, I am not a fishing enthusiast, so I am not 100% sure I perfectly compared apples to apples in terms of technical specs for very specialized products.

Brunswick Corporation

An almost $7 billion corporation and 13,000 employees, Brunswick is the elephant in the room when it comes to recreational boating and fishing, especially in the US market. The group has recently re-centered on marine activities, selling its Bowling, Billiard, Fitness and Cycling departments and acquiring a few marine-related businesses.

I am not exaggerating when talking about the elephant in the room, just give a look at a slide from their investor presentation displaying all their brands.

Source: d1io3yog0oux5.cloudfront.net

The company also moved from making most of its money selling boats to mostly selling motors and mechanical parts. This new re-focused, leading in the motor segment is a serious competition for JOUT.

I would however say that Brunswick seems to prefer to communicate about the power of its engines, and have a focus on bigger, high-speed boats for leisure, than for fishing.

Brunswick’s communications, Source: d1io3yog0oux5.cloudfront.net

In contrast, Johnson has its communication centered on shallow water fishing and the silence of its engines.

To me, both companies’ communication strategies align very well with their respective customers, and they seem for now to be fine keeping it separate that way.

Nevertheless, I consider Brunswick the most dangerous of JOUT’s competitors. It could, if it wanted to, easily invest massive amounts of money into the shallow water fishing segment (the cash maker of JOUT) and develop a strong competing brand in that niche, while still cashing on the high-speed boating leisure segment.

At the moment, the deeper commitment of JOUT to the fishing segment only, and its complementary offer of sonars, motors, anchors, and maps is probably its biggest asset, as it offers all fishing gear from one supplier, while Garmin and Brunswick each offer only a part of the full fishing gear set.

But Brunswick is active in the fishing segment, especially at sea, and JOUT will have to maintain the strong focus and product development of the last years to maintain its position in the segment against Brunswick.

Any shareholder in JOUT will have to regularly monitor that the competitive situation on this segment is still unchanged, and that JOUT products stayed on par with Brunswick’s.

The North Face

A private company, the North Face is a giant, with a respected brand and strong reputation in hiking, camping and mountaineering. The brand has evolved over time, and is now mostly focused on apparel more than equipment. Nevertheless, it is still selling tents, at a very steep price range (from several hundreds dollars to $5,500). So despite its size, I would not consider it a large threat to Johnson Outdoors, as it is essentially targeting the highest-end of the market, while Johnson is more focused on delivering great quality for a good price.

You can also learn more about The North Face’s rather fascinating business history here.

MSR (Mountain Safety Research) / Cascade Design

Part of the Cascade Design group, MSR manufactures cooking gear for camping, with a focus on mountaineering and alpinism. Its products are definitely of high quality and even its design looks similar to Johnson cooking gear. I frankly have no idea who copied who here.

The price range seems a bit higher than Johnson’s stove lineup, so I think while it is a serious competitor, it is one that JOUT might be able to compete successfully with. In addition, MSR’s focus on mountaineering allows for Johnson to have a different marketing approach, less focused on absolute efficiency and engineering, and more on practicality and good price/quality ratio.

Camel Expeditionary

Camel is a private company manufacturing 45% of all US’s Armed Forces tents, for a total of 750,000 tents over the years. This is clearly the well-established insider in this market, and Johnson Outdoors will have to keep hard at work to keep taking military tenders away from Camel.

Source: johnsonoutdoors.gcs-web.com

Quantitative Analysis

Financials

Revenues

Johnson Outdoors (JOUT) is a company which has experienced steady growth in revenues since 2015, and its share price nicely reflects it.

JOUT earnings per share have also steadily grown, showing that the company has managed to generate this growth in revenue without sacrificing margins.

Dividends

Growing revenues and earnings also allowed it to start paying a dividend in 2014, which has been steadily increasing since. The dividends’ yield is not really high, only 1% on average, but the steady dividend per share growth allows for some hope it might inch somewhat higher in the future, or at least, keep up with the rising share price.

Source: www.finbox.com

Debt and Balance Sheet

JOUT revenues and earnings are showing a good quality, steadily compounding company, with ample room to keep growing. But where it really shines is in its balance sheet.

As you can see below, JOUT has virtually no debt at all, especially when compared to the massive amount of cash and current assets on its balance sheet. The total net debt is a negative $-170 million. As it is standing at the moment, JOUT is an extremely financially solid company, which would be able to handle an economic downturn very well.

In fact, with such a pristine balance sheet, I suspect JOUT could benefit from a recession, by being able to maintain marketing budgets when competition is cutting them, acquiring smaller distressed brands or expanding in new markets by deploying the cash at hand.

Source:www.finbox.com

Cash Flow

As cash flow is strongly tied to the ultimate return an investor can expect from a stock, let’s take a look at JOUT’s cashflow metrics.

The cash flow has been steadily rising, and while unstable partially due to seasonality of JOUT sales, has been at an average of 5% for the last decade.

Source: www.finbox.com

Source: johnsonoutdoors.gcs-web.com

When discussing cash flow, we need to discuss if we trust the management to use it well. Cash is being reinvested in creating valuable patents resulting in top-of-the line products. There have been no botched acquisitions wasting capital in inefficient diversification. The company stayed laser-focused on its core competency, outdoors equipment for camping and water sports.

They are actually able to wait patiently for a good opportunity with a good price, and not rush to make overpriced acquisitions. This was very well expressed by the company CEO, Helen P. Johnson-Leipold:

Source: www.fool.com

Combined with the family ownership, this gives good reason to expect good management of the cash generated, and to see it channeled toward more growth without the company losing its focus and competitive advantage.

Well used capital and the brand strengthening is apparent when looking at the ROIC (Return on Invested Capital), which has been rising from a lower 6-8% in 2011-2015 to a 10-15% in 2015-2020.

Source:www.finbox.com

Categorization and Valuation

Investment Category

I can squarely put Johnson Outdoors in the high-quality companies category. It has a stable business, solid margins, strong brand and quality management. It also has plenty of room to grow to become a steady compounder for the decades to come.

I expect JOUT to increase its market share in its core sector (fishing) while steadily expanding in its main growth sector (camping), both in B2C and with government contracts.

Over the next 10 years, I would not be surprised if they added to the camping segment a lineup of backpacks, trekking shoes, walking sticks, etc… that would capitalize on their existing industrial facilities and experience with fabrics and polymers. The diving section should get back to normal once the COVID-19 crisis subdues, and the kayaking section should either become profitable or be abandoned.

Discounted Cash Flow

One way to calculate JOUT’s valuation is using the discounted cashflow model. You can see what it means and how it works here. To me, this is the best method to calculate the value of a quality steady compounder like Johnson Outdoors.

Free cash flow has been growing over the last year at an impressive 19% CAGR (Compound Annual Growth Rate). I prefer to assume that such returns might not always stay and picked an expected growth of 15% for the next 5 years, and “only” 12% for the five years after that.

This gives me an intrinsic value of $126 per share, below the $151 in April 2021. You will note that I put 0% in margin of safety, as I was interested to know what the intrinsic value of the business is.

I used as a terminal value multiplier the lower range of the price / free cash flow ratio. It has varied a lot over time but seems to always go back to a baseline around 12 and not below.

In order to stay safe, I also use a 15% margin of safety to determine the ideal buying price of the stock. So, with the recent increase, JOUT would be slightly overvalued, and somewhat lacking a margin of safety, expect for the quality of the business itself.

Earnings Growth Model

I expect JOUT to keep growing, so another way to guess its future returns is to look at earning growth. Over the last 10 years, earnings have grown at the rate of 18.1%. To keep a margin of safety, I took an expected growth of 15% in the next 5 years, and only 10% in the next few years. With this relatively conservative expectation, this would give JOUT an annualized return rate of 8.6%. So, it would fall quite short of the 15% I usually aim for, but this would not be too shabby either.

In order for JOUT to actually deliver a 15% annual return rate, it would have to perfectly stay on track with its 18-19% earnings growth rate for the next 10 years.

This is not impossible, but 10 years is a long time. In that period, a recession can for example impact the budget of its customers, reducing their willingness to gear up for fishing trips or visiting national parks on the other side of the country. P/E has been very variable in the past, so I picked a conservative 15 instead of a more optimistic 20.

Equity Bond Yield

Equity bond yield is a method that considers JOUT stock as if it were a bond and calculates the yield it would bring. Instead of basing its calculation on free cash flow, this model uses the Return on Equity (ROE) as a base. You can learn about it in my article here.

This model shows an estimated annual return rate of 11.4%, which would make JOUT an okay compounder, but not an exceptional one.

However, I do not think that this method is the best to judge JOUT, as the calculation is highly dependent on the estimated P/E ratio. And that ratio has been all but stable in the last years, so it is anyone’s guess what should be the right number here, making the calculation inherently less reliable. If the P/E ratio used was 20, that would give an annual return rate of 14.5%, illustrating how sensitive this valuation method is to that data point.

Source: www.finbox.com

Other Calculation Methods

Considering the very low dividend yields, other valuation methods like yield on cost are not relevant for Johnson Outdoors.

Final Assessment

Company Synthesis

Johnson Outdoors is a quality company, offering the combination of a rock-solid balance sheet, a family-owned business honest with outside shareholders and a steady compounder with large addressable markets. Outdoor sports are not going anywhere, and the cultural shock of the COVID-19 crisis might create a durable shift toward less crowded activities outside. Long months of lockdown in cities will also likely create a longing for open space and nature.

Will that be a long term trend or just a short term reaction, it is hard to tell. I can easily imagine that many people might try holidaying mask-less by camping in a national park instead of a densely packed beach resort, and discover they liked it and keep doing it in the future.

In a period of increasing speculation and market volatility, a very solid balance sheet is also a good place to park cash, at a time where most valuations do not make sense in regard to fundamentals. It is a fool’s errand to try to call a market top, but the intense speculative mood of 2020 and early 2021 is definitely reminiscent of the Tech bubble of 1999, so a no debt, growing company like Johnson Outdoors might be safer than over-hyped technology plays.

Short term projection: 1-3 years

In the short term, JOUT is likely to do well, as the business fundamentals are very good and likely to stay this way in the immediate post-COVID era.

Long term projection: 3-10 years

A lot of the long-term growth will depend on the ability of Johnson Outdoors to accomplish the following tasks:

• Expand overseas. While very popular in the US, the brand is not yet well established in Europe and almost not at all in Asia.
• Become a regular supplier of the military and other similar organizations, which would provide it large volume contracts and help it scale up its production
• Use its R&D budget to create new high-quality products in the sectors it is already profitable in and have a client base who trusts them, like camping (shoes, backpack, etc…) or fishing (fishing rods, boats, etc…)
• Get diving back to profitability when travel comes back to normal.
• Turn the kayaking sector into a profitable and growing activity, maybe by expanding to white water sport (down river torrent).

In any case, Management is unlikely to dilute existing shareholders or waste the company cash on pointless acquisitions and diversifications. So the higher probability for a bear case is that growth slows down and JOUT stays a profitable, well established sports brand that slowly turns from a growth story to an established and “boring” cash cow.

Valuation

JOUT’s current price is seemingly a little bit too pricey according to the earnings growth model and other valuation methods. Always erring on the side of caution, I would tend to believe the price is a little bit high at the moment. This is rather clearly reflected in the quite high P/E ratio of 22, showing the market already priced-in future growth.

At the same time, it does deserve higher multipliers thanks to its pristine balance sheet, steady growth and excellent management. So, I suspect this is a typical case of an “okay price” for a great company, or in Warren Buffett’s terms:

“It’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful price”.

The post Johnson Outdoors (JOUT) Stock Research Report appeared first on FinMasters.

Quick Stock Overview

Ticker: EPD

Source: www.tikr.com

Key Data

• Sector: Energy
• Sales ($M): 32,572
• Industry: Oil and gas midstream
• Net Cash per share: $-12.89
• Market Capitalization ($M): 48,253
• Equity per share: $11.36
• Price to Free cash flow: 11.9
• P/E: 12.7

Investment Thesis

Buy When There Is Blood in The Streets

The sentence above is a famous piece of investment advice attributed to Rothschild. This is the heart of every contrarian investing method. Another way to say it is “buy low, sell high”. Seems logical and easy, right?

In practice, most investors do the exact opposite. If you want proof of it, look no further than the recent mania around Tesla and Cathy Wood’s ARKK ETF. It feels a lot better to buy a stock that has been going only up for a decade, than one that has consistently lost money.

Beyond perverse incentives about career risk in the money management industry, even retail investors are highly susceptible to this problem. We are social animals, and it simply goes against our nature to go against the crowd. Nevertheless, buying when it is cheap is the core of value investing.

So how to do it? One way is looking at countless companies and finding mispriced ones. I do that a lot, and many of the reports I publish here are found this way.

But sometimes it is even simpler than that.

An entire sector of the economy might have durably underperformed. It might be simply that it is out of fashion. Or that real economic and profitability problem hit the sector. Or there might be political and cultural reasons for this sector to be unpopular.

With the sector I will present to you today, all 3 reasons are present at the same time.

The Industry Everyone Loves to Hate

The industry of which I am referencing is the most maligned in the markets right now: the energy industry.

Of course, not the part that is going to save the planet: solar panels, windmills, etc… No, I am talking about the dirty, evil part of the energy industry: fossil fuels. All emitters of carbon will irreversibly destroy the planet’s climate, this is a fact. They are responsible for terrible things, like ecological disasters, the destruction of local water resources and be a even the primary culprit  for conflict in the Middle East.

Ask anybody in the street, and you will be hard-pressed to find anyone in support of the oil and gas industry. And why would you support them? They are malicious, corrupt, and greedy polluters; at least that is the consensus. The same critics  of fossil fuel energy will then hop in a car, get back to a gas heated home full of plastic-based devices.

I am not so much pointing out the hypocrisy of modern lifestyle with an ecological lifestyle (although this could be discussed too). But we need to remember that literally, everything in the modern world is possible thanks to abundant fossil fuel energy.

From food abundance thanks to gas-produced fertilizers, to high-tech and low-tech plastic gadgets, to quick and efficient delivery of the goods to your local supermarket. In most countries, electricity is still produced with the dirtiest of fossil fuels: coal.

Do not get me wrong, I am actually an ardent supporter of green energy, and would love to see fossil fuels phased out. I truly think it is the future and that in the long run, electrification and renewables will dominate the energy landscape.

However, I also know to not let my personal preferences or hopes go in the way of my analysis. Renewables are indeed the future, but the transition will sadly happen a lot slower than it should, and investors need to be aware of it.

When it comes to investing, people are currently unwilling to come anywhere near energy companies. This goes against the trend of ESG investing and for many, would simply make you a bad person. Besides, it is simply a bad investment. Just look at the oil and gas ETF: XOP.

It is significantly down since the 2014 peak, be even much lower since the 2009 low. So, does investing in oil and gas mean you are both evil and stupid?

Source: www.yahoo.com

Do you see where I am going with this? This is the typical “blood in the streets”, and the oil industry has bled out over  the last decade. But why could it change now?

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Chapter 1: A Postmortem

Several Storms at Once

The energy market, especially oil, has been suffering from a terrible image for a while now. This started with large oil spills, like the Amoco Cadiz, or the Deep Water Horizon in the Gulf of Mexico. And with the growing conscientiousness about climate change, a general concern that fossil fuels are quite literally going to kill the planet.

So, investors were already not happy with the PR of the oil industry. But it was giving very good and stable dividends, so many, including a lot of large pension funds, ignored it.

Source: www.finbox.com

But then came the threat of electrification. Oil is used largely for transportation, and with electric cars going mainstream, many have announced we passed peak oil demand. The IEA (International Energy Agency) is forecasting already 14% of the cars to be electric by 2030.

This might mean that most of the oil in the ground will become worthless before it is extracted and sold. This is a huge problem for entire countries like Russia or Saudi Arabia, but also for oil companies. Their largest assets are the oil deposits, and if it goes bust, so do they.

Terrible image control and bleak long-term prospects were looming over the industry, but at least profitability was still good. Most investors were getting worried, but not all left the boat…until the shale oil revolution.

Shale oil’s new technology allowed the USA to reverse dramatically a long-term trend of declining production. This also resulted in a sudden flood in the market of millions of barrels per day, outpacing demand.

In most circumstances, this would have led to lower prices, and then lower production. But with the US capital markets flushed with cash from the Fed, shale oil companies managed to keep raising more capital, more debt, to keep drilling more wells. The promise of lower production costs with economy of scale and technology maturing kept investors in shale oil complacent.

The result was the not so surprising collapse in oil prices. Adjusted for inflation, oil prices in 2016 were as low as in the mid-1980s. Shale oil producers started to lose investor confidence, OPEC production cut helped too, and oil price was starting to recover.

And then came Covid…

If you remember, in 2020, oil prices went negative for a few days. Producers are had to pay to get their oil taken away. If that is not a contrarian indicator and a signal of a bottom, I do not know what is.

Source: www.macrotrends.net

A Dead Sector? Not So Fast

After negative prices, you could believe the energy sector would be toast. But is it? Let’s look again at the XOP ETF, but with for the last 12 months. Roughly +100% performance. Not so bad if you had looked at negative oil price as a signal.

Now this was not for the faint of heart, and you will see, I will present a company less speculative than this. But I just wanted to show you the power of going against conventional wisdom.

Let’s looks objectively at the energy sector prospect. Will oil demand go to zero in a decade or so? Hardly. You see, even in transportation, more than 60% of oil demand is not for cars, but for planes, buses, trucks, ships, or even rail.

So even if everybody by 2040 is driving an electric car, a dubious idea when a large part of the world is likely to lag behind, oil demand would still not so low. Changing the entire transportation fleet of the world will take a while, whether we like it or not.

Source: https://www.eia.gov/

Besides, a lot of fossil fuel is not used for transportation. When it comes to electricity, a lot of it is gas. Most heating for homes and offices are also consuming a lot of oil and gas.

All of those are going to switch slowly to renewable, but probably not as fast as we would like. In the first place, replacing coal with gas for electricity production will be the fastest and most impactful action on carbon emissions.

I cannot cover in this report the whole depth of the discussion about the future of fossil fuels usage. If you are interested to learn more about, I recommend this excellent report from Lyn Alden that was part of what triggered my interest on the sector.

Chapter 2: Not All Energy Stocks Are Created Equals

The Unfairly Punished Sub-Sector

You probably noticed that I only talked about the energy sector as a whole so far. This is because I need to first push aside the worries (or hopes?) that in 10-15 years, everything will be electrified, and fossil fuels will be history.

For better or worse, the world economy will still massively use fossil fuel for the next two decades.

The energy sector is usually split into three segments: Upstream, Midstream, and Downstream.

• Upstream: these are the oil and gas producers, the ones actually drilling and producing it (Exxon, Shell, BP, etc.).
• Midstream: these are companies transporting the petroleum products, usually in pipelines.
• Downstream: these are the refineries transforming the energy into final products, like gasoline, jet fuel, or plastic components.

Upstream companies are the most vulnerable to price downturns, as illustrated by the recent bankruptcy of Chesapeake Energy. Downstream companies are usually very low margin and very capital intensive, leading to brutal cycles of non-profitability when prices go down.

Midstream companies are different. They make their money not from the oil and gas price, but from the volume transiting in their pipelines. As long as people drive cars and need electricity, they are in business. This reliability gives midstream companies stable prospects and predictable cash flows.

Are Midstream Right for Value Investors?

In many ways, midstream companies are the ultimate defensive assets. They have very long-lasting assets (a pipeline can last for decades). Their revenues are easy to forecast and mostly in line with the broader economy. Because their assets are so durable, they are amortized over extremely long periods, leaving plenty of cash for the company to give back to shareholders in dividends or share buybacks.

Cheap Despite Good Results

To the risk of getting redundant, I will go back to the base tenet of value investing: buying assets for less than their real value. Midstream companies are broadly viewed as part of the “energy” sector and priced accordingly. When oil prices skyrocket, they are overvalued. And when oil is out of favor, they are undervalued.

This phenomenon has gotten more extreme with time, due to the rise of passive investing. Many, maybe most investors today, are not investing in companies. They are buying sectors, ETFs, funds, and other financial products quite blindly, not caring much about their exact composition or exposure.

When energy became the sector to avoid, all energy companies were sold off. Upstream, midstream, downstream; it didn’t matter. Profitable pipeline companies saw their share price collapse together with cash-burning shale oil drillers and refineries.

This allows us to buy them on the cheap!

The Ultimate Moat

The rejection of fossil fuels also had unintended consequences. One such consequence is that anything related to the sector has become politically radioactive. While some Republican politicians are still supporting the sector, the political class as a whole is not looking forward to being associated with a planet-killing industry. This also means very strong grass-roots opposition to any fossil-fuel-related project.

The perfect example is the cancellation, restart, and re-cancellation of the Keystone XL pipeline. In the current climate, building a new pipeline is virtually impossible, as this implies support the fossil fuel industry. Between environmental agency, local protesters, and reluctance from DC, it is unlikely any major pipeline project will be completed soon.

Such projects cost several billion (with a “B”) and many years to be completed. Investors are likely to be reluctant to approve such spending if, at any time, it can turn into a complete loss.

Existing pipelines are not exposed to this problem. They have been approved a long time ago,have a very good safety track record, much better than train transportation, for example. So, the existing networks of pipelines can operate without any new competition coming in to steal market share.

When we speak of a moat in value investing, we usually mean that it is very difficult for competitors to attack the position of the established company. But in this case, it is downright impossible. And with Big Oil’s image not improving any time soon, I can see this moat becoming even stronger over time.

An Undervalued Hedge Against Tail Risks?

Slowly, the topic of protection against inflation is becoming relevant again in the financial community. I am personally agnostic regarding inflation prospects, but I do prefer to have some protection against it in my portfolio, and to even profit from it if it ever becomes a real problem.

One popular way is gold, and I have covered this topic in my previous report about Kirkland Lake, a smaller Canadian gold miner. But another way to combat inflation is with energy companies. I am sure many of you have noticed the price of a full tank has risen quite a bit lately.

If inflation picks up, it is likely to be partially due to energy prices. You see, the depressed energy prices for the last seven years have forced a lot of non-shale oil companies to cancel or postpone investments in traditional fossil fuels, both onshore and offshore.

A new oil field can take 10 years to be developed from discovery to full-speed production. Also, a discovery can only be made if exploration budgets have been high enough.

The whole industry has chronically under-invested in future production during the lean years of the 2010s. Despite a level of already too low capex spending, another $44B of capex has been slashed due to Covid in 2020. This leaves the largest oil companies with decreasing oil reserves.

I fully expect that in the next 3-5 years, the combination of rising inflation, rising energy costs, and the communal realization that the green transition will take a while, will all happen at the same time. This  same phenomenon  has depressed all energy stocks in unison is also likely to lift them all up the same way.

The same result would happen in the case of black swans like a war with Iran, a successful terrorist attack on a Saudi oil field, a flare-up of tension in Taiwan or Ukraine, etc…

Overall, midstream companies can provide a super solid moat, predictable business, good cash distribution back to shareholders, and a hedge against inflation and geopolitical black swans.

Chapter 3: Why Enterprise Product Partner?

Picking The Right Target

The more I research the topic, the more I was convinced of the general idea of the energy sector, and midstream companies in particular. But this still left me to narrow it down to a specific target. So here was my list of criteria:

• US-based to reduce geopolitical risk
• Large enough to operate at scale and manage the growing regulatory burden, ideally one of the top five in the country
• Manageable debt
• History of responsible capital spending and cash distribution to shareholders
• Low exposure to crude transportation, as this would make it depend on the (mis)fortune of shale oil. I prefer other chemical products and gas instead.

This narrowed it quite a bit. Some of the good candidates were not publicly traded, so I could not invest in them. Some are now parts of larger entities, like Berkshire Energy Partners (16,400 miles of pipelines). Of course, noticing the presence of Buffett in the sector was somewhat reassuring, more precisely, Berkshire bought for $10 billion worth of extra pipelines in 2020.

Some other candidates in the top 10 midstream companies were too centered on Texas and shale oil. Some had poorly managed debt and the downturn, showing me substandard management.

I ended narrowing it down to two companies: Magellan Midstream, and Enterprise Product Partner. Both had a very similar profiles and good qualities, but EPD is almost 5x bigger, so I think it will be more able to operate at scale than Magellan.

EPD’s Operations

Except for the West coast, EPD is at the core of the whole US energy infrastructure. It manages 50,000 miles of pipeline transport all types of energy products. These pipelines connect together gas fields, 22 natural gas processing facilities, and 23 fractionators (they separate the different components of natural gas into pure products), as well as very large storage facilities.

Source: www.enterpriseproducts.com

The bulk of EPD business is with natural gas and Natural Gas Liquids (NGLs), 65% of the total activity. The rest is split between petrochemicals (14%) and crude oil (21%). This is perfect in my opinion, as I am still not sure if shale oil will ever be a really profitable technology. In addition, if I underestimated the impact of electrification on transport, oil will be the sector the most damaged, not gas. Instead, EPD carries products required in almost every manufacturing process of the modern world.

Source: www.ir-west.enterpriseproducts.com

Management seems top-notch, with many of them in the company for a decade or more. The business is ultimately simple to operate, as long as management is careful to not overstretch with debt or acquisitions. The company keeps collecting fees as long as power plants and refineries need natural gas and NGLs.

During the worst of the downturn, margins were somewhat compressed as clients renegotiated as much as they could with transit fees in EPD pipelines. But ultimately, pipelines have such a strong moat that only temporary rebates occurred before the company returned to business as usual.

This was reflected in the growing net income and an ROIC that stayed positive even in the worst moment of the oil price crash.

Source: Finbox.com

Overall, I really appreciate how simple it is to look at this company. They put upfront capital to build billions of dollars’ worth of infrastructures, and then everybody in the industry needs to pay the toll charges for the decades to come if they want to use it. The pipelines themselves are a tried and tested technology, and competition is reduced to a minimum.

Historically the company has expanded with a mix of acquisitions and building new facilities. It seems that with the sector largely consolidated or in strong private hands like Berkshire Energy, any future growth will come from building. At the moment, $3.1B of projects are under construction, most of it in the petrochemical segment. The sector is only 14% of EPD’s gross margin, so I assume this is the area where there is room to grow.

This is also the least susceptible to disruption from electrification, renewables, and carbon taxes, so good to see EPD’s long-term vision is not blind either to changes coming in the 2030s and 2040s.

Source: www.ir-west.enterpriseproducts.com

The Financials

EPD has made $32B in sales in 2020, with a consistently growing gross profit margin over the last 10 years, from 6% to almost 20%. Despite that, the stock price has gone nowhere for most of the decade, before being hammered by covid and recovering recently. This means that the P/E ratio of the company has declined strongly, from 32 in 2012 to just 12-13 today.

Source: www.finbox.com

One special characteristic of EPD, as well as most midstream companies in the US, is that it is not registered as a standard corporation. Instead, the company is structured as a Master Limited Partnership (MLP).

These are very special structures that offer some taxes advantages and force the company to distribute most of its profit to the owners/shareholders. In return, they are not required to pay corporate taxes. The details are quite a lot more complex, and you can learn more about it here.

The major problem with that structure is that it will significantly complicate the tax declaration of the owner of shares in an MLP. As every individual situation is different, I strongly recommend you would consult a trusted tax advisor about it before investing a large amount in EPD or any other company with the MLP structure.

This said EPD has a rather impressive track record of cash distribution to its shareholders. 22 years of continuous growth in distribution, mixed between dividends and buybacks when the stock price justifies it. Buybacks have been smartly used, mostly at the moment the company stock was very depressed, including at the height of the Covid panic in 2020.

This smart practice buying back stock at depressed levels is rarely seen in management nowadays and it is refreshing to see being implemented at EPD.

The distribution did not either hinder the company’s ability to reinvest in the future, with 20-40% of cash flow still used to reinvest and grow the bottom line.

Dividends have grown slowly but steadily, and dividend yields have oscillated between 6-15% for the last 10 years. In many ways, EPD stock is acting more like a perpetual bond of the company than a stock. The possible upside of the stock price is a nice bonus if it happens, but the dividend yield is the base return expected by the shareholders.

One last element to look out with capital-intensive industries like this one is debt. A too-large debt or too-high a cost of capital could hurt the company, or even kill it. Hence why management quality and track record are so important. Debt maturity can be a concern too, as most of the company income is stable and occurring far in the future.

The amount is significant, no less than $32B. This is not surprising for a business with a very large capital expenditure, but not a pristine balance sheet either. Half of EPD debt is due in 30 years or more, and 83% of the total debt is due in 10 years or more. This has been a determined strategy of EPD to lengthen the debt perspective, to lock in lower interest rates. This succeeded, as the average cost of debt for EPD has gone down from 5.8% to 4.4%.

This might look small, but on $32B, this represents $450M fewer interest costs per year. With net income at $3.8B, proper management of the debt interest has contributed largely to the company’s net income growth.

All in all, the debt is consequential while not being worrying. Management has protected the company against a rise in interest rates for the next decades. The long life of pipeline assets should also shelter them from any eventual rise in inflation.

Source: www.ir-west.enterpriseproducts.com

Judging Future Risk

I am in general pretty optimistic about EPD’s future, but I think I must still add a word of caution. By being a central piece of the US energy infrastructure, EPD is at the center of the storm about global warming and ESG. We have recently seen the pressure from ESG focused activists affect policies and prospect of some of the Big Oil companies.

For example, Royal Dutch Shell has been ordered by a court to reduce its carbon emissions by 45%. Another example is the small activist investor fund able to grab board sit at Exxon despite owning just 0.02% of the company. Or simply all major banks freezing funding for artic oil projects.

Can it happen to EPD too? Could government, court, or activist force it to redirect its cash flow into a green project? Yes, I think so. I do not think it is likely in the next 5-10 years, but it could happen.

Energy policy is very rarely just rational. You can look at the emotions any discussion about nuclear energy to have a proof of that. Carbon emissions are becoming as politically and socially heavy as nuclear with global warming becoming more and more of a concern.

So, I think that EPD is a great value and probably has a good future prospect. But if the political or judicial landscape change quicker than expected, I might have to reconsider it. Just keep that in mind if you decide to invest in EPD and balance your portfolio accordingly.

Chapter 4: Valuation

When it comes to picking a valuation method, I was split between the equity bond and the discounted cash flow method (DCF).

On one hand, the extreme stability of EPD yields well to the equity bond method. But this valuation method is likely to underestimate any growth potential coming from extra capex and improving moat.

The DCF method takes better growth into account, but with the very unstable multiplier markets have applied to the company, it is a less robust valuation.

So, I think that the equity bond method represents more of a base minimum return EPD should provide, while the DCF is more realistic.

In both cases, I used relatively conservative numbers and a high margin of safety, just to consider the volatility of the energy markets.

The equity bond method gives me an annual return rate of 7%, which is in line with the current dividend yield of 7-8%. Again, I think this is a bit pessimistic as the EPD dividend has increased constantly for the last 22 years.

Free cash flow has increased at the astonishing level of 28% in the last 10 years. I took an “only” 10% growth rate and still get an intrinsic value of $31, to compare to the current $22. By this metric, EPD is really undervalued. I think this is likely considering how out of favor the whole sector is. This also explains why Buffett was so interested in large acquisitions in the sector.

I was curious to see what free cash flow growth would justify the current price, and it turns out that with only 7% of growth per year, EPD price would still be quite cheap and offer a 20% margin of safety.

Finally, I was curious about what a best-case scenario could look like. If the market gives a better multiplier to the company, and growth slows down from the current 28% to 20% and then 15%. This would mean a 29% yearly return rate. I am not saying this is what will happen, but the fact that it could is still very appealing.

Conclusion

When I started my research for this report, I went the other way than usual. Normally I find a company with something promising, a good moat, a cheap price, and dig up from there. This time I went from top to bottom, starting by picking the energy sector and narrowing it down to a specific segment and then a specific company.

I think both methods can work, even if I will probably keep doing the bottom-up approach more often.

Enterprise Product Partner is similar to a utility company but selling at the price of a cyclical at the bottom of the cycle. The price at which is sold is really low, and I am sorry to not have thought about even earlier during 2020 when the dividend yield was 15%. I mostly can thank the general lack of knowledge of the energy sector, ESG, and passive investing for the current mispricing.

EPD benefits from all the strengths of its sector: stable business, stable margins, low cost of debt, strong and reinforcing moat. But it adds to that the right product mix, good management, and economy of scale.

I have no doubt other companies in the energy sector could be a good pick, but if I am looking for exposure to energy and protection from inflation out of gold and other metals, EPD seems like a good choice.

I am not sure what returns I should expect from this stock. A bare minimum of 6-8% from the dividend yield is likely, with some upsides possible. The upside will depend on many unpredictable factors, so I do not know if it is possible to accurately measure it. But if any of the following happen, EPD is likely to provide an extra 3-5% yearly return to the 6-8% base rate:

• Geopolitical crisis in an oil-rich region
• Inflation spiraling out of the Fed control for a few years
• Delays in the green transition
• Reindustrialization of the USA

I do not know if or when any of these could happen. But with the recent withdrawal from Afghanistan, tension with China, money printing, and so on, I expect the next 10 years to be somewhat unstable in one way or another. And I think EPD can help provide some hedge to a portfolio against all of these.

The post Enterprise Product Partners (EPD) Stock Research Report appeared first on FinMasters.

Quick Stock Overview

Ticker: MELI

Source: Yahoo Finance

Key Data

Industry	E-commerce / Fintech
Market Capitalization ($M)	$55,945
Price to sales	5.9
Price to Free Cash Flow	35.9
Dividend yield	–
Sales ($M)	998
Free cash flow/share	$31.38
Equity per share	$32.43
P/E	207
ROIC	9.1%
ROE	16.6%

1. Executive Summary

E-commerce has taken over the world… at least the Western world and China. Other regions are just getting started. Even with the pandemic giving remote buying a significant boost, some areas of the world are only now reaching a point where e-commerce is starting to overtake brick-and-mortar retail.

One such region is Latin America. It is home to 656 million people, double the US population. It is also quickly developing and modernizing.

One company you might have never heard of is dominating Latin America’s e-commerce market: Mercado Libre.

It follows the simple but powerful model of imitating Amazon, while also adapting to the peculiarity of its home market. As a result, it has managed to absolutely outmatch Amazon and its other regional competitors in its home market.

The stock has now cooled off since the pandemic highs. If it was “just” the Amazon of Latin America, it would be an attractive investment, but not more than that. But it is also leading the fintech revolution in a region where half of the population has no bank account.

So Mercado Libre is best described as early Amazon + early Paypal merged into one company, with the potential to grow into THE tech company of the region and become the first LATAM super app.

In this report, we will take a deeper look at what has made the company successful and at its growth potential.

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2. Extended Summary: Why MELI?

The Regional Giant

Mercado Libre has come to completely dominate e-commerce in the LATAM region, which offers one of the world’s greatest growth opportunities for e-commerce.

It has managed to keep out foreign giants like Amazon and eBay, as well as out-compete local alternatives, using a mix of imitation and a talent for solving the problems specific to South America, notably logistics and payment.

Logistics is now a solid moat, and payment has turned into a second profit center with even more growth on the horizon than e-commerce.

Mercado Libre Future Potential

The e-commerce segment is still growing fast and has the potential to do so for the next 10-20 years. The fintech section is highly profitable and growing at 50-60% per year, and is likely to become the source of the majority of net income for the company.

The Mercado Libre ecosystem is the best candidate for creating the first LATAM super app, imitating the success of companies like Alibaba and Tencent in China.

Financials

The company’s growth metrics are impressive, and it is strongly profitable and free cash flow positive. Debt is reasonable. Valuation is relatively high compared to free cash flow and sales, but still at a level that makes sense when taking into account the growth of the fintech segment.

3. The Regional Giant

A Difficult Start

If you would have had to guess where the Amazon of Latin America would be founded, you could have given a few reasonable guesses. Maybe Mexico for its proximity to the USA. Or Brazil, by far the largest country in the region.

You would probably not have expected it to come from is the perpetually dysfunctional Argentina. Since Mercado Libre was founded in 1999, Argentina has defaulted on its debt in 2001 and went through several debt restructurings in 2005, 2010, and 2015. It defaulted again in 2020 and might be headed for another round of hyperinflation.

So really, this is not the sort of economy where you would be expecting x100 returns, which Mercado Libre has already created.

Mercado Libre now has 667 million LATAM visitors per month, compared to Amazon at 169 million and 493 million for ALL its competitors together. Mercado Libre is so dominant that it controls more than half of the e-commerce traffic to platforms in the whole of the LATAM region.

In fact, if you look at the most visited e-commerce websites in LATAM, Merdaco Libre national sites are the top 1, 2, 4, and top 10. It is not only dominating the region as a whole but the market of each of the individual countries as well.

I think the Argentinian origins are a big reason why the stock went off the radar of most investors. Argentinian stocks and horrific investing losses usually walk hand in hand, so most people would not even look at it.

I also think that this is the reason why Mercado Libre has out-competed everyone else. A company whose operations can casually handle currency collapse, poor infrastructure, and impoverished consumers can handle anything. In comparison, even Amazon’s notoriously efficient operations will feel lazy and bloated.

This idea of staying lean and savvy actually made the company survive its earliest war with a much better-funded competitor in DeRemate, and is still fixed in the company’s DNA.

You can see the full story here on how DeRemate would not survive funding drying up in 2000 when the dot-com bubble popped, while MercadoLibre thrived on a shoestring budget. Even then, a focus on organic customer acquisition, word-of-mouth marketing, and high retention rates paid off handsomely.

Mercado Libre went public just as the 2008 financial crisis began. While most growth stocks are always at threat of increased rates or a downturn in the world market, Mercado Libre boomed precisely when the rest of the world was in crisis.

Copying in a Unique Way

I mentioned in the introduction how Mercado Libre “just” copied what worked for Amazon and eBay. In terms of the basic structure of the business, and its obsessive focus on acquiring users and keeping them happy, it is true.

But quickly it also hit the brick wall of Latin America’s under-development in the early 2000s. Very few people had credit cards, and cash was king. That’s a serious issue if you are in e-commerce. On top of it, postal services were not efficient, trusted, or reliable. Poor to nonexistent Internet connections were also an issue.

It was common wisdom at the time that e-commerce could not work in such an environment. It was something only doable in more “mature” markets, where infrastructure, habits, and technology were advanced enough.

Unfazed, Mercado Libre created its own payment system in 2003, Mercado Pago (Mercado Pay in Spanish). It partnered with local shops for people to both take delivery and pay in cash for their online purchases. What started as a necessary measure has evolved into a division as important, if not more than the original e-commerce core.

In 2009, the company would also rebuild its technology from scratch to adapt to the rise of mobile following the appearance of the iPhone in 2007. In general, the company culture seems focused on innovating alone, not relying on acquisitions or external providers. That helps it keep close control over associated costs.

Dealing With Geography

I have mentioned that the postal service in Latin America mostly ranges from poor to nonexistent. The road network can be pretty poor as well, and railroads are almost nonexistent. Much of the region’s population lives in mountainous areas, from inner Mexico to the Andes or the Brazilian Highlands. This means high transport costs.

In the early day in the 2000s, it did not matter too much, as anyway, the Internet infrastructure was limited to urban areas. The first users of Mercado Libre had to be living in cities and be affluent enough to have access to Internet.

Later on, to keep growing and use the exploding development of mobile Internet, Mercado Libre needed to reach remote areas with little logistics available.

Stopgap measures helped, like a fleet of motorbikes for deliveries or local providers. But it was not enough. So the company has spent most of the last 10 years building an advanced logistical network, unique in the region. The effort ranged from a fleet of airplanes to logistic centers to the acquisition of logistic software companies. It also shields it from the risk of post services increasing prices and cutting into its margins.

It allowed Mercado Libre to reach same and next-day delivery rates of 55%, and 80% for 48H deliveries, astonishing performance in the region. Mercado Libre now offers a catalog of 397 million listings, with convenience never heard of before (like 82% of deliveries with free shipping). It’s also generating $32.8B in annual GMV (Gross Merchandise Volume).

At Amazon, I know what the big ideas are: low prices, fast delivery and vast, huge selection.

Jeff Bezos

The Mercado Libre logistics network is also leveraged by thousands of local SMEs that otherwise would be stuck in just their region or even city. Mercado Libre even provides them with tools to build their own website, an online ad service, etc.

I will also say that Mercado Libre has more trust with sellers than Amazon, as it does not sell its own products. There is no risk of Mercado Libre suddenly competing directly with a seller once it found a profitable niche. So it is closer to eBay or Alibaba than Amazon in that respect.

4. Mercado Libre Future Potential

E-Commerce & Logistics

The e-commerce business growth profile is going strong with 10% growth year-to-year in unique buyers, unfazed by the end of the pandemic, unlike e-commerce in many other markets.

More interestingly, this is NOT a South American phenomenon. Brazilian e-commerce revenue for Black Friday in 2022 fell by 23%, reflecting the global post-pandemic dynamics. Mercado Libre, however, increased its gross sales on Black Friday in Brazil by 19%. The company explains it by “the great integration of our ecosystem and synergy with the platform’s sellers“. (More on the ecosystem at the end of this chapter).

Aside from the temporary post-pandemic setback, e-commerce progression in LATAM still has a lot of space to grow. 192 million people have shopped online so far, with the number expected to swell to 350 million in 2 years. This would still leave half of the population having never bought anything online.

From these numbers, we should expect MercadoLibre’s e-commerce business to have at least a decade of rapid growth ahead, maybe several decades:

• Growth of the total market as e-commerce gains popularity in the region.
• Growth in overall consumer spending, thanks to economic development and the “re-shoring” and “friend-shoring” of production away from China.
• Growth in market share, as by now, it is clear that e-commerce has a winner-take-all dynamic in every market worldwide.

Unlike other online businesses, including Amazon, the e-commerce section stands on its own and is profitable with growing net revenues.

Payments (Mercado Pago)

In addition to e-commerce, Mercado Libre has hadits own payment system, Mercado Pago, for 21 years. Its value proposition is easy to understand even by just using Google Translate on the main page (see below).

1. No bureaucracy (LATAM banks are notoriously slow, expensive, and generally unpleasant to deal with).
2. The ability to use your money instantly from your mobile.

The QR code system essentially replaces the need for cash with a smartphone, which most people have all the time with them anyway. Transfers are free and instantaneous. You also can access an international Mastercard for free.

Some security features, like easy changes to ATM passwords or the ability to pause the card from a phone, are also a strong selling point in countries where personal security is sometimes less than optimal.

Users as young as 13 years old can open accounts, a great way to lock in future users as early as possible.

The same convenience allows shop owners to benefit from Mercado Libre’s large user base and powerful cashless payment systems. The result is rapid growth of the payment ecosystem.

If this growth continues for a few years, MercadoLibre might become THE dominant payment system in LATAM. This is a business with a lot of network effects: If enough people have one, every shop on the continent must accept it. If every shop has it, why bother using something else?

This could become a very powerful moat, as Visa and Mastercard show.

Loans & Investing (Mercado Credito & Fundo)

This is a segment I am personally less enthusiastic about. I understand why Mercado Libre would not like to leave the credit potential of its fintech untapped. There is simply too much money to be made by offering short-term loans at high rates.

And for sure, there is a demand for credit for online purchases. So why not capture that market yourself, and offer an extra service to your users?

While that logic is undeniable, it increases Mercado Libre’s vulnerability to downturns, as credit risk is highly correlated to economic conditions and often hard to predict. So the real profitability or risk for losses is always very hard to evaluate.

The credit portfolio has grown very aggressively, more than doubling since last year. The bulk of the volume is now consumer and credit card loans.

The quality of the loans has been stable, and margins seem great. I am not entirely sure the 10% of provision for bad loans is enough, and we will discuss that further in the chapter on the financials.

On a more positive note, Mercado Libre also offers its user what is essentially a short-term fund deposit, Mercado Fondo. This can provide the company with a lot of operating capital at almost no cost. Please note that the 63% yield offer below is actually deeply negative with Argentina’s inflation currently above 90%. So Mercado Libre is in practice getting paid by its users for accessing free working capital.

On the Way to Becoming a Super-App?

Over the last few years, Mercado Libre has started to form a more coherent move toward making its app a fully-fledged ecosystem. The idea is to copy the Asian model of the superapp.

This model increases engagement by being THE go-to app on someone’s phone. Where you do payments, shop, take a loan, and ideally also chat, socialize, get entertained, etc. For many users, the Internet as a whole become synonymous with the superapp, leveraging the addictive power of the smartphone to a high degree.

Mercadolibre does not have (yet?) a social media or chat aspect, but it started to offer HBOGo and Disney+ to its customer. I think the next step should be to venture into promoting video games, e-sports, or other activities of that kind.

A chat system is also an option. If everyone below a certain age already has the Mercado app installed, it would make sense to make it into the LATAM WeChat.

This is rather early, but there is a good opportunity for Mercado Libre to turn into a true Internet giant, and by far the dominant actor in the Spanish and Portuguese world. In that respect, maybe some extension toward the Iberian Peninsula could be an option as well.

Overall, we should expect the ecosystem effect to become more powerful over time. It will also provide Mercado Libre with a wealth of data that it can to make other moves, like improving lending decisions.

5. Financials

Cash Flow & Balance Sheet

Profitability is good, revenues have been on a solid growth trend for the last 10 years, and free cash flow is now truly flowing. There is not much to comment, the picture is pretty rosy here. And this is at a time when most tech companies in the world are firing 5-10% of their workforce.

Mercado Libre have spend $953M on R&D in the last 12 months, compared to $352M in 2020. I am not sure where the money went, but I would suspect data analysis on credit and the ads segment are the new priority.

Overall, the company’s management has an excellent track record. Founder Marcos Galperin is still the chairman, president, and CEO. As long as this is true, I expect the company not to squander its money on fool’s errands. So I would guess this R&D spending to pay off in the future.

The company has some long-term debt, but nothing dramatic. It also has a rather large cash cushion of $2.4B. As long as the cash available is equal to the total credit portfolio, I think we can be somewhat reassured that even a period of poor performance by the credit department could not endanger Mercado Libre. The same is true for debt, especially considering the $1.6B in free cash flow.

I expressed my worries about Mercado Credito, but even if it turns sour, I do not think it could endanger the company in any significant way. Even a tripling of losses to 30% bad debt would “only” involve $600M, or 1/3 of the free cash flow.

Valuation (E-Commerce)

Valuation is always a tricky thing with growth stocks, as so much of the value depends on predictions of what will happen 5 to 10 years in the future. The price-to-sales ratio of 5.9 is not cheap, nor is the price-to-free cash flow of 35.9. The P/E of 209 is even more out of bounds.

So we could say some of the growth is definitely already priced in. If the business was only the e-commerce part, I would suspect this is a fair price, considering the still large untapped LATAM e-commerce potential and Mercado Libre’s dominant position.

But if Amazon taught investors anything, it is that a dominant position in one market can turn into a dominant position in plenty of other markets. So the investment case relies on large part on the potential for Mercado Libre to take over some of the financial systems of the LATAM region.

Valuation (FinTech & Other)

Fintech

The online payment section grew 50% year-to-year. The point growth (new selling points like local brick-and-mortar shops) grew 78% year-to-year. The QR payment system grew at a triple digit percentage.

Overall, the system of Mercado Pago processed 1.4 billion transactions in Q3 22, up 66% year-to-year.

At $1.2B, the fintech segment (Pago + Credito) represents almost as much net income as the $1.46B of the e-commerce segment. The growth rate of the FinTech segment, at 50%-150% depending on the sub-segment, indicates how large the opportunity is and how untapped this market still is in Latin America.

I think this kind of explosive growth is worth a rather pricey valuation. My only reservation is still the Credito segment. It might be incredibly profitable, but it might also turn Mercado Libre into too much of a bank or a credit supplier for my taste. Still, as long as it stay small enough compare to the overall business, it is fine with me.

Future Opportunity

Some of the service providing by Mercado Libre is for now, just the cherry on the cake, like streaming HBO and Disney+. It is still yet to see what will come out of such opportunities and if they will be profitable.

At the very least, they should reinforce the strength of the ecosystem and help boost the adoption of both e-commerce and fintech solutions.

6. Conclusion

Mercado Libre is a success story that will be studied by entrepreneurs and investors for decades to come. It could be tempting to imagine we “missed the boat” when looking at its 100x return since the depth of 2008 markets. I think this is incorrect.

For sure, some of the growth opportunities have been missed already. In the confines of its geographical region, I think the comparison to Amazon is fair. Amazon’s IPO in 1997 at $0.12/share made a lot of people think there was not much opportunity left when it hit the $12 mark in 2012. It would then go on and reach an all-time high of $175/share in 2021.

Can Mercado Libre do as much as another 10x from here? Maybe, but it does not need to do that to still make a good investment. Even if it “only” makes 2x-4x over the next decade, it would still be a great contributor to any portfolio.

Considering a growth rate of 15%-20% for the e-commerce segment, and 50% or more for the FinTech segment, this is an entirely reasonable growth expectation.

Over time, Mercado Libre is probably going to outperform many stocks, driven by the joint forces of regional economic growth, Internet adoption curve, e-commerce growth, and new products and segment launches.

This is an opportunity captured by the superb execution of an experienced leader and his team that have made the “impossible to do e-commerce in Latin America” an everyday reality for hundreds of millions of people. It would be hard to bet against Mercado Libre expanding its dominance in a region where e-commerce and fintech penetration still has enormous room to grow.

The post Mercado Libre (MELI) Stock Analysis appeared first on FinMasters.

Quick Stock Overview

Ticker: BAYRY

Source: Yahoo Finance

Key Data

Industry	Healthcare/Agriculture
Market Capitalization ($M)	$71,274
Price to sales	1.5
Price to Free Cash Flow	26.2
Dividend yield	3.1%
Sales ($M)	48,715
Free cash flow/share	$0.70
Equity per share	$9.12
P/E	64.9

1. Executive Summary

Bayer is a German juggernaut in life science. Bayer is a very well-established company, operating since 1863. The company operates in the agriculture and pharmaceutical sector. It evolved from producing dyes to other chemicals and then pharmaceuticals.

Since 2000, Bayer has refocused its activities around life sciences, spinning off branches involved with plastics (Lanxess AG) and material sciences (Covestro). The sales and spin-off financed the first acquisition of Schering AG, a pharmaceutical company initially pursued by a hostile acquisition from Merck, for €14.6B.

In 2018, the German company merged with the American Monsanto, another leading agricultural business established in 1901. The deal was enormous, $66B, compared to Bayer’s market cap at the time of $88B.

The merger quickly went wrong, with Monsanto getting sued over allegations that its flagship product, the herbicide Roundup, causes cancer. The following negative press led to a crash in Bayer’s stock price and a November 2020 low of a $46B market cap. Today, the market cap of the merged company has partially recovered to $73B but is still below the pre-acquisition value. This compares to the estimated theoretical value of $177B of the combined companies.

The current stock price is explained by the lingering risk of legal action and settlement costs. In this report, I will argue that the market is likely overestimating this risk, ignoring recent developments, and ignoring the long-term strengths of the company’s products and R&D pipeline.

It also ignores the multiple secular positive trends in Bayer’s markets, as well as the dominant positions (number 1 or in the top 3) it holds in them.

The company’s stock has finally started to wake up in the wake of a growing realization of the vital importance of agriculture and food production due to the Ukraine invasion. With food prices rising, agro-businesses are becoming a trendy sector, with fertilizer companies seeing often stock prices up x2 or x3 in just a few months.

By comparison, Bayer stock has still barely gone up, still below its June 2020 levels. I believe that the combination of the following factors will make Bayer a strong buy-and-hold stock for the decade to come:

• Limited future damage from the already partially settled lawsuits.
• Dominance over the agro sector.
• Strong pharma products and R&D pipeline.
• Durable OTC pharmaceutical catalog.
• Secular trends supporting each of the 3 branches (agriculture, pharmaceuticals, OTC).

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2. Extended Summary: Why Bayer?

The Monsanto Acquisiton

By acquiring Monsanto in 2018, Bayer became by far the largest agribusiness firm in the world, dominating the sale of herbicides, pesticides, seeds, and other agricultural products. It also inherited a wave of lawsuits accusing Monsanto’s flagship product of causing cancer. After a stock crash and $16B in provision for damage later, the company is finally seeing the end of the tunnel, with 80% of cases already settled.

The Business Behind the Controversy 

Bayer is a global leader in crop sciences. It is also a profitable and steady pharmaceutical company. It is also the home of OTC pharmaceutical brands like Aspirin, Alka-Seltzer, Bepanthen, and Claritin.

It should become even more dominant in agriculture and keep growing in pharmaceutics from its massive R&D and investment program. Synergies from the Monsanto acquisition are still ignored by markets.

Bayer’s Financials and Valuation

Bayer’s profits are yet to fully recover from the Roundup crisis. Nevertheless, the company is now priced lower than before the $66B acquisition, despite the legal costs being mostly already paid. It is also in a perfect position to respond to the increasing demand for more food production, as well as the ongoing food crisis developing from the Ukraine war.

3. Roundup Of Legal Issues

A Brief History of Monsanto

I must warn you, Monsanto, and by extension now Bayer, is (was?) something of a caricature of the “evil” corporations as imagined if you are leaning left politically. I will refrain from giving my personal opinion about Monsanto and simply declare that indeed, some of Monsanto’s past actions are dubious. It was involved with various toxic (or used in overseas wars) and now banned products, like DDT, PCB, white phosphorus, and Agent Orange.

In more recent years, the company refocused its chemical expertise toward agricultural products like herbicides and pesticides, as well as GMOs (Monsanto was the first to create a GMO plant in 1983). For some people, this might make Monsanto extra evil. As a former plant biochemist before I studied financial analysis, I am rather favorable to GMOs as long as the right precautions are taken. They can drastically reduce the use of dangerous chemicals, and the gene modifications are not so different from other ways to create new varieties. But again, I can understand the discomfort that many people have with the topic.

Many investors might feel that Bayer is not an ethical investment. Still, I would like to play the devil’s advocate, and discuss the benefits of modern agriculture. The last decades have seen the world population exploding. Despite that, hunger and starvation have generally receded, even if not fully eliminated yet. This was largely due to steady growth in crop yield for staples like potatoes, maize, rice, wheat, soybeans, etc…

Contrary to common misunderstanding, such progress was not easy or just the result of fertilizer application. The Green Revolution is the only reason why the apocalyptic predictions of the 60s and 70s happened to be wrong. Notably, Paul R. Ehrlich, in his 1968 book The Population Bomb, said that “India couldn’t possibly feed two hundred million more people by 1980“.

Between 1975 and 2010, the population of India doubled to 1.2 billion, reaching the billion mark in 1998. The 1,352,642,280 Indians alive today have companies like Bayer and Monsanto to thank for proving Ehrlich wrong.

Many agricultural chemicals are inherently somewhat toxic. This is true for herbicides and pesticides. But I would argue that the chemicals which powered the Green Revolution have saved a lot more lives than they killed. And if properly used, their dangers can be managed.

Glyphosate’s Magic and Dangers

The Magic Crop Yield Booster

If you know something about farming or gardening, you know that keeping a crop alive and optimally growing is a constant war against weeds. Other plants would like to use the soil and sunshine and replace our corn, bean, or wheat crops. Applying herbicide is always somewhat tricky as you want to kill the weed, but not the crop one centimeter away, and chemical molecules generally don’t care about the difference.

This is why glyphosate and GMO glyphosate-resistant plants were such a game-changer. Monsanto discovered glyphosate in 1970 and started commercializing it in 1974. It was a powerful herbicide that quickly became one of the most used herbicides in the US and the world. Commercialized under the Roundup brand, it produced a significant portion of Monsanto’s revenues.

This is when plant genetic modification came into play. By inserting a gene in a plant, making it resistant to glyphosate, Monsanto created corn, maize, cotton, and other crops that are insensitive to the herbicide. This allowed the free use of the herbicide in the field during the growing season, keeping the land fully utilized by the crop and not the weeds. Overall, GMO crops, glyphosate-resistant, and other GMOs created a jump in yield from 6%-25% depending on the country.

The Dangers

The problem with glyphosate was not its efficiency, but its toxicity. While toxic in high concentrations, glyphosate had been deemed safe for use in fields by regulatory agencies. Most notably, it was declared “not likely to be carcinogenic to humans.” by the EPA.

Nevertheless, doubts remained about the link between cancer and the controversial herbicide. Virulent opposition to the type of intensive farming it empowered made the debate extra partisan, as GMO plants and herbicides are viewed by many as evil in themselves.

Nevertheless, upon further investigation, significant doubts persisted and it is now admitted that at least some level of exposure is likely to increase the risk of cancers. You can learn more about it from Bayer here.

Court Cases & Consequences

Just when the acquisition by Bayer was closing, Monsanto lost a lawsuit in June 2018. A 42-years old had got himself covered in Roundup after a malfunction of his sprayer. He later developed non-Hodgkin’s lymphoma. The courts considered Roundup was a likely cause and awarded the plaintiff $289M. This was followed by quite a few other lost trials.

Quickly after, the number of plaintiffs swelled dramatically, reaching up to 125,000 people. Obviously, if each of these cases was awarded tens or hundreds of millions in damages, this would be much more than Monsanto-Bayer could ever pay. So instead of valuing the merger’s synergies, markets started to value the company as a dead man walking.

4 years later, the situation and risks are a bit clearer. 100,000 lawsuits have been settled, for a total of $11B. This leaves roughly 25,000-30,000 lawsuits left. The court case is now likely to involve the Supreme Court. Bayer has already put aside $16B to cover the claim.

Will $16B be enough? I consider it nearly impossible to put certain probability or cost on the leftover cases. Previous settlements put the average lawsuit cost at $110,000, so leftover claims would be $3.3B. Bayer provides its side of the trial and its plan to end all future litigation here.

And I am not a legal expert, so I will not venture into judging the fairness of these court cases. I however believe a historic parallel in financial history can be illuminating: the history of cancer trials against tobacco companies.

“The first big win for plaintiffs in a tobacco lawsuit occurred in February 2000, when a California jury ordered Philip Morris to pay $51.5 million to a California smoker with inoperable lung cancer.”

Nolo.com

The situation was similar, with an initial big win by the first successful plaintiff seemingly indicating a cost so high it would for sure destroy all tobacco companies. Similar claims of manipulation of sciences, willful misinformation, and failure to warn the public were made as well.

In that situation, you could expect tobacco companies to have been terrible investments in the last 2 decades, right? So why is Altria, one of the largest tobacco companies, #24 in the rank of the “best 30 stock in the past 30 years“?

The fact is that the cost of the trial was grossly overestimated and the persistent demand for tobacco products was grossly underestimated. This resulted in tobacco companies being consistently one of the best possible investments for the last decades, sitting neatly together with Apple, Alibaba, Berkshire Hathaway, and Tesla.

I suspect the situation is similar for Bayer when it comes to litigation costs. The company has settled 80% of the cases for $11B. I imagine the $5B leftovers in provision should be approximately enough to cover the rest.

Don’t get me wrong, I think the company should pay up if it did wrong and caused cancer. But contrary to tobacco companies, it did not provide a toxic, addictive drug and hide the risk. It provided a very useful product key in keeping worldwide famine at bay, that after review by the EPA was considered to be not carcinogenic. Bayer’s main products, seeds, pharmaceutical treatment, and aspirin also do not cause cancer. So the business model as a whole was never in danger, contrary to that of tobacco companies.

Overall, I think most of the damages by the Glyphosate/Roundup trials are already done. Former shareholders of Bayer have paid for it. Newcomer investors will just get a great company at a discount if they are ready to brave the incertitude of the last 20% of cases not settled yet. So how strong is the rest of the company? This is the topic of the next chapter.

4. The Business Beyond the Roundup Controversy

Bayer’s Agricultural Dominance

Growing food is a complex business. It requires the right seeds, pesticide, herbicide, insecticides, fertilizers, irrigation, tractors, soil, rainfall, etc. Currently, the crop sciences department is roughly 45% of Bayer’s sales and EBITDA.

The company is also the uncontested leader in this sector. Margins are solids and also the highest among the other industry leaders.

It is #1 in market position for corn and soybean seeds, #1 for herbicides, #2 for vegetable seeds and pesticides, and #3 for insecticides. The business is truly global, with an equal split between EMEA, Asia, North America, and South America.

Most farmers of key crops trust and rely on Bayer products for their next harvest. In a business vulnerable to drought, flood, storm, machinery breakdown and market fluctuation is it very important to know that at least risks from seed quality, pest control, and weed control are predictable. This means that farmers will not easily change suppliers or try other products, and will instead stick to what worked so far.

While Roundup does not make up the totality of the Bayer herbicide line, it is a large part of it. So it is important to check if the worst-case scenario of a ban on the product could lead to problems. Herbicides are a large segment of the crop science division, but still only 25% of the whole (and so 10% of the company’s total sales only). Overall, Bayer could take a hit up to 5% of total revenues from a total, worldwide Roundup ban, but it would not be dramatic.

Following the FAO projections for 2050, in 30 years we will need 50% more agricultural production (food, animal feed, and biofuels) while compensating for a 20% reduction of arable land by capita and 17% harvest loss from climate change. This leads to a 100% jump in crop demands at least. And this was before geopolitics threw a wrench in the world’s food supply. We can look at the recent response to the Ukraine war from wheat prices vertically rising to see how unstable it could be during worsening shortages:

The last time food prices spiked up this much, they triggered the Arab Spring revolutions, destabilizing the entire region. Bayer expects consistent sales growth at 3-7% until 2024 depending on the product categories. And again, this forecast was before the current looming food shortage from war and embargo.

Another factor that is still developing is the synergy between Bayer and Monsanto. Bayer used to be most dominant in Europe, while Monsanto was dominant in the USA. They also had no large overlap in crop type (Bayer with a focus on cereals, Monsanto on corn). By leveraging each other’s sales and distribution networks, it is likely that both Monsanto and Bayer products will achieve higher market penetration in both USA and Europe.

The growth will be driven by both the general market growth and new product lines, notably insect and herbicide-resistant soybean, short-stem corn, RNAi insect-resistant corn, etc. Overall, Bayer has 500 new varieties of corn, soybean, cotton, and vegetables in preparation. Of which 5 new traits (like new resistance to specific insect species for example). On the chemical side, 300 new crop protection registrations are awaiting approval.

The superior market position and margin have allowed Bayer to outspend its rivals on R&D, with a total investment as high as its next 2 largest competitors. The flood of new seed, resistance, and crop protection products is evidence of that R&D dominance.

The Pharma Business

With all the talk of Roundup trials, seeds, and pesticides, the crop science division takes the spotlight away from the equally large pharmaceutical component of Bayer. The company has a diversified portfolio, with a focus on cardiovascular and women’s health.

The sector is attractive, with high margins and long-term positive trends. The aging population, rising access to healthcare in the developing world, and digitalization are all trends supporting the pharmaceutical business.

The near-term future of the company will be affected by the loss of exclusivity (patent expiring) of its flagship product, the anti-blood clot drug Xarelto. The company is forecasting a decline in sales during that period before the new product lines arrive in the market and restart growth.

Xarelto’s decline might even be less dramatic. Finding new use cases or getting approval for a new type of patient is a classic way for pharmaceutical companies to extend the value of expiring patents. New applications extending the exclusivity might still increase Xarelto’s residual value, like the recent US approval for the treatment of children and the 2 years extra of patent protection by the EU for the 1/day formulation.

Around 5 products (2 cancer drugs, 2 cardio, and 1 women’s health) are expected to come into the Bayer treatment portfolio, with an average Peak Sale Potential (PSP) of $1B on average. PSP represents the estimated peak maximum annual sale for a product (most pharmaceutical products will be covered by a patent exclusivity for 10 years or so). Interestingly, Nubequa’s PSP has recently tripled to $3B. You can see more about the approval of these new drugs on the news section of the Bayer website, notably Vitraki in China, Kerendia in Japan, and the EU.

The company is also investing heavily in long-term R&D and technology able to create new classes of treatments, like RNAi, RNA-SMOLs, PROTACs, AI, gene therapy, and cell therapy.

The pharma division is likely to somewhat stagnate for the few years ahead, but should not experience negative impacts either. It is likely to bring value only from the 2026 period onward when the most innovative treatments like gene therapy and RNAi enter more advanced stages of clinical trials for yet incurable diseases.

Over-The-Counter (OTC)

Bayer’s pharma division covers patented drugs used under medical supervision. The OTC or Consumer Health division produces drugs you can buy without a prescription, very often older with a patent that expired a long time ago. This means that any pharmaceutical company can manufacture the active molecule and sell it. This does not mean that branding and marketing cannot help the legacy products to continue dominating the market once the patent is expired.

The OTC department, or Consumer Health, is managing the sales of such products. You are actually likely to know some of Bayer’s products and have them in your medicine cabinet. Many are old drugs with a stable market and faithful customers. The staying value of OTC brands is best illustrated by Aspirin, around since 1898. There are plenty of functionally equivalent pills of acetylsalicylic acid, but only one Aspirin. Most people are fine paying $0.3 extra more for the “real one”.

Here too, Bayer is among the top players worldwide, notably #1 in Cardiovascular OTC products (likely building on the expertise and reputation of its pharma department) and #2 in Nutritionals and Dermatology. Allergy, digestion, and pain raking are pretty good too.

To keep growing the OTC segment, Bayer is looking to boost the higher margin e-commerce sales from 7% in 2020 to 15% and more by 2024. It was just 3% in 2018, so the growth target feels reasonable, especially with the pandemic having boosted online adoption.

Consumer health is a slowly growing business, at 3-5% per year. Additional growth might come from new markets like China, India, and SE-Asia, as Asia represent only 13% of OTC sales at the moment.

Inter-Division Synergies

At first glance, it can feel that Bayer is 3 different companies grouped together without much coherence. But this is ignoring that biology & medicine are not separate fields. When Bayer develops new technology or insight about RNA, it can be used to create RNAi maize, resistant to a specific type of fungus. Or it can work on new RNA-SMOLs technology to develop a whole new drug category. More importantly, the ideas and challenges of the plant team might help the progress of the pharma team.

At this level of technicity/abstraction, the best researchers for both agro and pharma divisions have similar profiles. An expert on organic chemistry can work in both fields. So a strong HR department able to find/poach them for both divisions at once will come in handy.

Similarly, producing a massive amount of a specific chemical, be it aspirin or Roundup, require strong in-house technical skill. The scale of operation also helps with cheap and efficient procurement of the required pipes, curves, bioreactors, and other advanced pieces of equipment needed to run chemical plants.

And last but not least, the merging of the different branches allows sharing of the corporate overhead costs. For a life science company, this is not only the offices, the headquarters, and the accounting department. The sector is highly regulated and requires a lot of legal expertise. So these synergies also cover the legal teams, lobbyists, regulatory affairs, medical marketing department, medical representatives, pharma representatives, clinical trials, toxicology, etc.

There have been calls by investors to split the company into its parts for years. That might create value for shareholders in the short term but I suspect that as a long-term shareholder, you might be better off if they stay together.

Partnerships & Venture Capital

Digitalization is the last aspect where Bayer divisions work well together. I mentioned personalized medicine, and access to medical data will be an important aspect of consumer health in the future.

This is equally true in agriculture. With the Bayer-Microsoft partnership that just got signed, Bayer will leverage Microsoft Azure cloud technology to power their agricultural technology revolution and provide a framework for companies working with agricultural data. This includes data on crop yield, satellite imagery, carbon emissions, farm supply chain, and much more.

Another partnership with a tech giant was the collaboration with Alibaba on the use of blockchain in agriculture.

Another project is the first digital agricultural marketplace, in partnership with Bravium, a Brazilian marketing agency. These are still in the early stages, but they are examples of the potential Bayer’s scale can create.

Bayer’s investment in innovative solutions for agriculture and health does not stop there either. The Leaps by Bayer program invests in a multitude of startup and tech companies in these fields.

You can see the full portfolio here, including drone cop spraying, vertical farms seeds, soil mapping, carbon capture, mental health AI, stem cells therapies, machine learning drug discovery, AI-assisted diagnostic, or a biotech startup incubator in Israel.

Studying the venture investment portfolio of Bayer could probably be a full report in itself. For now, let’s consider it as a cherry on the cake on top of the core businesses.

5. Financials

Balance Sheet

Considering how troubled the Monsanto acquisition was, this feels like a good start for studying Bayer’s financials. The acquisition increased the company’s net debt drastically, from almost zero to €35B. Considering it also came with almost €20B worth of litigation costs, this was a very expensive acquisition.

This increased the leverage of the company, in a similar way to what previous successful acquisitions did, like Schering in 2006 and Merck OTC product line in 2014. What changed this time is that Bayer failed to quickly work on reducing its leverage right after.

The tens of billions of euros put aside for litigation were presumably money initially intended for reducing debt. Now that only 20% of lawsuits are left and a large cash allocation is in place to cover them, the threat of excessive debt can be reasonably treated as minimal.

2022 Outlook

After an okay 2021 year, 2022 is expected to bring growing earnings per share and free cash flow. This would bring the free cash flow toward a more normal, pre-crisis level, even if there is still a long way to go.

On a side note, Bayer just announced it will also get extra cash from selling its non-crop business, like forestry, for $2.6B. This should reduce the net debt by 10% and help focus the company’s agro division on farming only.

Valuation

With a current price to free cash flow ratio of 26, Bayer seems fairly valued, but not cheap. Of course, if its free cash flow would return to just 2019 levels, this would more than halve this ratio and make it very cheap for a growing company of this size. But this is hope and hardly constitutes a margin of safety. The current 3% dividend yield is equally nice to have, but not enough by itself. The extra costs from the Roundup trials are obscuring what real profitability might be.

I think where the company shines in the value of its assets. Remember, both pre-crisis Monsanto and Bayer itself were worth as much as Bayer’s market cap today. Essentially, markets are valuing the new Bayer as if the Monsanto division was entirely worthless.

We are slowly sliding into a global food crisis while I am writing this report. Grain and oil exports from breadbaskets of Russia and Ukraine threaten to be poor to non-existent. But you also have Serbia, Bulgaria, and Hungary banning grain exports. Argentina is limiting exports of soy. Indonesia, producing 1/3 of the global cooking oil supply, just banned all palm oil exports as well.

Considering the broader context, I think Bayer agribusiness is undervalued. Especially considering that governments all over the world are likely to start subsidizing fertilizer/pesticide/herbicide/seed purchases to keep yield up and social order stable. The combination of Monsanto and Bayer’s pre-existing crop business will be at the forefront to keep yields up and starvation at bay.

I expect this change of context to also change Bayer’s perception by the public, politics, and investors. We observe a similar phenomenon with fossil fuels. In October 2021 at the Cop26 conference, they were evil and “with no future“. Only 6 months later, Western leaders are making desperate pleas for OPEC to increase production. Shortages of vital commodities have a way to make everyone a hardened realist quickly.

Besides the agro-business, Bayer pharmaceutical sales, OTC sales, and venture investment all have significant upside potential. R&D spending and startup investing have stayed steady and created a massive pipeline of new products in both medicine and agriculture.

At the current price, you get a growing blue-chip company at a reasonable valuation. Any extra upside or positive surprise comes “for free”:

• Smaller costs than expected for leftover RoundUp cases.
• Synergy from fusing together of Monsanto & Bayer sales network.
• R&D success from Monsanto & Bayer research projects merging.
• Larger than expected addressable market from drugs in development.
• Prolongation of existing drug patents through new applications.

6. Conclusion

Bayer is a complex case study. The Roundup trials make it looks, on a surface level, like a tobacco company. This actually would make a good case for investing in it considering the tobacco sector’s track record, but might still scare off most investors. It is also a successful pharmaceutical company solving life-threatening ailments. And it is a household brand of consumer products, holding onto century-old brands like Aspirin.

I think the company’s scope and complexity are what lead investors to reduce it to a simpler, but inaccurate narrative. “Bayer the pharmaceutical company” became overnight the “Roundup/cancer trial company“. I would not be surprised in 2022-2025 to see Bayer becoming the “food growing/crop yield company” while the shocks of the Ukraine war still echo. And maybe, later on, the “growing pharmaceutical company” back again, going full circle in narrative over a decade.

After the lows of the last 2 years, Bayer stock has started to rebound. The fading away of out-of-control trial settlement risks is the first catalyzer for a re-pricing. The food crisis and a global realization of the importance of basics (food energy, defense) over the superficial (software, media, etc.) is the extra catalyst to power this turnaround.

In previous reports, companies have been presented as belonging to a firm investing category and strategy. But Bayer resists this categorization.

• It is a growth company, compounding steadily through R&D and acquisition for over a century.
• It is a defensive stock, a pharmaceutical blue-chip with high-quality patents and century-old OTC brands.
• It is a deep value asset play, with unloved, ignored valuable assets.
• It is a turnaround story, emerging from the Roundup crisis not nearly as damaged as everyone assumed.
• And it is a macro/geopolitical play, capitalizing on worldwide dire demand for higher and reliable crop yields.
• It is a leading AgriTech and MedTech incubator for groundbreaking technologies.

I think this has left many investors confused and not daring to try to understand such a complex situation.

As I see it, a company that is simultaneously undervalued, turning around, growing, and carried by geopolitical tailwinds seems like an interesting bet on the future.

Even if some of these angles about Bayer turn out wrong, we just need a few to be right at current prices. Of course, only time will tell.

The post Bayer Aktiengesellschaft (BAYRY) Stock Analysis appeared first on FinMasters.

1. Executive Summary

For a long time, discussions about energy were focused on carbon emissions and global warming. With a brutal energy crisis engulfing the world, and especially the EU, it gets more evident by the day that reliable, cheap, and low-carbon energy is more needed than ever. This gives nuclear energy a chance to grow again and make outstanding profits.

In addition to this macro environment, new technologies are being developed. A new type of reactor is promising a modular, flexible and safer design. They will also be built quicker and with much smaller upfront costs, two of the main constraints on developing new nuclear power plants.

The entire industry is turning to this new technology. The companies featured in this report are at the forefront of this revolution in a long-stagnant industry:

• One is the most trusted supplier of nuclear reactors to the US military.
• One is the startup that first moved to make this technology a reality and is likely to be the first one to deploy it.
• And the last company is at first glance a simple, “boring” utility. But it will also be the first one in Europe to deploy this new technology and have an ambitious plan to double its nuclear power production in the next decade.

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2. Extended Summary: Why Invest in Nuclear?

Nuclear Power History

Nuclear power history is one of crisis. From a boom in response to the 70s energy crisis to crashes with Chernobyl and Fukushima. A new boom is likely, with the current European energy crisis unfolding. This might make the industry the new focus on an investing community that ignored it so far in, preferring renewables and green tech like EVs.

Industry Overview and New Technologies

The industry is roughly separated between manufacturers (making the reactors), utilities (operating the reactors) and uranium miners. New types of reactors are coming to the markets. The most interesting technology is SMR (Small Modular Reactor). It promises to alleviate most of the inconveniences of traditional nuclear reactors (size, upfront costs, safety profile).

A Selection of Nuclear Companies

This report covers 3 different companies: BWXT, a military nuclear reactor producer, NuScale, an ambitious startup looking to make SMR the standard template for the nuclear industry, and Nuclearelectrica, a European utility selling at an attractive price.

3. Nuclear Power History

A Controversial Past

Nuclear energy is a complicated topic. It triggers a lot of passions, fears, and hope. It is a very technical industry, with technology truly understood only by experts. It also carries a heavy emotional load, from its association with doomsday nuclear weapons to the trauma of the Chernobyl incident and its nuclear fallout all over Europe.

The idea of nuclear power was initially welcomed with overwhelming enthusiasm. You can read almost any novel by Isaac Asimov for an idea of the hopes put on nuclear energy as soon as the 30s. Literally, every vehicle or gizmo is nuclear-powered in the novels of the grandfather of science fiction.

When engineering caught up with science fiction, it triggered a massive build-up of nuclear power plants in the 60s and 70s, most notably in the USA, Russia, and France, but other developed economies as well. The 70s inflation and oil crisis (through the OPEC embargo) seemed to confirm the advantages of nuclear over geopolitically vulnerable fossil fuels.

The gradual realization of the dangers of radioactivity soon created a small, but very vocal opposition to nuclear power. Initially welcoming the alternative to coal mining and oil, ecologist activists and Green parties turned against nuclear and are still to this day massively opposed to the technology. The incident at Three Mile Island increased the fear of a serious nuclear incident one day.

But for the wider public, the turn of opinion was in 1986 when the Soviet Chernobyl nuclear reactor exploded. This dispersed highly radioactive compounds all over Europe. Suddenly, from cheap and safe, nuclear power plants acquired the image of a ticking time bomb. Four decades of fearing a post-apocalypse nuclear wasteland did not help either.

This led to essentially freezing of new projects, except in small parts of the world where local politics justified continued investment in nuclear, notably in France. During that period from 1986-2011, nuclear power was very slowly coming back in favor as fossil fuels became accused of putting the entire planet and its climate at risk. Wind and solar might one day be enough, but nuclear was perceived by many as a possible “transition” solution. And Chernobyl was now getting blamed on antiquated technology and Soviet corruption more than nuclear power as a whole.

In 2011, a historic earthquake and tsunami devastated Japan, notably the power plant of Fukushima. This immediately reawakened the fear of the Chernobyl incidents and led Japan to stop all nuclear power plants in the country. It put in motion a plan by Germany to phase out all nuclear power as well.

The Growing Energy Crisis

The world is currently short of fossil fuels. The crisis had been brewing for a while, due to a combination of factors :

• No discovery of mega oil & gas fields to replace aging resources like Saudi oil.
• Low oil prices in the 2010s due to short-lived, but abundant overproduction by US shale oil.
• ESG pressure to switch to renewables, cutting funding to oil & gas exploration.
• Political pressure to reduce carbon emissions as soon as possible.
• ESG and political pressure and low prices led to historically low capex in the energy industry.

This report will not try to pit renewables versus fossil fuels. We have covered before companies working in energy, from Brazilian hydropower Copel/ELP, fossil fuel Argentinian Pampa Energia and American Enterprise Partners, to American renewable Brookfield.

The fact is, for now, the sun and wind cannot fully replace fossil fuels. This is due to the intermittency of renewables, and simply the sheer gigantic and growing demand for energy in the world. But keeping fossil fuels is barely an alternative when global warming is judged an imminent and existential crisis. Alternatives like nuclear fusion of commercial geothermal are still decades away.

On top of this, geopolitics made a bad situation worse. The war in Ukraine is echoing the 70s oil embargo by Opec countries. Europe is now desperate to try to find enough energy for next winter. It is preparing for anything between blackouts to complete economic collapse.

I singled out Germany in the above headline because this is the EU country that has both the largest energy-intensive industries (heavy manufacturing, chemicals, etc…) and have been the most aggressively turning toward renewable.

This is also the country in Europe the most opposed to nuclear power. Look again at the recent headlines above. Despite this gloomy outlook, Germany shut down 3 of its 6 nuclear power plants in January 2022. And insist on stopping the last 3 by the end of the year.

Germany has maintained it will switch off its last three nuclear reactors by the end of the year despite a senior EU official urging the bloc’s biggest economy to rethink.

Source: MSN.com

Turning Tides for Nuclear

Even just 1 or 2 years ago, Germany’s plan to phase out nuclear was eventually criticized for being too quick, but that was it. But since the largest energy crisis in the history of the EU, the discussion has changed. The neighbors of Germany are trying their best to make them keep nuclear production.

The EU is not an organization known for its quick-acting or pragmatism. It is however able to realize when a problem is getting really too massive to ignore. As a clear sign of growing desperation, the EU has reclassified nuclear energy (and even gas) as “green” energy.

So far I mostly spoke of the EU because this is where the change is the most dramatic and the need the direst. For example, Poland is looking to acquire 4 to 6 last-generation reactors (EPR) from France. The same France that will build 14 additional reactors for itself, instead of mostly closing them like planned 1 year ago. The UK is now planning one new nuclear plant per year.

The rest of the world is doing the same, signaling a global turn of events not limited to Europe.

South Korea has restarted the construction of 2 new reactors. It is also South Korea that is producing the UAE’s first nuclear reactors.

Japan is also turning back to nuclear since Fukushima. 9 of the 39 reactors have already been restarted, and the rest is now expected to be restarted as soon as possible, notably because LNG prices are at a record high.

India is aiming to triple its nuclear capacity in the next 10 years.

But the elephant in the room is, like often, China. The latest energy plan of the country is to build no less than 150 nuclear reactors in the next 10 years. The decision was announced last November, and one can wonder if news of the incoming Ukrainian war did not precipitate this outsized renewed enthusiasm for nuclear power.

4. Industry Overview and New Technologies

Investing in the Nuclear Industry

The sector can be separated along the nuclear value chain, from fuel production to electricity generation.

Manufacturers

When it comes to nuclear technology, investors are offered a somewhat limited set of options. Many major actors are state-owned companies without public listing. Nuclear power plants use a lot of components supplied by major engineering companies, like Siemens for example, but often the nuclear segment is just a fraction of the company’s activities. Still, some companies are available, and one of the companies in this report is a manufacturer of nuclear reactors.

Utilities

Another way to invest in nuclear power is to invest in utilities producing power through nuclear plants. This will be especially true if the utility company is focused solely on nuclear power plants. One of the companies analyzed in this report fit this mold.

Uranium

The last option is to bet on the fuel used by the power plants to rise in price. #Uranium has been a trendy topic on FinTwit (financial Twitter) these last months, but I stay relatively unconvinced. The argument is based on the rising popularity of nuclear. With uranium fuel just 1-3% of total costs, utility companies are not really price-sensitive when it comes to uranium.

Of course, if a lot more reactors are built, demand will grow. But supply is also likely to catch up. And as a reactor can take 10 years or more to be built, the demand will rise at a steady, but slow pace, possibly several years in the future. In addition, uranium is barely traded on the spot market like other commodities. Instead, long-term contracts and stockpiles mean this is a very hard-to-trade market.

The sector is dominated by 2 companies, Kazatoprom and Cameco.

The first one operates in central Asia and carries a very significant geopolitical risk. It is cheap, but it ties to Russia and arguably justifies it.

The second one is in Canada but has historically struggled with profitability and with delivering good returns for its shareholders. Other miners are much smaller, with plenty of junior exploration companies hoping to join the boat of the nuclear renaissance.

The last option for uranium investing in the Sprott Physical Uranium Trust. It is a trust holding its asset in the form of uranium fuel. The idea of the Trust is to stockpile uranium until the price is right, then sell and distribute the profit to its investors. It might work, but this is mostly for speculation more than investment purposes.

For all these reasons, this is why this report does NOT include uranium itself as a possible way to invest in the comeback of nuclear energy.

Nuclear Innovation

Another possible investing strategy is to bet on innovation. Already, the new EPR (Pressurized water technology) and other Generation III+ reactors are miles ahead in terms of efficiency and safety compared to older designs like the one at Fukushima.

Out of the public gaze, a new generation of engineers have looked at “classic” nuclear power plant designs and have found them lacking. Flaws of classical nuclear power plants are:

• Every new reactor is designed from scratch.
• Large construction projects are plagued by delays and over costs.
• Uranium is not the ideal fuel and other materials could be used as fuel.
• Smaller designs are inherently safer.

Thorium Reactors and Other Designs

I will no go into the technical detail, but the short version is that uranium is not really the optimal fuel for nuclear power generation. The reason it came to dominate the industry is that it was useful to the military nuclear industry. While in the Cold War, this was viewed as a pro, this is very much a downside nowadays.

An alternative is thorium, another radioactive element. You can check here a more detailed discussion about thorium advantages, which include less nuclear waste, inherently safer reactors (no meltdown possible, as the reactor, cool down spontaneously), abundant resources, and no risk of using its byproduct for nuclear weapons.

Early design goes back to the 1960s. China is the current leader in the field, notably building waterless thorium designs that can be used in deserts with a high safety profile.

Other Designs

Over the decades-long history of nuclear power, many other designs have been tested. One with a lot of potential is fast breeder reactors. Their main advantage is the much more complete use of nuclear fuels. This means it could use the nuclear waste of traditional plants.

Unfortunately, most of those are decommissioned old designs, prototypes, or done by public companies that cannot be invested in. This design nevertheless solves in large part the problem of nuclear waste, so I thought it was worth mentioning it.

Small Modular Reactors (SMR)

This is the most interesting innovation in the nuclear industry in decades. The idea of SMR is to miniaturize a reactor down to the size where it can be transported by a truck in a freighting container.

This gives SMRs multiple advantages:

• Modularity: if you need more energy, just add more reactors.
• Higher safety: due to size and design choice, SMRs are almost always self-cooling. An accident like Fukushima or Chernobyl is impossible with SMRs.
• Production at scale: Thanks to their size and standardization, SMRs can be produced in the same way we make a truck or a car: in an assembly line, with mass-produced components assembled hundreds of times in a row. No more engineering headaches from reinventing the wheel at every new reactor building site with its own design.
• Decentralization: a few SMRs can be used to power operations in remote areas or energy-hungry industries. This might power charge (pun intended) the electrification of mining operations and heavy industry.

While thorium or fast breeder might have a space in the industry, SMRs are widely viewed as the future of the industry.

Poland, eager to get a safer energy supply and independence from Russia, is leading the charge, notably with KGHM (a copper producer) and Orlen (an energy and fuel producer).

5. A Selection of Nuclear Companies

Now that we are done with the explanations, let’s start with the actual investing.

I hope this was not too lengthy, but at the same time, I felt it was needed to give enough context to explain:

1. Why nuclear power is attractive again, now that the political and macro-economics winds have turned.
2. What sectors in the industry are the best opportunities.

We will look at 3 companies I feel offer a wide enough pannel of opportunity and investment profiles:

The first company is BWX Technology, a nuclear reactor producer. The company is deeply intertwined with the military reactors industry in the USA. In addition to its military and civilian activities, it is also developing its own SMR.

The second company is NuScale, a widely ambitious startup solely focused on SMRs. There are actually many other such startups, but few are as advanced as NuScale or publicly traded.

The last company is Nuclearelectrica. This is the utility in charge of nuclear power generation in Romania, trading at an attractive valuation and with a generous dividend yield.

Together, these companies offer the possibility of investing in nuclear for any portfolio and investment strategy. BWXT is a more established and “safe” company, NuScale a bet on growth and innovation with large potential, and Nuclearelectrica a steady, “boring” dividend/income stock.

5.1. BWX Technologies (BWXT)

Quick Stock Overview

Ticker: BWXT

Source: Yahoo Finance

Key Data

Industry	Nuclear/Defense
Market Capitalization ($M)	1,041
Price to sales	3.4
Price to Free Cash Flow	100
Dividend yield	1.6%
Sales ($M)	2,127
Free cash flow/share	$4.23
Equity per share	$7.24
P/E	17.5

BWTX is a well-established actor in the nuclear industry, with 6,700 employees and 14 sites in North America.

The company is largely focused on nuclear power for the government. This includes military nuclear reactors to power ships like submarines and aircraft carriers. So this is as much a defense stock as a nuclear one. Notably, BWXT is the only actor besides the government with authorization to manipulate highly enriched uranium (20%+, potentially usable for nuclear weapons).

The main attraction of the company is the quality of its investing moat. The firm is fully aware of it and has even a neat diagram synthesizing all of their advantage making the company a very “moaty” high-quality business:

The Military Opportunity

Jobs for the military offer extraordinarily high visibility to BMXT on future cash flow. This is the first time I see a company offering in its presentation the upcoming maintenance and upgrade contracts up to 2052; notably for Ford-class aircraft carriers and Virginia and Columbia class submarines. This is a steady source of business, as the US navy is planning to grow from 293 ships to 335.

BWXT is developing its own range of SMR and micronuclear (even smaller scale than SMRs) technology. Its connection with the US government gives it a unique position to land contracts with NASA or the military (Including the Space Force).

Off-grid supply of energy to military facilities has been a long-time logistical headache for the military. BWXT will be offering solutions to alleviate the costly and military vulnerable supply chain of fuel and gas to military bases. This is also in line with the goal to slowly go fully electric for military vehicles in the next decade.

Considering the high reputation of BWXT and its connexion to the Pentagon, I think it likely will be one of the big winners of the army electrification program. In a time of renewed geopolitical tensions and military spending, this is a good business to be in.

Civilian Activities

The company is also active in nuclear medicine (radiotherapy). They have stricken deals with some of the industry-leading actors, like Bayer, to provide them with the nuclear component and reactors for treatments. This market is expected to grow quickly, and BWXT is aiming to grow its current revenues from $50M to $200M+ by 2025. This would turn the current $5-10M losses of this segment to $75M EBITDA.

It is also providing services and fuel to nuclear power plants, for example in the last year contracts worth CA$130M with Bruce Power and $50M for Ontario Power.

SMR Technology & Space Tech

The company’s SMR effort will rely on the BWXT Advanced Nuclear Reactor (BANR) design. It provides everything an SMR should: modularity, higher safety, etc… What seems unique to BWXT design is a unique high-density fuel, allowing for refueling only every 5 years versus 2 years on average in the industry. Such low maintenance design seems already geared up toward military needs. An initial test of a microreactor will already be delivered by 2024, in a $300M project called Project Pele.

I also think that the possibility to build the SMRs in pre-existing and accredited facilities (with both defense and nuclear accreditation at the same time) will be a huge industrial advantage over its competitors. The existing base of expertise and manpower is also great to have in an industry that chronically trains too few people.

In addition to terrestrial SMR, BWXT is also developing space-based reactors. One application can be the local power supply for future Moon and Mars missions. Another one is space propulsion.

These technologies will probably be needed to reach reliably Mars, and with a new space race between the US and Russia+China heating up, this might be as well a growth sector for BWXT in the long term.

Financials & Valuation

At a P/E of 17, BWXT does not seems overvalued at the moment. Operating cash flow is steady and rising over time.

The company also has a policy of returning at least 50% of Free Cash Flow to shareholders through dividends and buybacks. FCF should improve in the years going forward, with capex spending going back down after a period of massive investment in growth in the last years.

Conclusion

BWXT is a way to play the nuclear comeback safely. It might not experience the most explosive growth or be at the cheapest valuation. But it has one of the best moats I have seen, with regulation, strong connection to the military, highly complex technology, unique intellectual property, certified production facilities, and human resources.

The company is not just relying on its moat, but aggressively using it to expand in new markets, like space-based energy, nuclear medicine, and last but not least, SMRs.

This makes for a buy-and-hold type of stock, where the company will slowly (over the next 2 decades) expand its activity from providing nuclear power to capital ships to the entirety of the $773 Billion annual budget US military machine.

5.2. NuScale (SMR)

A Careful, Slow Strategy for Outsized Ambitions

Where BWXT is the established, well-connected giant, NuScale is the ambitious upstart looking to take over the world. This ambition goes way back to 2008 when NuScale started its design and application with the US Nuclear Regulatory Commission (NRC).

The company is the only one to have received NRC standard design approval, a big deal for a newcomer in a very tightly regulated industry. It is also providing extra protection for the company and reassurance for its clients:

We started off as a new company in 2007. We started our engagement with the NRC in what was called a pre-application in 2008. We submitted an application that required 800 people working on it, 12,000 pages long, $500 million to put together. The NRC spent 200,000 hours reviewing it, asking a bunch of questions. We spent $200 million answering those questions.

(…) You still need to do all that engineering and things, because ultimately, the compact we’ve made is that we have liability protection because we’re regulated.

Chris Colbert, Chief Strategy Officer at Nuscale, Energy Power and Renewable Conference

So while NuScale is making headlines now, this was built over 14 years of preparations. A slightly amusing proof of this first mover advantage is in the ticker of the company’s stock, SMR.

Quick Stock Overview

Ticker: SMR

Source: Yahoo Finance

Key Data

Industry	Nuclear
Market Capitalization ($M)	1,041
Price to sales	3.4
Price to Free Cash Flow	100
Dividend yield	1.6%
Sales ($M)	2,127
Free cash flow/share	$4.23
Equity per share	$7.24
P/E	17.5

The Backers

When judging ultra-technical projects like nuclear reactors, I think it is pointless to try to judge the technology except if you are an expert yourself with 20 years of experience. Instead, I prefer to rely on the actions of actual experts in the field.

Over its history, NuScale has been backed by reputable firms, like the engineering giant Fluor, Korean conglomerates Doosan and Samsung, as well the Department of Energy (DOE) which awarded $1.4B to NuScale for testing a 12 SMRs power plant in Idaho.

At this point, I think it fair to describe NuScale as firmly backed by the US government, and that was true through both Republican and Democrat administrations. So political risk seems rather low. If anything, NuScale is now a valuable US government asset and will be supported as such.

The Technology

NuScale basic unit reactor is large, but still small enough to be assembled in a factory and transported by truck. The reactors (in batches of 4, 6, or 12 reactors) are then assembled together into a full power plant.

One of the key advantages of the design is that the reactors can restart even if the grid is down, something traditional nuclear power plants are unable to do. So having NuScale reactors plugged into the grid actually makes it a lot more resilient.

Another strong advantage is the Emergency Planning Zone. SMR technology’s inherently higher safety allows for a very small exclusion zone compared to traditional nuclear. This means NuScale reactors can be installed on site of existing or decommissioned coal-powered plants or other industrial facilities, reducing drastically the regulatory burden. It also then reuses existing power transmission, which can often be harder to get approved than a power plant.

Besides power generation, SMRs like Nuscale’s can be used for direct heat generation. As a rule of thumb, only 20-30% of the heat generated can be converted to electricity. So when heat is directly needed, it is better to not use electricity from it but directly from the power plant heat itself. For example, a 4-reactors NuScale power plant can provide enough heat for the desalinization of water to supply the entire city of Cape Town in South Africa.

NuScale is also developing and integrating a lot of technology besides the reactors themselves, from cyber-resistant control systems to a dedicated delivery system.

One even more interesting idea is a “marine-deployed” (aka: on a ship) power plant, together with Prodigy Clean Energy. Such sea-based power plants have already been proven viable by Russian Rosatom, but this is something that could be deployed to provide clean and carbon-free power to arctic regions, island nations, and coastlines all over the world (coastline harbor 80% of the world population). The combination of a ship-based nuclear power plant and SMR modular design seems a great match to me.

A Growing Pipeline of Projects

As a sign of official support, The US government has been supportive all the way for NuScale to land a first contract with the Romanian utility company Nuclearelectrica (the third company analyzed below in this report). Starting from a USTDA grant for finding a site, followed by paying for a simulator to train Romanian operators.

This culminated in the agreement for a 462MW power plant, to be fully operating by 2028. While this might seems far in the future, this is actually lightning speed in an industry usually needing 10-20 years from signing a project and having it running.

With its technology validated by the US government and a major national nuclear utility, NuScale is going at full speed to secure as many new projects as possible. Here are a few selected projects:

• Polish KGHM copper producer for its factories, smelters, and mines.
• Polish Unimot energy company to replace coal power plants.
• Carbon Free Power Project in Idaho Falls, Idaho, USA.
• Associated Electric Cooperative Inc., Missouri, USA.
• Ontario Power Generation Inc., Canada
• Bruce Power L.P, Canada.
• Ukrainian Energoatom is looking into SMR in its plans to rebuild once the war is over.
• Kazakhstan’s KNPP is interested in deploying SMRs.
• Bulgaria’s KNPP-NB (same acronym, different company) to add to its existing nuclear power plants.
• Jordan’s JAEC, looking to reach 30% nuclear for its electricity by 2030.

Financials & Valuation

NuScale is still essentially a pre-revenue startup, so usual metrics like cash flow or earnings are pretty irrelevant. While I dislike Total Addressable Market (TAM) as a metric, this is maybe one case where it makes sense. The strong interest by not only utilities but industrial companies like KGHM seems to make the TAM of SMRs a lot larger than for traditional large nuclear power plants.

NuScale gives us the per plant economics of the business. The bulk of the money is made in years 6-10, with the sale of the module themselves, at $200M-$250M of average yearly revenue. The gross margin should be for the lifetime of a project around $250M million by year 10, and then a regular $5M-$15M/ year for the next 30+ years.

The company is projecting to become cash flow positive by 2024, with real significant cash flow by 2027. Considering the Romanian and Idaho projects already signed, with Polish projects well ahead, and many others in the pipeline, I do not think this is unrealistic.

The good news is that through its listing via a SPAC, NuScale has a stash of $425M in cash. The company management estimate this should be enough to reach the point where it will generate free cash flow. NuScale has very little capex needs, design costs are already done and it will be paid for its reactors before they are built. So this seems reasonable to me as well.

I think more projects or existing negotiations speeding up is also a real possibility. We are just at the beginning of the current energy crisis, and it is not accidental that Romanian and Polish clients are the first ones looking to get SMRs as soon as possible. I fully expect the rest of Europe to realize the need to switch away from unreliable Russian gas or very expensive LNG.

At this time last year, they were looking for a 2034 plant. In November, they said they wanted it in KGHM, we started working with in September last year, and then in February, they announced that, “We’re going to early works agreement to start selecting sites and looking at what this looks like in the Poland context.”

Chris Colbert, Chief Strategy Officer at Nuscale, Energy Power and Renewable Conference

Competition

This is maybe the most difficult part to assess. The sector of SMR is booming, but so is competitive pressure. At the moment, NuScale seems to have a first mover advantage. But many industrial giants are in its footsteps and might ultimately win through economy of scale and connections with governments, industrial clients, and utilities. This makes NuScale an inherently speculative investment, with the typical high-risk, high-reward profile of a growth startup.

Among competitors for NuScale are:

Large corporations

• BWXT (see above)
• Roll Royce (UK)
• GE-Hitachi (Japan – USA)
• EDF (France)
• CNCC (China)
• Westinghouse (USA)

Startups

• TerraPower (USA)
• X-Energy (Canada)
• Fermi Energia (Estonia)

This should not be an issue for NuScale in the sense that it will likely be able to grab a quite large section of the market anyway. In addition, its water-pressurized reactors are a proven technology. More innovative but untested molten salt or other methods might manage to succeed as well in due time but will face the very conservative streak of a nuclear industry always dreading a new Fukushima.

Conclusion

Now a 15-year-old “startup”, NuScale is ready to scale up and really enter the market. The energy crisis and the renewed interest in nuclear will only speed up its growth.

Its focus and spending to get the highest level of validation by US nuclear authorities will give it an edge in staying ahead of its competition, including large corporations. It will also be promoted by the US government as a way to support its allies in Europe and the Middle East. The partial ownership from Japanese banks and Korean conglomerates will help open doors in the Asian markets as well.

At the current valuation of $446M, NuScale is still a micro-cap yet to rise. IF the free cash flow projection from NuScale management is accurate, this is a bargain. But of course, any success investing in the company will need it to turn profitable, something still to be done.

This whole report is based on the assumption that nuclear energy will become a new focal point of the investing world in the next year when energy prices and shortages are becoming a major concern.

If this turns out to be true, NuScale stock could rise quickly.

If not, it will be a much slower potential, depending on continued progress until the 2027-2028 mark when the company turns on its first power stations in Romania.

The involved Romanian company, Nuclearelectrica, is the next and last one we will look at.

5.3. Nuclearelectrica (SNN)

This report is already quite long, but luckily, the last company is also the simplest to analyze.

In its current form, Nucleaelectrica is a classic utility company. It produces power, sells it in its home market, and makes a profit from the difference between its costs and its selling price.

As discussed in previous reports, utilities are very predictable companies. So the main points should be:

• A history of good maintenance and management of the assets.
• An ability to control input costs.
• A good market price for the stock.
• A policy friendly to shareholders with large dividends distributions.

Quick Stock Overview

Ticker: SNN

(quotation in Romanian Lei / RON)

Source: NuclearElectrica

Key Data

Industry	Nuclear
Market Capitalization ($M)	2,704
Price to sales	2.12
Price to Free Cash Flow	10.6
Dividend yield	10.7%
Sales ($M)	1,273
Free cash flow/share	$0.84
P/E	5.14
Share price in $	$8.96

SNN is a public company, owned at 82.5% by the Romanian state, and with 17.5% trading publicly on the Bucharest Stock Exchange.

It operates 2 reactors, Unit 1 and Unit 2. They are each producing 650 MW and are responsible for producing 19% of total Romanian electricity.

It is also investing in the construction of Units 3 and 4 to expand production, both rated at 720 MW. These new units would bring nuclear to 36% of the country’s electricity production. They should be connected to the grid in 2030 and 2031 respectively.

As discussed in the NuScale chapter, it is also working on adding SMRs to its mix, making it the first European site for SMRs. The project is for 462 MW of power. SNN’s CEO is aiming for the company to become “a regional trendsetter in nuclear energy”.

Company Quality

Since its launch, SNN reactors have operated with a 91.6% capacity factor, making them the number 1 in the world by that metric. The company never had a nuclear accident and has a good safety record.

Between 2026 and 2028, Unit 1 will be refurbished, giving it another 20-30 years of operational life. This should cost around 40% of the costs of a new reactor. Unit 2 will need to be refurbished in 2037.

Contrary to fossil fuel power plants, nuclear station costs are all upfront. So the company has very good control over its input costs.

Overall, SNN seems like a quality utility with a large potential to benefit from rising power prices as its costs should stay relatively stable. It is also going to quickly grow its production from the current 1.3 GW to up to 3.2 GW by 2031.

Valuation

Besides its relative quality and stability, the main attraction of SNN is its price.

The company’s shares are trading at a low P/E of 5.25 and have a dividend yield of 10.5%. Price to Free Cash Flow is 11.5

The company’s policy is to distribute between 50% and 100% of net income. Once taken into account skyrocketing electricity prices in Europe, and future production growth, SNN valuation seems rather attractive. The fact that the company produces carbon-free power is also an advantage in the EU, which taxes carbon heavily.

Conclusion

SNN’s current valuation is relatively low, despite having gone up 10x since its listing 10 years ago. This is most likely due to its listing exclusively in Romania, far from the attention of most investors.

This makes SNN a company similar to Copel, a Brazilian utility we covered in a previous report. Both have low costs and stable “fuel” input (uranium for SNN, water from the Amazon rivers for Copel) in a rising price environment. Both have a friendly policy for shareholders and generous dividends. And both are ignored as they operate in smaller, oversea stock markets. For reference, Copel was trading at $5.29 when we published the report and is now trading at $6.23 while distributing a generous 15% dividend yield in the meantime.

SNN has a shareholder-friendly policy and an excellent safety record (considering prejudice against Eastern Europe nuclear power plants, it might come as a surprise).

Its assets are ultra-durable and will produce power far in the 2030s. With reduced capex spending, they can keep producing up to the 2060s. Combined with stable input costs this makes SNN a very conservative, buy-and-hold type of asset.

On top of this “safe” profile, the company will grow its income significantly in the next decade, more than doubling its production. In the case power price do not revert fully to the pre-war levels, earnings are likely to stay quite high as well.

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6. Conclusion

The energy transition is usually framed as fossil fuel versus renewables. Nuclear energy is the alternative to both that have long been ignored in this discussion. Its importance in the energy mix has been brought back to the front light by the stubborn decision of Germany to phase out nuclear no matter what. This made an already bad European energy crisis more acute, and reduce the continent’s ability to reduce its dependency on Russia.

The industry might never fully recover in terms of public image from the Chernobyl and Fukushima disasters. Nevertheless, new innovations like SMRs, and maybe thorium and other fuels, are radically changing the real risk profile of nuclear. By moving away from massive uranium plants to smaller, more flexible designs, SMRs also increase dramatically the range of applications nuclear energy can be used for.

To properly invest in and profit from this nuclear renaissance, we need to focus on companies for which nuclear is the core business and not just one small division in a large corporation.

If you think public acceptance of nuclear is still too low, or SMR an unsure bet, BWTX is probably a better choice. Its bread and butter still come from producing and servicing nuclear reactors for the US navy. With rising geopolitical tensions with China, this seems like a safe enough sector to put money in.

Any profit from BWTX’s SMR design and its deployment in the US military would just be the cherry on the cake. It is however likely to happen in some capacity. The push for electrification in the US military is there to stay, and will not be dependent on public opinion.

If you think civilian utilities are in dire need of more low-carbon, reliable power supplies, NuScale is where you want to invest. The startup has a higher risk profile but should be cash flow positive in a few years. Its first-mover advantage, certifications, and proven technology make it a likely winner in the race to SMRs widespread commercialization.

If you think the energy crisis in Europe is a golden opportunity for low-carbon, high-volume producers of power, you will prefer Nuclearelectrica/SNN. The company is trading at an attractive price and gives generous dividends. Contrary to other European nuclear producers, it is safe from political interference and has strong support to double its production in the next decade.

As the first one to implement NuScale’s reactor and the first utility to use an SMR in Europe, it will also be on top of nuclear news, which might prove a catalyst for repricing.

Together, these 3 companies can be combined to make an interesting mix to hedge risks in a portfolio when it comes to investing in nuclear. SNN provides dividend income with some slow growth, NuScale explosive growth potential, and BWXT the steady safety of a major supplier to the US military.

Of course, all of these are exposed to another nuclear crisis like Fukushima striking out of the blue. This would destroy confidence in nuclear once again, and trigger a crisis for the entire sector. So while a company risk profile might seem low, the overall sector risk should not be ignored.

Overall, nuclear investments should be part of a balanced portfolio and play the role of a bet on growth and an inflation edge at the same time.

The post Nuclear is Back: An Analysis of the Nuclear Industry and Selected Companies appeared first on FinMasters.

Quick Stock Overview

Ticker: ZIM

Source: Yahoo Finance

Key Data

Industry	Marine Shipping
Market Capitalization ($M)	$8,870
Price to sales	0.8
Price to Free Cash Flow	1.8
Dividend yield	13.4%
Sales ($M)	8,623
Free cash flow/share	$30.35
Equity per share	$38.35
P/E	1.9

1. Executive Summary

ZIM Integrated Shipping Services is a shipping company specializing in container transportation. The company is a small actor in the industry, controlling only 1.5% of the total sea freight market. Stock Spotlight hasn’t covered a shipping company since DHL, and I wanted to wait for one with solid management at a decent price.

Based on 2021 numbers, ZIM is selling at a radical discount. But this would be ignoring the fact that the shipping industry is highly cyclical and supply chain problems have supercharged the whole industry’s earnings. So in that respect, we need to take the record-breaking recent results with a grain of salt. 2021 is in no way a normal year for the sector.

To illustrate that, we can look at ZIM’s valuation, which is somewhat in line with Chinese Cosco and cheaper than Danish industry leader Maersk. The whole industry is either cheap or making a lot of cash.

What makes ZIM more worthy of attention than just relative cheapness is its business model. The company has a strong focus on innovation and on cost optimization. Its smaller size also means it operates smaller ships instead of the mastodons of the larger companies. As I will explain, this should give a hedge compared to larger ships in the middle of the supply chain clogging.

It also operates an asset-light business model, able to optimize the size of the fleet to market conditions, providing some margin of safety in case of a downturn. This model allowed it to quickly access LNG-fueled ships to reduce its exposure to rising fuel costs.

In addition to the long-term market positioning and costs, ZIM is also pursuing a prudent financial strategy with a focus on returning profit to shareholders. Debt has been reduced radically with the 2021 windfall, and dividends are high enough to ensure a strong and regular yearly yield.

Finally, ZIM has also aggressively positioned itself to benefit from rising energy costs, upgrading its fleet to newer fuels. With pollution regulation tightening, this will help avoid expensive upgrades or fines that will hit competitors’ less advanced or aging fleets. This might also raise ZIM’s ESG profile and help attract more attention from ESG funds and investors.

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2. Extended Summary: Why ZIM?

Why Shipping?

Shipping has turned from a loss-making industry to a cash machine since 2020. Normally, we’d expect this highly cyclical sector to be moving into a slowdown. But with durable damages to the world shipbuilding capacity, the shortage of shipping capacity is here to stay longer than normal. Aging fleets and clogged harbors are also going to help maintain high freight rates for a longer than usual period.  

Poised to Rip the Shipping Boom 

ZIM is a global company active in sea-borne freight, and a small actor in its industry (1.5% of total volume). It specializes in smaller and quicker ships. In addition to operating ships, the company is also providing SaaS solutions to its clients for shipping and international logistics. The company operates an asset-light business model, “renting” ships instead of owning them. This gives its more flexibility to manage unstable market conditions.

Armored Balance Sheet and High Dividends

ZIM has significantly de-risked against a recession thanks to prudent balance sheet management and debt reduction. Free cash flow in 2021 was equal to half of the current market cap. Thanks to the asset-light model, the company should be able to adapt to unstable market conditions. The dividend policy is very friendly to shareholders, with a current dividend yield of 25%.

3. Industry Overview

A Booming Sector

Often out of public sight, container shipping is the heart of the global supply chain. Only an exceptional incident like the Evergreen ship blocking completely the Suez canal brought it into the spotlight.

Bordering countries might trade by train and trucks, and light freight and mail go by planes, but almost everything else is shipped by sea. And if the pandemic showed us anything, is how interconnected the world has become. A coal shortage in China can stop production at a car factory in Detroit due to a $1 electronic component being out of stock.

Containerized shipping has made sea transport more efficient. Previously, ships would be loaded and unloaded manually by dockers, a lengthy and expensive process. Having all shipments first fit into a standardized container allowed all harbors in the world to have a standardized set of cranes, trucks, and rails to safely and quickly load and unload freight ships. You can learn more about how radical a change the standardized container was to the world trade system here.

In this industry, these containers are referred to as TEU (Twenty-foot Equivalent Unit).  As a result, freight ships are classified according to how many TEUs they can carry. In the last 2 years, the rates to charter these ships have gone through the roof, for all ship sizes.

Understanding the Shipping Business Cycle

Understanding the shipping industry starts with understanding the cyclical nature of that industry. The cycle goes as follows:

1. Low charter rate and low margin. No new ships are built and the oldest ships are sent to the scrapyard.
2. If it goes on long enough, this first phase leads to declining ship numbers and a crash in shipping companies’ stock prices. Weaker companies may close or be acquired by stronger ones.
3. Reduced ship inventory leads to a shortage in capacity and rising charter rates. Companies with damaged balance sheets or serious debt or bankruptcy problems are not able to order new ships. Banks are also reluctant to loan to a sector “in crisis”.
4. The persistent short ship inventory leads to an acute shortage of freight capacity. Freight rates go up quickly and profitability increases dramatically. More ships are being ordered.
5. Arrival of new ships reduces freight rate. The freight market is now vulnerable to a recession that would bring overcapacity. Possible return to stage 1.

From this cycle analysis, we are somewhere between stages 3 and 4, but several years can pass between stages 4 and 5. This is due to the fact that building a ship is a massive endeavor and it takes several years from the ordering to the delivery of the new ship.

What makes the cycle we are in special is the extended duration of the previous stage 1. This chart from FreightWave says it all. Rates were last at an okay level in 2013. They then went on a decade-long depression, with rates essentially equal to the cost of shipping or below. For a long time, freight companies made little or no profit. Then Covid hit and rates went wild. 

Source: FreightWave

A 2017 report indicated that shipyard capacity had declined by a tremendous 62%. 10 years without new ship orders led to the permanent closure of most of the world’s shipbuilding capacity. These closed shipyards cannot be re-opened easily, as the physical infrastructure is simply not there anymore, nor is the skilled workforce and know-how.

This also led to the global aging of shipping fleets. That left the world completely unprepared for the 2020 surge in demand for physical goods and a broken supply chain. Shipping companies want to order new ships but cannot find shipyards able to build what they need.

This means that the arrival of stage 5 of the cycle, where many new ships are delivered and the freight rate crash back down, will be significantly delayed. This time, it might take as long as 4-6 years to see a significant increase in capacity.

The aging of the existing fleet is also going to help. Many ships have been dragged on simply because the companies owning them could not afford to replace them. These ships are more costly to maintain and operate and more accident-prone. In the next 5 years, many of them will be sold for scrap metal or put aside for 1 to 2 years for upgrades, partially compensating for the arrival of brand new replacements. 

Persistent Higher Demand for Shipping

Increased Demand

The pandemic has shifted a lot of consumption from entertainment to physical goods. This initiated the surge in freight rates, as we collectively bought more stuff, clogging the global supply chain. This effect might slowly fade away with the pandemic cooling off, but it is also possible that some durable shifts in consumption patterns are here to stay. Fewer restaurants and less travel, more online shopping.

Another effect of the pandemic was that every company on Earth learned how fragile their supply chain actually was. We spent the last 3 decades developing a sophisticated just-in-time supply chain that brought inventories as low as possible. With the now years-long shortage in semiconductors, raw materials, and components, industries worldwide are rebuilding inventories in a rush.

Just-in-time is being replaced by just-in-case, and this trend is not going away. This will lead to consistent higher demand for shipping for a few years until the inventories are rebuilt.

Clogged Harbors

Shipyards are not the only logistical infrastructure that has suffered a long period of under-investment. Ports have been also not properly sized to the growing trade volume. As a result, the 2020 surge led to a line of ships waiting at sea for a spot to unload their cargo. It is hard to overstate how unprecedented this phenomenon is. This means a lot of ships are not carrying cargo but just sitting there waiting, reducing the capacity available even more.

This problem is far from being resolved, with the new record number for ships waiting reached in January 2022. This shows this is not just an effect of the Christmas season but a durable trend. We will see later how this should benefit ZIM specifically.

International Disorder

The Ukraine invasion is an additional shock to the shipping system. Unexpected production interruption, re-routing of trade lanes, interruption of Russian export of raw materials, and the general chaos of the war have created more demand for cargo in general and longer trade routes.

Altogether, these trends are creating a durable increase in shipping demand. As we all experienced during the pandemic, shortages tend to breed more shortages as panic buying and hoarding increase the supply shortages. Carmakers, furniture shops, and supermarkets are as sensitive to this as toilet paper hoarding crowds.

4. ZIM profile

Posed to Rip the Shipping Boom

ZIM is a global company active in sea-borne freight, and a small actor in its industry (1.5% of total volume). It is specialized in smaller and quicker ships. In addition to operating ships, the company is also providing SaaS solutions to its clients for shipping and international logistics. The company operates an asset-light business model, “renting” ships instead of owning them. This gives its more flexibility to unstable market conditions.

A Globalized Business

ZIM is based in Israel but operates as a truly multinational business. Its trade exposure by volume carried roughly reflects the world trade itself. The largest routes are on the Transpacific (Asia to America) and the second-largest in intra-Asian trade.

Source: Investor Relations | ZIM

The company is operating a fleet of smaller ships than its larger competitors, with its larger ships at 12,000 TEUs. It is operating since 1947 and now operates 98 vessels. In 2020, the company chartered 98.9% of its capacity, compared to 56% of the fleet for its competitors (that was before most of the shortage in freight hit, today the industry’s numbers are much better).

The very large majority of ZIM freight is so-called dry freight, with a little bit of high-margin specialized cargo like especially large cargo or those that need refrigeration. The customer base is very large (30,080 in 2020) with the top 50 customers representing a third of total revenue.

Source: Investor Relations | ZIM

Besides their freight activity, ZIM also provides a complete suite of software for sea-borne freight, both for internal use and as a service for the clients. This includes tracking cargo, online booking platform, CRM, cybersecurity solutions, or cross-border shipment assistance.

Source: Investor Relations | ZIM

Some of the largest freight ships can carry up to twice as much as ZIM’s ships. Larger ships can be theoretically more profitable, as they carry more at once and spread fixed costs on a large base of orders. However, their absolutely massive size is a limitation as well. Only a few harbors in the world have a design able to cater to them, limiting possible routes. If the receiving harbor is clogged by already 100 other ships waiting for weeks, there is no possibility to re-route to a secondary destination with a shorter waiting time.

Smaller ships are also quicker and have short turnaround times which come at a premium when customers are worried about growing delays. Interestingly, when air freight got slowed down in the pandemic, ZIM quick ships managed to take away business from air freighters, something a less flexible or slower fleet of giant boats could not do.

ZIM has been recognized for its flexibility and efficiency by some of the largest actors in the sector. Notably, ZIM signed an agreement with Alibaba to get buyers on Alibaba.com (the B2B international site of Alibaba) to directly purchase freight from ZIM on the Alibaba platform.

Forward-Looking Management & the Asset-Light Model

For every capital-intensive industry with mobile assets, like airline or sea freight, comes the question of asset ownership strategy. Many companies prefer to outright own the ships or planes themselves. This gives them more control over how the equipment is operated and maintained and maximizes profits during booms. But this also means that during a crisis, these assets can become liabilities if they are not in demand.

The alternative option is to “rent” the ships. This is the model that ZIM follows. By not owning the ships, ZIM is able to quickly modify the size and composition of its operating fleet according to market conditions.

Recently this has paid off in multiple ways. In 2020, the company let go of 20 ships that were idle in the initial stage of the pandemic, before the surge in demand for shipping. They were then able to quickly increase the fleet size above pre-pandemic levels to exploit the massive surge of demand and charter prices.

ZIM is booking around 60% of its ships for 1 year, and the rest for 1-5 years. This seems like a reasonable plan for me. If demand crashes, they can quickly not renew the bulk of the fleet without a loss or having to cover the costs of the idle ships. But the 40% long-term ships allow it to also keep under control a rise in the price for “renting” ships if demand stays elevated.

In a business as unpredictable and cyclical as shipping, a business model flattening the ups and downs seems a plus to me. Maybe ZIM will not benefit as much as others from a persistent boom in shipping, but their downside is a lot more limited as well.

Another advantage of the asset-light model is flexibility not in the number but in the type of ships. With demand staying elevated longer and higher than any other cycle, ZIM is modifying its fleet composition. This also comes at a time when oil prices have gone up significantly and supplies of the bunker oil used by ships are not necessarily easy to find. This was true before the beginning of the Ukraine war, which increased the pressure on oil supplies.

The solution for persistent higher demand of freight volume and fuel costs rising was to charter, since 2021, 10 ships of 15,000 TEUs capacity (the largest ever operated by ZIM) and 13 ships of 7,000 TEUs capacity. Each of these ships is LNG-fueled. By using them on the Asia-USA East Coast route, ZIM will be able to utilize the much cheaper American LNG costs to save money.

This will also make ZIM one of the least carbon-intensive actors in the sector. With climate change a growing concern, this will provide ZIM with 2 benefits. They will have a competitive advantage if carbon taxes get higher and they will offer an ESG-friendly investment profile, a rarity in the shipping industry, which is generally powered by the dirtiest fuel, known as bunker fuel.

These ships will be delivered starting next year. If demand stays steady or reduces they can partially replace the existing “rented” fleet. If demand stays explosive they then just add up to the total fleet. This is the beauty of this model in times of instability. ZIM can relatively effortlessly change its fuel requirement and size or number of its ships to adapt to market conditions. Considering that all the last 3 years’ decisions have been on spot in anticipating problems, we can feel reasonably confident in management skills in using this flexibility well.

5. Financials

Armored Balance Sheet and High Dividends

ZIM has significantly reduced recession risk thanks to prudent balance sheet management and debt reduction. Free cash flow in 2021 was equal to half of the current market cap. Thanks to the asset-light model, the company should be able to adapt to unstable market conditions. The dividend policy is very friendly to shareholders, with a current dividend yield of 25%.

A Reinforced Balance Sheet 

I have lately tried to focus reports on the “big idea” than the nitty-gritty of financial data. This stems from the idea that if an investment is a good one, it should be obvious and not rely on complex financial models to reveal it. With a company operating in an industry so exposed to market cycles and potential outside shock, we have to talk more about debt and cash.

At current earnings, ZIM is valued very cheaply (P/E of 1.9). As I said, these earnings are somewhat exceptional, so this is not enough to assume the company offers enough margin of safety. Where ZIM shine is in the very cautious management of the balance sheet. A lot of 2021’s outsized profits have been used to reinforce the balance sheet.

First, total debt has been more than halved, from $3.3B to $1.5B.

With a parallel rise in cash on hands, this has brought net debt from a good -$500M to a great -$1.7B.

With such a strong balance sheet and bankruptcy concerns firmly put aside, let’s look at cash flows. Free cash flow has gone up in 2021, standing at $4.8B

When seeing these numbers, we can keep in mind that the current market capitalization is $9.8B. If 2022 is as profitable as 2021 was, the free cash flow should represent as much as half of the company’s current valuation.

Dividends and Shareholder Returns

Of course, a lot of cash flow is irrelevant if the cash never makes its way into the shareholders’ pockets. A friendly profit distribution policy is a must. ZIM already had a solid dividend history, with $21.5 / share distributed since the January 2021 IPO (roughly 1/4 of the current share price)

The new policy aims at guaranteeing a strong quarterly dividend, equal to 20% of the quarterly net income. This comes from a special dividend in the fourth quarter so that the yearly distribution reaches 30-50% of annual net income.

For reference, 2021 annual net income was $4.6B, so the total distribution under the new policy would have reached $1.4B to $2.3B. Again, to compare to the $9.8B market cap.

The fact that the dividend distribution is quarterly is also great, as this ensures that money is transferred to shareholders continuously, instead of being hoarded and possibly never actually distributed.

Valuation

Considering how full of surprises 2022 seems to be, I feel a precise valuation tool, like discounted cash flow, would likely give me a “precisely wrong” estimate. So many factors can affect the demand and pricing for shipping:

• A slowdown in the European and/or Chinese economy
• A steep rise in inflation
• Supply shock from commodity shortages
• Change in rates policy by central banks
• Sanctions against China in response to support for Russia
• A peace agreement signed in Ukraine
• An escalation of the Ukrainian conflict
• New conflict in another region (Iran, Turkey? Or God forbid, the Baltics or Taiwan).

So my assumption for a base case scenario will be the persistence of 2021 trends. High shipping rate, but not growing. Constant high demand but not rising either. In these conditions, dividends alone would bring roughly a 25% yearly return. This would also leave $2B+ in free cash flow to completely extinguished the debt and some spare cash leftover.

One more year like that means the company’s free cash flow will cover half of the current market cap. So from 2023, even a decline in free cash flow could provide a decent return through the generous dividend policy.

A scenario where profits go up is not unlikely, but I expect that higher shipping rates might be compensated by higher shipping costs in 2022. Cost increases from fuel, salaries, and the cost of “renting” ships are likely, especially considering that the new LNG-powered ships will only arrive in 2023.

All in all, I think ZIM could deliver anywhere between 10%-25 % yearly returns from the dividends alone in the next few years. A speculative move on the stock price itself could add some extra profit or losses, but this is almost impossible to predict.

The bear case would lie in a radical slowdown in the world economy. Higher energy prices, various commodity shortages, and a deflating tech and real estate bubble in China could derail demand and shipping rates.

A catastrophic bear case would be exploding tensions with China, following open support of Putin’s Russia or an attack on Taiwan. Frankly, after the last few weeks, I don’t feel I can completely rule this out. But I also feel that in that scenario, there would be very few places in the market to hide anyway.

6. Conclusion

ZIM is almost the opposite of Rakuten, the company we covered in the last report. Rakuten is centered in one country, with very diversified activities and expanding in a capital-intensive segment. ZIM is fully globalized geographically, razor-sharp focused on sea-borne freight and operating a capital-light business model.

From an industry perspective, ZIM seems set for a few great years. Shortages of container ships, limited shipyard capacity, and restricted harbor unloading facilities have created an environment conducive to shipping rates higher for an extended period. This is not dissimilar to how energy companies are now seeing record profits thanks to years of insufficient CAPEX spending.

ZIM seems uniquely positioned to profit from this situation, as its asset-light structure allowed it to expand capacity much quicker than its competitors waiting for new ships to be built and delivered. The smaller size of the ships in its fleet permits quicker and more flexible deliveries at a time when clients are frustrated by a clogged supply chain.

At the current valuation, the future returns from an investment in ZIM will depend on the state of the world economy.

If the current supply chain issues, energy and commodity prices, and war in Europe trigger a worldwide recession, demand for shipping will decline. In that case, ZIM’s profit margin might decline dramatically. This scenario would hurt such investment, even if the strong balance sheet and flexible fleet composition would avoid a disaster.

If the current trend lasts for a few 2 or 3 more years, ZIM will be a cash machine. 2022 free cash flow could be used for paying off all the debt and still give a 25% dividend yield. 2023 would see even more free cash flow available for a rising dividend. I could imagine in that case the entire current price given back in dividends by 2024, not counting on a stock price rise.

If everything goes well, thanks to the asset-light business model, ZIM will avoid the temptation to overpay for more ships at the end of the business cycle, favoring shareholders’ returns instead. In an industry known to miscalculate the business cycle and waste the money of bountiful years on “vanity growth”, this makes ZIM special.

The dividends are massive, but the cyclicality of the industry implies some risks to the capital invested. So from a portfolio management perspective, ZIM should be in my opinion a relatively small position.

 In any case, this is not a buy-and-hold type of investment. At some point, either the economy will cool down or the shipyards will have built enough new ships to depress rates again. It seems this point is at least 3 years in the future, but this is not an investment where we want to overstay our welcome. So a cautious look at the number of ships available and the health of global trade will be useful to know when to take the chips off the table.

The post ZIM Integrated Shipping Services (ZIM) Stock Analysis appeared first on FinMasters.

Quick Stock Overview

Ticker: GILT

Source: www.stockrover.com

Key Data

• Sector: Technologies
• Sales ($M): 85,594
• Industry: Communication equipment
• Net Cash per share: $0.99
• Market Capitalization ($M): 476
• Equity per share: $4.05
• Price to sales: 2.6
• P/E: 10.2
• Price to Free Cash Flow: 8.5
• ROIC: 19.4%
• Dividend yield: 11.7%
• Free cash  flow / share: $0.99

Investment Thesis

The Space Tech Comeback

You may not know this, but I am an avid space enthusiast. Even though I ended up working for the US Navy, space has always been something I have been especially fascinated with.

I think it’s safe to say that progress within the space industry has been disappointing for a long time. In my short 28 years of life, we have made so little progress in space that it seems impossible to accomplish anything of importance.

After Armstrong’s first steps on the moon in 1969 and after the last man on the moon in 1972, the space industry has stagnated, with at best incremental improvements. Yes, we put some rovers on Mars and constructed a few satellites. By far the most valuable space innovation has been the GPS. As a result, public enthusiasm for space technology has declined.

Global warming, social and political issues have dominated the world’s attention for a long time. Talks of space expansion were reserved for more optimistic times.

Thanks to the private sector, this perception has changed. We began with SpaceX founded by Elon Musk, then Blue Origin founded by Jeff Bezos. By cutting launch costs drastically, these two billionaires have re-energized the space industry.

Even if many see it as a waste of resources, I am delighted to see some life brought back to a field so long dominated by bureaucracy and conglomerates. Now NASA plans to return to the moon with the Artemis mission and the Chinese and Russians are planning their own permanent moon base.

Musk still wants to go to Mars, and Bezos wants to build a space habitat in Earth orbit. At the same time, the Russians are trying to stay in the race, and the Chinese are feverishly catching up with the other space giants.

All participants are developing new launchers to reach these lofty goals. In addition to being larger, they are much cheaper as well. In just a decade, it went from $54,500 per kg to $2,720 per kg; a 20-fold decrease!

This is largely due to re-usability. Up until recently, rockets were destroyed upon launch. Think of it this way: every time United Airlines offered a commercial flight, the company simply scrapped the plane afterwards.

Imagine the cost!

SpaceX changed that, and the rest of the industry is following them. The later fully reusable and larger rockets like the Falcon Heavy (and soon-ish the Starship) should bring costs even lower.

Source: ttu-ir.tdl.org

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The Satellite Boom

Often, people think that satellites cost a lot because of the very complex technology in them. But that’s not true. It is common for the launch cost to be as high as that of the satellite. Hence, reducing the cost of a kilo in orbit by a significant amount is important.

In the past decade, global launches averaged around 25-30 per year. For its Starlink project, SpaceX alone is building 120 (lightweight) satellites each month. Within a few years, Starlink hopes to offer high-speed Internet from satellites in Low Earth Orbit (LEO) anywhere on earth.

No fewer than 42,000 satellites will be launched simultaneously for this purpose. A similar plan has been laid out by Blue Origin and Amazon, with “just” 3,236 satellites planned. As you can see, the sky is no longer the limit for satellites.

I have been wondering how to invest in this trend for a while. However, Blue Origin and SpaceX are private companies. Since their backers are the richest men on Earth, they have no need to raise more funds through an IPO. Musk is notoriously volatile when it comes to public governance, and Bezos is attracted to the absolute control he has as the sole owner.

As a result, I had given up on trying to profit from the new space race since the main culprit was outside the public investing universe. This is until recently a company popped up on one of my screens.

Gilat Satellite Network manufactures equipment for satellite communication systems. As I delved deeper into the company’s business profile and financial metrics, I became more and more interested.

So, let’s jump into orbit …

Chapter 1: Making Sense Of Satellite Telecommunications

A Key Component of Telecommunication

There are three main components of satellite telecommunications. They are the satellite manufacturers, the launchers to launch them into orbit, and the ground-based operators.

The focus of this report will be on the ground. Essentially, satellites are connected to the rest of the world’s communication network (internet fiber, mobile networks, etc.). The signal travels through small antennas and dedicated electronics.

Some of Gilat antennas

Ground stations are also responsible for coordinating and optimizing the flow of data from and toward space. In this video, from 22:30 to 23:30, you can see an example of pointing the beams in the right directions, changing satellites, when necessary, etc.

Obviously, this is a very complex and technical field. The explanation of how it works would extend far beyond this report. An engineering degree is probably the minimum requirement to understand that. I will also avoid acronyms whenever possible.

Here is a slide from the company to illustrate why I think explaining each component one by one would make this report unreadable.

As a business model, however, it can be understood.

Telecom operators need the expertise and equipment provided by companies like Gilat to handle exchanges with satellite constellations. The product’s benefits are easy to understand, even if we aren’t experts in its technology.

Access to data and connection everywhere, at all times.

Gilat charges a fee for providing it.

Due to the rapid changes in the market, these fees will soon multiply.

The Roaring LEO

With the move away from geosynchronous satellites, the industry is experiencing a great deal of change. Until recently, the main way to put a satellite into a distant orbit was to keep it hovering above the same area of Earth all the time. When you have a few dozen satellites orbiting the Earth, you have worldwide coverage.

In this case, the problem is that geosynchronous orbit (GEO) is 35,000 kilometers away from the Earth. In terms of communication, this is a problem, since the signal has to travel a long distance back and forth. Due to the huge distance, data travels at a low speed.

Television broadcast satellites did not have this problem since they usually receive only one input (the TV program) and transmit only one output (the TV show) over a vast area. This was also fine for satellite pictures, monitoring an oil rig, and other data.

As data travels up and down from multiple sources on the ground, it is not so great for Internet data transfer. In this case, slowness is synonymous with poor quality. Consumers and businesses want and need high-speed, low-latency Internet.

GEO satellites are just not good enough for modern purposes. A satellite Internet connection might allow you to send an email and (slowly) browse the web, but you can’t stream, play games, or make a group Zoom call.

It was also expensive because GEO orbits were rare and large, heavy satellites were required. Imagine how much money we used to spend on phone bills and how bad the performances were with 56k modems, but with modern needs.

“The industry conversation has changed from requiring megabits per second to gigabits per second.

The Internet is no longer mainly the provider of content, but the platform for considerable data sharing requiring high bandwidth”

Source: Gilat Investor Presentation

The trend is now towards non-geostationary orbits (NGSOs), especially low Earth orbit satellites (LEOs), to solve the problem.

That’s a mouthful of acronyms. The idea is for you to understand that we are moving from a few large, very distant, and expensive GEO satellites to a swarm of smaller, much closer, and cheaper LEO satellites.

A Whole New Gigantic Market

Instead of ground-based mobile phone towers, LEO satellite constellation will provide 4G/5G connectivity via satellites.

Not only is this a huge increase in satellites to manage, but it also means an exploding market. Previously, this was an expensive service for remote areas, but now it will compete with Internet companies like AT&T for most rural areas.

While SpaceX’s Starlink is the most ambitious LEO constellation, Amazon, OneWeb, and Telesat are also working on it. You can count on other companies or countries wanting to grab a piece of this pie soon as well.

It will simply have no competitors in developing countries. Neither in price nor in performance. Outside of the main cities already covered by cell phone operators, developing countries’ countryside is likely to immediately switch to satellite internet.

This is similar to the way mobile internet took over before landline Internet ever became available. The country of Peru, a very mountainous country with remote regions, falls into this category. Through a partnership with Gilat, it is bringing the Internet to millions of people. The Peru project could serve as a template for similar projects in many other nations. Southeast Asia, for instance, would be a suitable candidate.

Additionally, I appreciated the company’s problem-solving abilities. Somehow or another, the devices need to be deployed. It does not matter if the equipment is delivered by riverboat or even by donkey!

Source: www.gilat.com

Chapter 2: Gilat’s operations

The Main Segments

Gilat’s activities are divided into different segments, each of which caters to a different type of client. As a result, the company can use the same basic connectivity technology but tailor it to the needs of each user.

The company has developed a large customer base over 30 years, expanding with the whole satellite industry. There are a lot of impressive clients for Gilat, including Facebook, Petrobras, Lockheed Martin, and Softbank.

The company mostly makes money in the Americas, with the rest of the world accounting for about a third of its revenues.

Cellular

https://www.gilat.com/solutions/cellular/

A mobile phone service operator can use this service to deploy their mobile network over satellites. It is also known as Cellular Backhauling, or CBH. A satellite-based solution is used in place of a traditional mobile phone tower.

Up until recently, the main market here was 3G backhaul. One of the company’s notable achievements was deploying 3G connections to Brazil and Canada. Now the company is focusing on more internet-friendly 4G. To describe Gilat as dominant would be an understatement. The company controls 80% of the CHB 4G market!

The reason Gilat’s dominance is due to GTP (General Tunneling Protocol) is that it allows connections to be established very quickly, instead of requiring a sluggish process. With Gilat patents, there is no need to wait 40 seconds for the connection to reach full speed.

In an age when LEO satellites have become commonplace, phone companies will increasingly use Gilat technology to connect rural areas instead of traditional towers.

Mobility

https://www.gilat.com/solutions/mobility/

Delivery of the Internet to moving targets is a difficult technical challenge. This is particularly true if you want uninterrupted data transmission. If you are doing it far away from the mobile network, it will be even more so.

If it weren’t for satellites, it would be impossible to deliver Internet at sea (merchant ships and cruise ships) or in high-speed trains and planes.

The market has also doubled since 2015 and continues to grow quickly. By 2025, it should grow another 20-30%. In-flight entertainment increasingly includes free WiFi, and internet access is increasingly essential for ships.

Internet of Things (IoT)

https://www.gilat.com/solutions/iot/

I am not the most enthusiastic about the Internet of Things. As a rule, I prefer my personal items to be “dumb” and functional, as opposed to smart and connected. I don’t need my fridge to run on Windows and be connected to the Internet.

But there is one field where IoT makes perfect sense, and that is in industrial settings (IIoT). Gilat uses pipeline monitoring on its website as the perfect example. Gilat systems monitor 700 locations for leaks or potential issues so that Philips 66 can respond quickly.

An always-on monitoring system based in the sky is the best option for sensitive or dangerous activities.

Gilat provides a useful infographic depicting all the possible applications. My two favorites are:

• The industrial/energy/agriculture segment
• The logistics and autonomous vehicles segment

Source: www.gilat.com

Industry and energy applications make the most sense to me as they need powerful remote connections and top-notch reliability.

In the future, Gilat will see a lot of growth from the logistics and autonomous vehicle sectors. The over-the-air update and constant connectivity of Tesla cars will become industry norms. Even more so with self-driving vehicles and delivery robots (as I detailed in my previous report on Deutsche Post).

In addition to spotless connections, same-day delivery logistics will also become increasingly complex. Gilat is prepared to assist. Click here for more information about each application.

Industry & Broadband

Flexibility is an essential part of Gilat’s offer. There are benefits on both sides.

To start their connection process, the client requires a low initial capital expenditure, but can scale up as they grow.

By spreading the costs between many, many clients, Gilat is able to amortize the massive operational costs and technological complexity.

Therefore, Gilat has multiple business moats, such as economies of scale, lower costs, and the ability to develop more patented technologies at a lower cost per user.

Source: www.gilat.com

As a leader in the field, it has the capacity to provide extra capacity when needed by its clients.

Source: www.gilat.com

The segment includes multiple sub-segments:

l  Remote education and E-Learning

l  Bank’s private network

l  Oil & Gas and Mining

l  24-hour news channels (and live broadcast from anywhere)

l  Residential broadband (home Internet for isolated places).

I find the last segment to be the most interesting. There are many regions that are too remote for 4G networks to be properly deployed. In these regions, getting a stable home Internet connection is either difficult, expensive, or downright impossible.

Up until recently, satellite broadband was too slow to be anything other than a last resort. Once LEO constellations are in place, this will not be an issue.

New Yorkers will still get their Internet through ground-based solutions. However, people living in low-density areas, such as the Rocky Mountains, the Alps, Northern, Central Canada, Scandinavia and most of Russia, are likely to switch to satellite Internet.

By establishing advanced remote work in scenic and cheaper villages, these areas will become more livable and modern.

Military

https://www.gilat.com/solutions/defense-and-government/

Last but not least, satellite communication is obviously used by military and government agencies. Historically, this is the first sector to extensively use satellites.

Almost all military operations today rely on satellites, including imagery, telecommunications, and GPS-guided missiles. It surprised me to learn that this is a relatively small market, with less than $1B expected by 2025, compared to $10B in the mobility sector.

Gilat seems to have the advantage here due to its product design, with an advantageous SWaP profile (Size, Weight, and Power). Gilat’s antennas and systems are light, small, and nimble enough to operate in front-line conditions, as well as on UAVs and vehicles.

In addition, the antenna and other electronics are described as “robust, ruggedized, and designed to operate in harsh environments“.

As an Israeli company, I also expect Gilat to have plenty of opportunities to test and demonstrate its products. Furthermore, I imagine it will also benefit from connections with foreign American and European allies.

Government

https://www.gilat.com/solution/public-safety/

Among Gilat’s services is the provision of emergency and disaster response systems for the government. Satellites are ideal for restoring communication lines after earthquakes, hurricanes, floods, and other disasters that destroy land-based systems. In addition to working well for the military, they are also effective for first responders.

Also, the company signed a deal directly with the government to provide Internet access to the population. An example of this is the agreement with Peru. As a result of this deal, Gilat will be able to generate initial revenue for building the network, as well as recurring and steady revenue for operating it.

This business model intrigues me. Per’s government pays upfront the capital expenditures for the system, and Gilat charges $50M/year for its operation. While most subscription-based business models require large initial capital expenditures, Gilat’s government contracts appear to have the capital expense covered by the local authorities.

Management

https://www.gilat.com/about-gilat/management/

As a company like Gilat is so dependent on proper execution and technical ability, I wanted to briefly review the management team.

Adi Sfadia, CEO

Since 2004, he has been involved with telecom and VoIP, mostly as a CFO. Sfadia’s financial background is not a technical profile but should ensure that Gilat’s capital is allocated effectively during its growth.

Ron Levi, COO

It appears that Mr. Levi, who holds diplomas in both computer engineering and management, is the ideal candidate to lead Gilat’s daily operations. His entire career was spent in telecom, including companies acquired by Cisco.

Noam Rosenfield, Senior Vice-President R&D

An Israeli Defense Forces former commander of cyber defense. Additionally, he headed the R&D efforts of Verint, a leading cyber intelligence solutions provider. In addition to handling the very sensitive infrastructure managed by Gilat, he also brings a software angle to the more telecom hardware profile of the rest of the board.

Chapter 3: The Company’s Future

The Key Growth Advantages

Gilat is in a perfect position to participate in the growth of satellite communication. Because LEO constellations are multiplying rapidly, the addressable market will expand much faster than most analysts think.

What was once a growing but also stable industry is now going to be the next big investment topic. In these volatile and profitable times, space is trendy again.

Consider Virgin Galactic, one of the three top private space companies (along with SpaceX and Blue Origin) that recently went public. A company with only a prototype and no income has been on a wild ride, from $7.20 at IPO to a high of $59 today.

With space investing becoming a popular investing trend again, I fully expect the whole sector to gain more attention. After the LEO constellations of Internet satellites are launched, Space Internet will be the next big thing. And Gilat is leading the way in building land-based receivers.

The Moats

In terms of investments, the telecommunications industry is known for being technology-driven and conservative. National telecom companies prefer working with other well-established firms.

Gilat is responsible for 80% of 4G satellite-mobile network connectivity. A company with this pedigree and all the right connections can grab a piece of the space-based 5G pie.

It will also have the ability to spread its R&D and capex costs, giving it a durable price advantage. The company sold 1.6 million satellite terminals in 100 countries.

The combination of a strong reputation, established relationships, economies of scale, and better technologies gives Gilat a powerful moat to remain competitive.

The Techs

As I mentioned previously, I believe it is beyond my capabilities and the scope of this report to dwell on the engineering itself. Gilat, however, has a few unique technologies that set it apart from its competitors:

l  The “Elastic Era” connection system; a specialized infrastructure able to handle LEO satellite high-speed orbits in the sky.

l  Layer-2 accelerated data. This simplifies the process of integrating satellite connections into mobile networks.

l  Fastest airborne modems available on the market

l  5G-ready CBH (Cellular) devices and infrastructure

I won’t pretend to understand it all. There’s no need for me to.

When it comes to overly technical industries, I refrain from second guessing the technology. As an alternative, I can rely on the purchases decisions of people who are way smarter than me, such as engineers at mobile operators or people who handle defense procurement.

I think a product is the right choice if almost all the experts who have worked in the sector for their entire lives choose it.

Financials

Gilat had a disappointing year in 2020. There was little flying, cruise ships stayed at the docks, oil & gas were in disarray, and many clients delayed investment until they could see the economic outlook more clearly. Revenue declined significantly, especially from product sales.

As a result of this very poor 2020, the stock price fell from +/- $8 to $5. A new line of 5G-ready antennas was announced in February 2021 and the stock rose like a rocket.

Due to the short attention span of today’s markets, the focus has instead been on “disappointing” quarterly results. It seemed that the new product would be sold instantly, rather than being carefully and slowly considered for the next round of investments by Gilat’s clients. Considering the bureaucracy of telecoms, that was not a possibility.

This presents us with an opportunity. The future growth of Gilat was already factored in at $20+ / share. At $8, not so much. Thankfully, the company’s revenues are improving in the first half of 2021.

Because of this, a company is selling cheaply despite excellent growth prospects. For the company as it is now, all metrics and ratios scream cheap. There is also no debt, and the dividend yield is 12%!

I expect Gilat to outperform the market in the long run due to the additional great growth prospects. It might take a little while, however, for revenues to increase as a result of the slow decision-making of its clients and the ongoing deployment of LEO constellations.

• P/E: 10.2
• Price to Sales: 2.6
• Price to Free cash flow: 8.4
• Price to Book: 2.1
• Debt: 0
• Equity per share: $4.05
• Dividend Yield: 12%
• ROIC: 19.4%

Chapter 4: Valuation

Considering Gilat’s financial ratios are more in line with a no-growth company, I expect Gilat to be undervalued. But by how much?

Discounted Cash Flow

Discounted cash flow is the most relevant valuation method for Gilat, as the majority of the company’s value will be in its future free cash flow once the satellite-based 5G Internet revolution begins.

The company has historically traded a price to free cash flow ratio of 10-20, with periodic spikes at much higher levels. The current ratio of 8.3 is very low by comparison.

There is no doubt that space enthusiasm will make a comeback in the near future. This is true each time SpaceX flies a fully civilian crew, Virgin Galactic takes a test flight, or when The Artemis mission brings us back to the Moon. At the very least, this should return the terminal value multiplier of Gilat to its historical norm.

Free cash flow grew by 8% over the last decade, so I will use that, even if that is probably too low, as I ignore the LEO-based Internet growth.

Even with these conservative assumptions, I still get a value for Gilat of almost $13, well above the current $8.23.

I was also curious to find out what could justify the current price.

We would need the value multiplier to never return to its historical level. Annual growth would need to drop from 8% to 5%. This still leaves a margin of safety of 15%.

The entire report was written under the assumption that satellite communication is about to boom. The valuation (at the moment) is so low that the business growth of Gilat has to slow down in order to justify it!

However, I see a bull case, where growth accelerates beyond the historical trend. An exploding mass consumer market can easily justify the switch from large airlines, oil & gas companies, and the military.

In the event that Gilat only experiences additional growth in five years, this still indicates a substantial undervaluation of the stock: intrinsic value would be more than twice what the stock currently trades for!

Conclusion

My interest in Gilat was sparked by the strong financials on my screener, but I had no clue what Gilat did.

I was intrigued by the satellite communication segment, but I was wary of the competition from SpaceX’s Starlink and similar companies.

I expected a business like ViaSat, which operates GEO satellites. The business model is still profitable, but also declining and in danger of extinction.

The current valuation would have justified the current valuation, making the company a typical value trap.

So I was genuinely surprised when I saw their presentation and found out that the switch to LEO satellites was actually an opportunity for Gilat.

As far as I can tell, the current valuation is more a function of short-term “disappointing” quarters. Covid’s aftermath seems to be holding back the company’s short-term results. In the long run, the company is still well positioned.

The current core business will continue to grow. Mobility continues to grow rapidly. The need for mobile connections has never been greater. Industry IoT is going to become a standard in many more industries. Sat-comm spending in the military is not going away.

Add to this very solid foundation the emerging but soon to be large and well-established residential satellite Internet.

At the current valuation, the businesses should provide a comfortable 15% annual return. However, if I am right, Gilat in the residential internet market is perfectly positioned to grab a leading position and expand its market share.

Growth in the core operation, expanding markets, a growing moat, and a sector poised to become a darling for investors, all at a discount. What’s not to like about Gilat?

The post Gilat Satellite Network (GILT) Stock Research Report appeared first on FinMasters.

Quick Stock Overview

Ticker: VWAGY

Source: Yahoo Finance

Key Data

Industry	Automible
Market Capitalization ($M)	$102,751
Price to sales	0.4
Price to Free Cash Flow	4.7
Dividend yield	4.1%
Sales ($M)	263,651
Free cash flow/share	$3.6
Equity per share	$28.03
P/E	5.2

1. Executive Summary

Volkswagen is the world’s second-largest car company by revenue, behind only Toyota. The Volkswagen Group consists of ten European brands from five countries: Volkswagen, Volkswagen Commercial Vehicles, Porsche, Lamborghini, Audi, Bentley, Ducati, CUPRA, SKODA, and SEAT.

Volkswagen is the type of company markets have hated for decades. Capital intensive, “old industry”, polluting, based outside the US. Making cars has definitely not been glamourous lately unless you make electric vehicles (EVs). The dominant narrative has been that legacy automakers are doomed to go the way of the dodo birds, replaced by Tesla and its countless copycats.

You can see a video of the meteoritic rise of Tesla’s market cap in the tweet here. In 2021, it was as large as that of the next 10 biggest automakers TOGETHER.

I think this is about to change, for the simple reason that the leading automakers are catching up and challenging Tesla’s domination of the EV (Electric vehicles) market. Volkswagen is at the forefront of this shift and is ideally positioned to bring affordable EVs to the market.

The group has the industrial capacity, financial resources, technology, and branding power to manage successfully the transition to electric mobility.

The switch to electric will also provide VW with the perfect occasion to modernize its corporate and financial structure. A lot has been done in this direction already, as you will see in this report. VW has also invested heavily in turning the industrial giant into a tech company, from software to self-driving cars.

Lastly, the VW group might also benefit from the planned Porsche IPO and has other prestigious brands that they could spin off in the future.

None of these developments seem priced in at this point. Tesla skeptics have been beaten down by years of failed shorts strategy, so no one seems to notice that the world’s second-largest car manufacturer is going all-in on electric cars.

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2. Extended Summary: Why Volkswagen?

The Electrification Challenge

The transition to electric vehicles is the biggest challenge the car industry has faced in decades. Tesla has been consistently leading the pack, creating a moving goalpost for legacy manufacturers. VW is uniquely positioned to catch up and shows early signs of doing so. Competitors are focused on other technologies or ultra-low price ranges.

Re-Learning Innovation

VW has built a new ground-up development process for building EVs, which it is sharing across the Company’s different brands. This dramatically increases the synergy between the group brands, reducing waste on redundant R&D. VW is also embracing the future of cars as connected devices, with massive progress on software, dedicated electronics hardware, and investments in self-driving technology.

Porsche IPO, Risks & Valuation

VW plans to sell 25% of its Porsche ownership this fall. Half of the proceeds will be used to finance electrification, half distributed as a special dividend. The VW group’s brands are likely to command a premium when trading separately.

VW risks are mostly related to actual and potential supply chain problems. A recession would obviously hurt as well, but valuation and earnings seem in line with the 10-year average and do not reflect the highs of a cycle.

3. The Electrification Challenge

One Battery To Rule Them All

If you are following financial markets, I doubt you have missed the hordes of devoted Tesla investors. Tesla’s value has recently reached a point where it was worth more than the entire traditional car industry.

The picture is very different when we look at the number of cars sold. With the industry churning out a total of around 70 million units/year in 2021, the 1 million production capacity recently reached by Tesla seems a lot less impressive.

Of course, Tesla’s market cap is predicated on the assumption that traditional automakers will never catch up with the EV market leader. So let’s look at the latest EV sales numbers. The image below from September 2021 would indicate that Tesla indeed still completely dominates the industry.

I highlighted VW electric cars. You can see that besides an ultra-low-cost “soapbox” car from China, VW was the second-best behind Tesla, but still far behind.

But this is old news. The ID.4 is quickly rising as a serious competitor, with sales up 65% in Q1 2022. At 30,300 units sold, the ID.4 is now above every other model but Tesla models 3 and Y. You can see a review of the ID.4 in this article.

The ID.4 starts at $40,760 in the US, significantly cheaper than Tesla’s cheapest entry, the Model 3, which starts at $48,440.

More importantly, the ID.4 was less than a third of the VW group sale of EVs. The VW group sold close to 100,000 EVs in Q1 2022, spread out between Audi e-Tron, Porsche Taycan, etc. Each of those is of equivalent quality to Tesla’s luxury models. It probably could have done even better, but “VW supply of EV for the US market ran out“.

Altogether, The VW group EV sales in Q1 2022 are roughly 1/3 of Tesla’s sales. If market caps followed EV sales volume, VW should be valued at $276B, compared to the current $118B.

VW also delivered 1,800,000 traditional cars in Q1 2022, or x18 of its EV volume. I would not base a VW valuation on Tesla, clearly an overvalued company, but still, it put things in perspective.

Is Tesla the Apple of Automakers?

If you need to remember only one thing from this report, remember this section. When studying Tesla, the best parallel would be Apple. Fanatical supporters, high prices, top-level tech, and sleek or surprising design. And that is alright. I think this is the perfect niche for Tesla, and judging by Apple’s history, it could be a very profitable one.

If the smartphone market is a good indication of the future of EVs, this means a counterpart to the Apple strategy. You could as well identify and buy the future Samsung, which slightly outsells Apple in total unit number.

The Apple/Tesla strategy is a powerful one. It is also a limiting one. By tying so much of the product and brand to luxury and identity, it locks itself out of parts of the market. A low-cost iPhone wouldn’t be a “real” iPhone. It seems the road to a $25k Tesla is similarly slow. The “cooler” cybertruck is going to arrive before the “boring” semi-truck (a project lingering in Tesla limbo since 2019) or “just cheap” models.

Volkswagen (whose name means “the people’s car”) doesn’t have such a problem. It can commercialize cheaper and mid-range models under the VW, Seat, and Skoda brands. It sells sports cars under Porsche and luxury models under Audi, Lamborghini, Bentley, and Cupra. If it wants to, it even can enter the market for electric bikes with Ducati. It also provides electric versions of its Scania trucks, MAN buses, and VW commercial vans.

For a perfect illustration of how VW is creating casual vehicles that fill niches unfit for the Tesla brand, we can look at the reimagined iconic VW van ID Buzz.

So if Tesla is the Apple of EVs, Volkswagen has the potential to become the Samsung of EVs.

It will likely be the master of the mid-price range section for EVs, while also taking a sizeable chunk of all the other sectors, from low-cost to luxury and sport. This should be helped by the arrival of multiple new products, notably the ID.5, ID Buzz, and Long-range Aero, but also the cheaper ID life.

The Other Competitors

The automotive industry is a rather fragmented one, and I expect it to stay this way. For example, I expect at least one of the Big 3 (GM, Ford, Chrysler) to stay important in the US market and be joined by Tesla on top of that market.

Judging by this list of the cheapest EVs, with Mazda, Kia, Nissan, and Hyundai, the low range segment is likely to be controlled by Japanese firms. This leaves VW virtually alone in the profitable mid-range segment.

I also expect the Chinese and Southeast Asian manufacturers to take over the niche of the ultra-cheap market, below $15k-$20k EVs. In that segment, we will also find Renault-Dacia with the Duster Spring. Their small batteries will confine them to urban and suburban usage.

The one competitor that could or should have been a serious threat to VW was Toyota. It had the critical mass, reputation, and resources to duplicate VW and even beat it. Instead of competing head front on battery EVs, though, Toyota seems to believe in a focus on hybrids and even hydrogen. Depending on the speed of the electric transition, this might prove a uniquely insightful strategy or a terrible blunder.

This is nevertheless the biggest threat to VW in the future, probably much more than Tesla. I encourage any investor in VW to pay close attention from 2025 onward to Toyota’s progress on solid-state batteries.

You will notice I did not mention other pure EV startups. This is because after Nikola’s outright fraud, the closest contender, Ford-backed Rivian, is in freefall after failing to ramp up production. Simply put, making cars is a tough business, and there is a reason why there were very few new entrants in the markets in the last decades.

4. Re-Learning Innovation

Re-Mastering the Art of Automaking

By its own admission, VW was too slow to react to the trend of electrification. It is now working overtime to correct that mistake. In part, its attention was distracted by fighting a rearguard battle against pollution control on diesel cars. This led VW to falsify pollution reports in a scandal now known as the Dieselgate.

The scandal resulted in costly fines and several executives were arrested or fired. It also pushed VW to embrace the EV revolution. The company was punished with $2.7B in damages but was also forced to invest $2B in clean emission infrastructures. You can read more about the turn to electric vehicles from the company’s CEO in this interview.

VW is an expert at making great ICE (Internal Combustion Engine) vehicles. So it needed a few years to learn how to transfer this expertise into electric engines. The skills were already there for great steering, gearboxes, brakes, suspensions, and all the other components that go into a modern vehicle.

Until now, VW has essentially been a conglomerate of brands. Each of the brands had its own designs, with limited overlap. This led to a very complex supply chain with, for example, hundreds of different gearboxes. The switch to electric has become an opportunity to redesign ALL the VW group’s new cars around common core hardware and software through the shared Scalable System Platform.

This is now handled by the newly formed Volkswagen component Group division. Management seems confident that they can strike the fine balance between keeping brands uniqueness and common designs:

“There are a lot of similarities which we can leverage in scale — even more so on the software side. If you drove an Audi or Porsche and Volkswagen today, you would probably have different hardware and software for navigation, for climate control, and even for the window lifter. That’s not necessary. … Software offers a huge opportunity for economies of scale, still allowing for brand differentiation.

Now, a Porsche can remain a Porsche, even better than today. An Audi can remain an Audi, and Volkswagen will offer a broad range of products, but the basic software stack can be very, very similar. Software is relatively expensive in automotive. Now it’s a one-time expenditure. … We think that we have a good chance to also become very competitive in software if we build a common basic software for all the brands. “

Embracing the Digital Revolution

Dieselgate was the shock VW needed to turn toward the future. Its innovation is focused on 3 areas: Batteries, Software, and Autonomous Driving

Batteries

VW is developing a hybrid solution between complete reliance on large third parties (CATL, Panasonic) and Tesla-style vertical integration. Its 2 main partners are smaller battery manufacturer NorthVolt and QuantumScape, a solid-state battery startup. It was considering an IPO for its battery division in 2021 but that seems to be on the back burner for now, with the Company focusing instead on the Porsche IPO (more on that later).

VW is also investing heavily in startups with valuable technology. For example, a $400M investment in Group14, replacing the traditional graphite anode in lithium-ion batteries with a silicon-carbon material, is boosting battery capacity by 50%.

VW’s low-carbon profile is also helped by investment in new facilities, notably $10B in solar-powered factories in Spain for electric cars and batteries.

The end goal for VW is to keep the high acceleration performance of EVs while also having very long range and fast charging. All of these will probably be fully achievable only when solid-state batteries are fully implemented.

Software and IT hardware

The CARIAD division is in charge of developing a group-wide software stack, to be used by all VW brands by 2025-2030. This will make all VW cars connected devices, following the footsteps of the On-the-Air updates by Tesla. It also handles the design of dedicated hardware allowing the removal of up to 1 kilometer of cable per car compared to previous designs.

Autonomous Driving

VW is partnering with and investing in Argo AI to develop autonomous driving solutions. Autonomous driving is a contentious topic among tech enthusiasts. Some expect it yesterday, others see it at best 15 years in the future. Considering the constant delays of Tesla Full Self Driving, it seems a tough nut to crack. You can read more about Argo AI methods in this interview with its CEO.

The ride pooling solution MOIA and its dedicated 6-seater are planned to complement the autonomous driving solutions.

VW’s approach is a cautious one, focusing on limited autonomy in a defined area, and expanding slowly from there. The cultural difference between US startup culture (the hare Tesla) and German industrialist (the tortoise VW) is probably at play here.

Our aim is to be able to drive a car as Volkswagen. We have two areas: one is pushing robotaxi technology with Argo. This involves shuttle services, limited areas, relatively slow speeds — they are typically ODD, which is learned and programmed. Then it goes area by area and city by city. The other way we are pushing is private mobility: we have the Audi team and CARIAD team working on that because we think that autonomous driving will not only cover this area of robotaxis, but also private cars. Step by step: first we tackle driving at level three or level four on open highways — German autobahns — and then we get into more complex areas.

The Verge

5. Porsche IPO, Risks & Valuation

Porsche AG IPO

A side notice: I am speaking of Porsche AG, the company manufacturing and selling the Porsche cars. Don’t confuse this with another company, Porsche SE. Porsche SE is the holding of the Porsche family, which owns a large part of VW, which in turn owns Porsche AG, the car company. Quite confusing I know. Welcome to German corporate structures.

VW acquired Porsche AG in 2012 and is planning the sale of 25% of the Company this fall. Porsche AG has recently shown a great gross profit margin of 18.6%. The intended pricing of the IPO is not yet clear. For example, Mercedes, BMW, and VW trade at 5-6x earnings; Ferrari at 40x earnings. So the multiple on Porsche earnings will be a major factor. The idea behind the IPO is to let Porsche AG trade at luxury/supercar multiples, instead of “boring” large automaker multiples.

At a middle ground P/E between Ferrari and German automaker, this would give Porsche AG a valuation of $84B. Even at half of that, a $42B would be a significant part of VW’s $102B current valuation. Plenty of debate exists about VW’s ability to lift its current “conglomerate discount”. The second part of this article provides more information on this issue and will help you form your own opinion.

Half of the proceedings of the IPO will be distributed to VW shareholders, and the rest applied to advancing VW’s electrification plans.

Other Brands?

No plans have been announced for a similar IPO for the other luxury brand in the VW portfolio. Nevertheless, if the Porsche IPO is a success, I could easily see Lamborghini, Audi, Bentley or even Ducati receive the same “25% sold in an IPO” treatment. This would help price discovery for these brands/companies, while still maintaining VW’s total control over the brands.

This is not as far-fetched as you could think. Last year, VW received a $7.5B offer for Lamborghini for example. VW refused the offer.

Risks

VW’s plans for electrification are the main attraction to the stock. Whichever of the top 5 legacy automakers will manage the electric transition will reap outstanding rewards. Nevertheless, the industry is facing quite a few headwinds:

Recession Risk

After one of the longest bull markets in history, rising rates, inflation, and war in Europe have all contributed to an increased risk of a global recession. The automotive industry is notoriously cyclical. All the recent high profits of VW and its competitors should be taken with a pinch of salt. We might be at the highs of the economic cycle, and car sales in the next few years might turn out lower than hoped.

Energy Costs

VW is a German company, and exploding energy costs in Europe are a real concern. The company is producing outside of Europe as well, but this can still hurt its home market disproportionately. If Russian gas stops flowing entirely because of the Ukraine war or sanctions, this would likely cause exploding prices for energy-intensive materials like steel and batteries.

Supply Chain Disruption

This one is less a potential risk as an ongoing concern. It also applies to most VW competitors. Chip shortages have plagued automakers for 2 years now. The recent wave of Chinese lockdowns is not going to help improve the supply chain either.

On top of that, a cheap but essential component, a wiring harness, was mostly supplied from Ukraine.

Supply chain issues limit production, and output levels are likely to be disappointing in 2022. I expect VW to handle it better than its smaller competitors, but this might still hurt sales volume.

Lastly, some supply issues might emerge in the long run. The supply of lithium, copper, cobalt, and nickel might be too short to cover all the batteries automakers are planning to build. New mines might take 10 years to get operational, so this is a serious risk. In that respect, VW might make a good pair in a portfolio with the miner Rio Tinto (covered in a previous report a few months ago). The rising costs of VW would be Rio Tinto’s profits, reducing the overall risk of the portfolio.

Valuation

An investment in VW is a bet that the company emerges on top of the electrification trend, or at least as a major player. Due to Toyota’s focus on hybrid and alternative fuels like hydrogen, I think this is likely. The persistent delays in an affordable Tesla car, build quality issues, and branding issues, make Tesla at most an equal, but not the domineering force people think it is. I think the recent ID.5 sales volume reflects this change in consumer perception when it comes to EVs.

With a P/E of 5.3 and a price to free cash flow of 4.3, it would be tough to argue that VW is overvalued. My main concern would be for this coming from abnormally high earnings or revenues in the last few years.

Looking at the past 10 years of revenue, net income, and profit margin, I do not see anything out of line. Only drops in 2016 (DieselGate) and 2020 (Covid) break the trend. VW is a very steady and stable company. I am also pleased to see that net income is stable even with the massive investment in electrification.

This is not a company that will see a 10x rise in value. But it gives a small dividend and might be much more stable than other overvalued portions of the market. A company with a major focus on software, electrification, and self-driving is also offering the low valuation of an aging industrial giant.

As we move to bear market territory, will market perception change from looking for risky hypergrowth to stability. You could argue that it’s already happening. If it does, VW stock will be there to capitalize on it. The Porsche AG IPO is another possible catalyst, with the special dividends seemingly not priced in.

In my view, if you’re considering adding a company like VW to a portfolio, the main focus should be on providing less volatility to the portfolio while retaining the potential for decent returns. Dividends and stable net income should provide that, given the low multiples. Short of a brutal worldwide recession, VW should provide decent returns, with a chance of a stock price surge driven by positive EV sales and production figures or a successful Porsche IPO.

The risk with these old industrial giants is the possibility that they will be caught unaware of a technology shift. You don’t want to end up owning the next Kodak all the way to zero. Considering the efforts VW has put into modernizing its line and innovation, I am confident they will benefit from the EV trend instead of being harmed by it.

6. Conclusion

Volkswagen is the type of investment that will probably never provide the highest returns in a portfolio. It is a safer, more mature type of company, reducing overall volatility. I would not necessarily have looked deeper if it was not selling at a rather cheap price.

On top of the price, I am appreciative of the strategy. The company did not rush into electrification, but when it decided to do the switch, it did it right. The product performances in mileage, quality, and price show a level of engineering equal or superior to Telsa, the market leader. The only maybe lagging part, software, is catching up at a breathtaking speed.

Developing the ID.4 and ID.5 was a massive endeavor in design, battery technology, electric engine, and specific parts like gearboxes. This EV expertise acquired in mid-price cars can now be brought quickly to all price ranges, as well as commercial vehicles, trucks, buses, or even bikes.

I expect VW scaling up electric vehicles will catch most observers by surprise. The EV market got used to seeing the opening of a new Tesla Factory on a new continent as big news. With companies of the scale of VW entering the market aggressively, this will be a common occurrence.

VW will also be able to draw from its almost 2 million traditional cars per year sales to finance the transition. Its “legacy” operations also give it access to a very deep pool of talented engineers, designers, researchers, designers, testers, etc, whose skills can relatively easily be repurposed for EV models. The same old true for brand strength, PR contacts, and sales networks.

The ability to still make money for ICE (Internal Combustion Engine) cars while turning to EVs seems especially useful for me. If the transition to EVs turns out slower than expected, or raw minerals for batteries are too rare or expensive, VW can simply slow things down a little and keep making money selling the cars that made the business strong for decades.

Lastly, the rich panel of brands in the VW group could be a source of hidden value. Luxury or sports brand tends to trade at a premium. After Porsche, VW could progressively consider IPOs for Lamborghini, Bentley, Audi, and Ducati. I suspect that the parts are worth more than the market value for the whole group together.

Using the Porsche IPO as a template, VW keeping 75% ownership would allow just enough price discovery, while keeping the brand safely at home. They will all benefit from the Group R&D and common base architecture for the transition to EV. This is something independent supercar companies like Ferrari could not afford without becoming over-reliant on third-party suppliers.

Finally, self-driving solutions contain a lot of options. I suspect that even if Argo AI turns out not to be the best technical solution, its methods will appease regulators better than Teslas. No one wants 2-tons of metal driving around by itself without enough data and feedback to be sure it’s safe.

So I expect the adoption of self-driving cars will be slow for regulatory reasons no matter how good the tech is. It will only be adopted on highways and well-known routes at first (like between airports for example) and expand from there. A reputation for slow and steady corporate methods seems more appropriate than the somewhat reckless and brash style of an Elon Musk.

The post Volkswagen (VWAGY) Stock Analysis appeared first on FinMasters.

Quick Stock Overview

Ticker: 300750.SZ

Source: Yahoo Finance

Key Data

Industry	Batteries / Electric vehicles
Market Capitalization ($M)	159,240
Price to sales	4.01
Price to Free Cash Flow	–
Dividend yield	0.15%
Sales ($M)	39,674
Free cash flow/share	–
P/E	40

1. Executive Summary

Update: CATL’s latest quarterly results, reported on March 9, 2023, showed a 92.9% increase in net income and a 152% increase in revenue over the equivalent quarter in the previous year. The margin was 17.2%, and the Company controls a dominant 37% of the global EV battery market.

Electric vehicles (EVs) are a growing trend in Western countries, led by high-end car brands like Tesla and, more recently, Audi, General Motors, and many others. But the real EV revolution is happening somewhere else, in China.

With China representing by far the largest EV market, it is not surprising that the largest battery manufacturer in the world is from there as well.

Battery tech is an ultra-competitive sector. Any advance in battery chemistry allows for more range, safer design, and cheaper vehicles. This also means intense requirements for a high R&D budget and economies of scale to beat aggressive competitors.

By controlling 1/3 of the world market, CATL can reach a scale and capacity that none of its competitors can rival.

Its newest technology is truly groundbreaking and should usher a turn for EVs from expensive innovation to everyday life items, as it can greatly reduce the current limitations of EVs.

In parallel, CATL will be able to grow in other new markets, like grid-scale energy storage, other types of vehicles (delivery, trucks, ships), and battery recycling. It is also starting to produce outside of China, trying to capture the quickly growing European market.

The company has a lot of cash on hand and a reasonable debt load. It is also profitable and growing rapidly. While not cheaply valued, it is now priced at a much more reasonable level than it has been in years.

2. Extended Summary: Why CATL?

Powering the Electrification of China

CATL has emerged in less than a decade from a spin-off from a Japanese consortium to the company producing 1/3 of all lithium batteries made in the world.

Its initial success was built on the back of generous state subsidies, but it is now standing on its own.

A Deeply Technical Company

The company is atypical in China, focusing on R&D and innovation. Through its technical excellence, it has brought almost every car maker in the world onto its customer list.

Through a company culture of openness and operational excellence, CATL has been able to keep these relationships growing and become the world leader among battery manufacturers, beating its Korean (LG Chem), Japanese (Panasonic), and American (Tesla) competitors.

CATL’s Future

CATL’s R&D effort is paying off, and the company can now manufacture a revolutionary “million-mile” battery with twice the energy density of previous technology. This will accelerate the growth of the EV market and open new opportunities for trucks, ships, and utility-scale energy storage.

The company is also proactively adapting to looming metal shortages (lithium copper, cobalt, nickel) thanks to prescient investments upstream in the supply chain (mining, processing) and fully developed recycling processes.

Filling an EV Investment Gap

EV manufacturers have been the darlings of the investment community for several years, with valuations often soaring far beyond rational levels.

Today’s market is becoming increasingly challenging for EV makers. EV adoption is expanding rapidly, but large numbers of new companies and new models are entering the market, generating unprecedented competitive pressure. It remains unclear, for example, whether specialist EV makers can compete with the economies of scale that legacy automakers can bring to bear as they enter the EV market.

It’s not clear who will dominate the EV market, but CATL clearly dominates the battery market and is well-positioned to continue doing so. That could make CATL a better bet than any single EV maker.

Financials

Revenues and net income are growing at an accelerating pace. So are investments in R&D and CAPEX spending. The company’s balance sheet is very solid, with a massive amount of cash on hand and a reasonable debt load.

Valuation is not cheap, but not outrageous either, considering the growth profile. It is, in any case, a lot more sensible than at its peak in 2021, 50% above the current valuation.

This report first appeared on Stock Spotlight, our value investing newsletter. Subscribe now to get research, insight, and valuation of some of the most interesting and least-known companies on the market.

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3. Powering the Electrification of China

From Humble Beginnings to Giant

CATL is a rather new company by today’s tech industry standards. Compared to Google or Amazon, founded in the 1990s, or even Tesla in 2003, the CATL foundation in 2011 is downright recent.

The company is a spin-off of Amperex Technology Limited (ATL), which produced batteries for small consumer electronics and was founded in 1999. CATL would go on to focus on electric car battery technology. ATL was incorporated into a Japanese consortium in 2005 and sold its last ownership in CATL in 2015.

From this early start, the company has grown into a key supplier of batteries for a very large array of car companies, including BMW, Daimler, Hyundai, Honda, Stellantis, Toyota, Volkswagen, Volvo, and – maybe the most spectacular achievement – Tesla, a company normally obsessed by vertical integration of its supply chain.

This impressive list does not even include the many Chinese car brands like BAIC, GAC Group, or Geely, less well-known in the West but still major contributors to global EV sales.

CATL is also unusual for being based away from the usual Hong Kong, Shenzhen, or Shanghai centers of operation of Chinese tech companies. It is still operating from Ningde, the hometown of ATL founder, Mr. Zeng.

Before becoming an entrepreneur, Zeng worked for a state-run company earning $30 USD a month. In 2021 Zeng became the second richest man in China, below Alibaba’s Jack Ma and ahead of ByteDance founder Zhang Yiming.

Ningde was a rather unremarkable coastal town, and even today, after tremendous growth and development, it is still home to “only” 3 million people, far from a big metropolis by Chinese standards. You can see the stunning growth of the city, almost entirely based on CATL’s success, in this QZ article.

It seems Zeng’s style fits his hometown, as his discretion and low profile have sometimes seen him called the “anti-Elon Musk.” Since earning a Ph.D. in condensed matter physics, his career and scientific work have been dedicated entirely to better battery technology. While many tech CEOs are mostly managers, I think it is fair to credit Zeng for the company’s track record in innovation.

Riding the Electric Subsidies

The success of CATL came partly from the usual sources of Chinese industrial companies’ success stories: cheap labor, very good engineering, and unrestricted and somewhat protected access to a 1.5 billion-person market.

But it would have gone differently without a massive push for vehicle electrification by the Chinese government. In 2008, the Chinese government mandated ATL for a fleet of prototype electric buses for the Olympic Games.

In the next few years, the government would launch a series of campaigns to promote research and development of electric vehicles. Perceiving an opportunity, Zeng left ATL and spun off CATL from it in 2011.

One part of the subsidies created the demand for this new market through public spending. For example, Shenzhen turned its entire fleet of 16,000 buses electric. The government also paid 1/3 of the EVs costs to the buyers.

And it worked. In 2022, 4 million of the new cars sold in China were EVs, and another 1.7 million were hybrids. This makes China a market 5x larger than the USA when it comes to “new-energy vehicles” (EV and hybrids). China is a bigger EV market than the rest of the world combined. And by 2030, 40 percent of vehicles sold in China will be electric.

Another part of the subsidies was cheap factory land, tax breaks, and other benefits for car manufacturers looking to produce EVs in China. The only requirement was to use batteries from a list of a dozen approved Chinese suppliers, including CATL.

But truly, when considering technical performance and production capacities, the choice boiled down to only two suppliers: BYD and CATL.

BYD had very good batteries, but as a car manufacturer, it was not interested in supplying competitors like BMW. Similarly, BMW was not keen on being dependent on its main competitors in China or providing it money to gain a competitive advantage in a field where German manufacturers were already lagging.

Today, BYD, which happened to have Warren Buffett among its investors, is the leading Chinese EV manufacturer, with 1.85 million cars sold in 2022. CATL dominates global EV battery sales.

The last key subsidies came from a steady supply of rare earth metals, a key component of batteries, and a supply chain largely under China’s control.

Standing on Its Own Legs

By 2018, the Chinese government was starting to feel that EV subsidies had become too costly. Besides, the technology was much more mature, and national champions like CATL and BYD were firmly established.

Subsidies were cut to almost zero by 2020, and competitors from Korean and Japanese battery makers were given much greater access to the Chinese market. For Chinese companies, this type of transition from subsidies and a protected market to a really free market can be rough or even deadly.

Luckily, CATL had planned for it. Leveraging now long-standing relationships with foreign auto manufacturers operating in the country, it was already growing its export markets quickly.

It also had established divisions in Western countries well before the local demand for batteries was mature enough to require them. Finally, the opening of the Shanghai Tesla factories allowed CATL to add the most valuable car company in the world to its client base, extending a deal to 2025.

CATL successfully transitioned from a protected national champion to an international company able to stand independently. As you can see below in the graph of the last ten years of CATL results, the end of subsidies did not hurt the company’s growth at all.

4. A Deeply Technical Company

A Scientist and Engineer-Led Culture

CATL’s founder was a scientist before being a businessman. The culture of the company he founded reflects that. From the beginning, CATL’s strategy has been to produce the best possible batteries, not necessarily the cheapest or the easiest to manufacture.

To achieve this, the company is spending as much as it can on R&D. For example, in 2017, the company spent 11% of its revenues on R&D, compared to just 6% for its competitor BYD.

Many Chinese firms are accused of stealing IP or failing to really innovate, but CATL definitely does not fit this archetype. Instead, it is filling an exponentially growing number of patents and developing new battery chemistry that produces outstanding performance.

The other key aspect of the company’s culture is a very high level of openness. First to foreign talent, notably with the poaching from General Motors of an American battery expert, Bob Galyen, to make him the company CTO.

Secondly, this is a company that avoids putting its employees in “silos,” inspired by the success of Huawei with this strategy. Every employee should have multiple roles and understand several aspects of the company’s operation.

This creates a culture where initiative and problem-solving are rewarded and where open interactions between departments can improve daily operations.

I was hired as a supply-chain manager, but then they also made me program manager, and then also design-quality manager.

One of CATL early employees

Staying at the Technological Edge

The focus on technical supremacy started with ATL producing lithium-ion batteries that would not swell or blow up, beating much larger companies like Sony at solving this problem. This also allowed the company to become the supplier of both Samsung and Apple when smartphones became a large market.

Batteries for EVs need to be custom designed for each car model. So by being early in the EV sector, CATL also learned to work with car manufacturers and adapt to their various technical requirements.

CATL can produce all possible types of batteries used in EVs, including cylindrical cells (Tesla), prismatic cells (BMW), or pouch cells (Jaguar). It uses two different types of batteries currently: lithium with nickel/cobalt/manganese for EVs (similar to smartphone batteries) and lithium iron phosphate for buses.

In just a few short years, CATL combined Japanese discipline, German engineering, and Chinese entrepreneurship to become one of the most desirable battery manufacturers in the world.

qz.com

5. CATL’s Future

Beyond Lithium-Ion Batteries

The main constraint for EVs has always been the battery pack. From it come all the limitations of EVs compared to fuel-powered cars:

• Limited range and a lot of extra weight.
• Slow recharge, even with dedicated facilities.
• Risk of electrical fires that cannot be put out with water.
• Poor efficiency in cold weather.
• Higher prices than internal combustion cars.
• Somewhat short lifespan, often below the lifespan of the car itself.

Each of these issues has been a brake on EV adoption. Most of these problems can be reduced but not completely eliminated with traditional lithium-ion battery design. This is why researchers and battery companies have spent billions trying to find alternatives.

LFP

The first step for CATL was developing the best Lithium Ferro-Phosphate battery (LFP) in the industry. As I said before, these have already been commercialized by CATL for electric buses, which require more power than individual EVs.

LFP batteries have many advantages compared to lithium-ion.

• Cheaper.
• Higher safety (fire hazard).
• No cobalt, which is often sourced from Congo and produced with child labor.
• No nickel, which is often responsible for the high price of lithium-ion batteries.
• Much longer lifespan.
• Faster charging.

LFP was the design chosen by Tesla for some of its vehicles in a bid to reduce prices, fire hazards, and reputational risk from cobalt supply.

Currently, CATL offers LFP at $80/kW. This is below the $100/kW considered the threshold required for mass EV adoption.

CATL’s price advantage comes from a much cheaper cathode, 43% cheaper than other more energy-dense options. LG Chem and General Motors are working on their own version of this technology but are unlikely to achieve this cost level before 2025.

Still, LFPs are not perfect. They offer less energy density (energy per kilogram) than lithium-ion. So even if the total might be cheaper, you need more of them for the same results.

Essentially, CATL leadership in LFP allows it to stay dominant until the next step.

This next level was announced in 2020 when Zeng announced CATL would produce a “million-mile battery” jointly with Tesla.

The Million Mile Battery

CATL’s LFP battery has a density of 200Wh/kg, up from 161 Wh/kg in 2020. This is good, but still not dense enough to produce cheaper and more efficient EVs.

Its new “million-mile” battery will not only be able to survive a million miles of usage (far more than most cars ever drive before turning into a rust bucket). It also has a battery cell density of 330 Wh/kg.

This near-doubling of density implies more than a doubling in efficiency. Batteries can represent up to half the weight of an EV: a Tesla Model S weighs 2130 kg (4697 lbs). By reducing the amount of battery needed, you reduce the total weight of the car. This reduces the amount of battery needed, which reduces the car’s weight, etc…

With the battery 32% of the total cost of an EV, reducing the battery needed by 60-70% means a huge cost advantage for manufacturers switching to the new CATL design.

Alternatively, it can offer a never-seen-before range of over 1,000 km for more pricey models.

And this is not all. This new design also has other advantages beyond costs (you can check CATL’s website for the details):

• much higher level of safety, even in case of a crash.
• low-viscosity electrolytes ensuring higher performance in cold weather.
• charging up to 80% in just 5 minutes.
• as mentioned before, a service life of 16 years or 2 million kilometers.

Overall, it seems CATL is on the way to keep growing its market share among battery volume, from the current 35% to potentially 40-60%. All this while the market itself grows quickly, driven by the costs saving CATL technology creates.

Currently, there are no serious competitors for the million-mile battery technology. The only serious alternative would be solid-state batteries, notably the one promoted by VW’s partner QuantumScape.

QuantumScape claims to have batteries reaching 550Wh/kg and even potentially 1100 Wh/kg. But these are, for now, just lab performances and have never been tested at scale.

Will this be an actual threat to CATL? Maybe. But for now, QuantumScape has been a lot slower than anticipated to bring its technology to a commercially viable scale. The transition from lab prototype to mass production is a difficult one. QuantumScape also has nothing even remotely close to the R&D and development resources that CATL has.

So this is something investors in CATL should keep an eye on but not lose sleep over.

Resources Shortages

Speaking of risks, one that should also be mentioned is the cost of metals used to produce the batteries. Lithium, but also copper, cobalt, nickel, and other metals have all exploded in price in the last few years.

So while new technology like LFP or the million-mile battery can bypass the need for cobalt or nickel, the rise in the price of lithium and copper, most of the costs of a battery, is more concerning. CATL is, after all, as much a CAPEX, resource-heavy industrial company as it is a “tech” company.

The situation is also likely to continue, as investments in mining have been insufficient for several decades now, especially in copper.

According to a new report from Wood Mackenzie, the world will need 9.7 Mt of coper mine supply over the next decade from projects that have yet to be sanctioned, if it is to meet zero-carbon targets. “To date, a shortfall of this magnitude has never been overcome within a decade,” WoodMac’s copper researchers and analysts said.

Looming Copper Shortage Could Slow The Global Energy Transition

This is not a problem unique to CATL but to all battery and EV manufacturers.

Actually, CATL has been proactive in securing supply by investing massively overseas in the upstream part of the supply chain. Notably:

• A $5B lithium battery plant in Indonesia, starting in 2024.
• Investment in the Pilgangoora Lithium-Tantalum project, one of the world’s biggest lithium development projects.
• Lithium processing facilities in South Korea.
• Stakes in mining projects in Argentina’s lithium-rich region and in Congo (for cobalt).

The new million-mile battery should also help, as it requires less lithium than a normal battery, despite the improved performance.

Resource prices increasing might put pressure on CATL margins in the short term. But as its competitors are in the same situation or worse, this should not affect its dominant position. Denser and cheaper batteries, like the million-mile battery, could enhance that dominant position.

Beyond EVs

Other Vehicles

CATL’s destiny is currently tightly tied to EVs. That could change. Batteries are becoming increasingly important for other applications as well.

The first is other types of mobility, in which CATL’s experience in LFP batteries for buses will come handy. The rest of the world is yet to follow China in electrifying its bus networks.

The progressive electrification of truck freight should provide an extra market by the end of the decades. Even if this might prove quite slow, as the elusive and regularly postponed Tesla Semi truck seems to indicate.

Another way to improve electric vehicle potential is battery swap or battery as a service (BaaS). Instead of having users wait for the battery to recharge, they can just have it swapped for a new, fully charged one. This removes a problem for users (long waiting time for charging and queues at the charging station) and also removes the fear of the battery packaging badly.

Utility-Scale Energy Storage

Currently, CATL stationary energy storage solutions are used for two types of applications:

1. Power backup for things like cell phone towers and data centers.
2. Peak shaving batteries allow energy-intensive industries like cement producers to buy power when it is cheap (like at night) and use it later when power is expensive).

Renewable energy tends to produce at times when the electricity is not needed and not when it is. For example, solar panels do not produce in the peak consumption hours in the evening.

To handle this daily mismatch between demand and production, utility-scale battery systems will be needed if we want the electric grid to run on mostly renewable power. This represents an absolutely massive amount of storage, the equivalent of thousands or tens of thousands of EVs for every small town and the equivalent of millions of EV batteries for large cities.

CATL is the leader in these solutions, with 100+ projects worldwide.

I think this market will stay open for growth for CATL. I am not sure, however, that it will be the main driver of the company in 10+ years.

The reason is that lithium batteries are specifically designed to reach an optimal energy/mass ratio. This is great for vehicles.

But for utility-scale storage, a very small or very light battery is not critical. A very low price per kW of storage is. Weight or size is not really relevant when the battery never moves and can be stored next to a power station.

So other solutions should perform better, like Ambri’s liquid metal batteries, Redox Flow batteries, GMG Graphene Aluminium batteries, or Iron-Air batteries. They are all too bulky/heavy for transportation but might be 10x cheaper than lithium-based batteries when their technology is mature.

For this reason, I expect these technologies to beat lithium batteries for utility-scale energy storage solutions, at least in the long run. These are technologies where CATL would not necessarily have a competitive advantage.

Still, for the incoming decade, we can expect utility-scale batteries to be the driver of extra profits for CATL, even if not a sustainable business line.

Battery Recycling

The last activity that will grow for CATL is battery recycling. The EVs currently in circulation will be retired at some point in the future. Their batteries are both a valuable source of key minerals and an environmental/safety hazard.

Safe and clean recycling of batteries will be a necessary step for EVs to become the main transportation system in the world, especially with buses and trucks that will carry as many batteries as 20-40 cars per vehicle. And even more, volume, if other industries like shipping electrify as well.

CATL is already recycling 50% of the used batteries in China, or 120,000 tons, through its subsidiary Brunp, with a 99.3% recovery rate for manganese and cobalt. They do not communicate their recovery rate on lithium or copper, so I assume some progress is still needed there.

The recycling business should also help CATL to alleviate resource shortages by essentially mining old batteries.

It will also give CATL access to a VERY large pool of old EV batteries. These batteries can be either recycled or reused in utility-scale power banks. The second option is attractive, as a lower efficiency or capacity battery might not be fit anymore for use in EVs, but a much lower price could make reused EV batteries more competitive in the utility market.

US-China Relations

I cannot cover a Chinese company without mentioning the continuous degradation of relations between China and the USA.

This is part of a long trend that started with the Trump trade war. The escalations of more sanctions by the Biden administration, notably on the semiconductor industry, made it even worse.

The support of China for Russia in the context of the Ukraine war did not improve the situation either. Nor did the saber-rattling from both sides around the question of Taiwan’s independence.

So this is a risk to keep in mind when considering an investment in CATL. If the Ukraine war taught us something, it is that geopolitics can matter a lot when investing in countries that have a rivalry with the West.

I would, however, consider that CATL is less vulnerable than many other Chinese tech giants for a few reasons:

• The company is only listed on the Shenzhen stock market. This means you need a broker with access to this exchange to buy the stock. It also puts the company in a safe position if the US authorities use delisting as a tool to punish China and Chinese companies.
• There are no bases for a claim of CATL benefitting from Chinese subsidies and punishing it with tariffs. If anything, it is the West that is subsidizing EVs these days.
• European car manufacturers are a large part of CATL’s overseas business and will be less willing to sever ties than US car makers might have been.
• Batteries are a truly civilian application, and CATL has no links with the Chinese military-industrial complex, unlike Huawei, for example.
• There is no “national champion” equivalent to CATL in the West. Its main competitors are mostly Asian (LG Chem, Panasonic) or are already CATL partners (Tesla, BMW, Volkswagen).

So overall, I do not expect CATL to become the center of an international power game, at least as long as the US and China are not going toward a full-blown war. And then, I fear the CATL share price would be the least of our concerns.

Markets seem to agree to that as well, with CATL a lot less punished by the Chinese tech bubble popping than other companies like Alibaba.

On February 1, 2023, Reuters reported that CATL is considering listing its ADRs in Switzerland, with a listing contemplated as early as May. The offering would raise $5 billion that would be used to develop manufacturing facilities in Europe. The report relied on confidential sources and has not been confirmed by CATL.

6. Financials

CATL’s investor relation website is remarkably poor for such a large and international company. Its annual and quarterly reports are exclusively available in Chinese. So I relied on Yahoo Finance and Finbox.com data for this part of the analysis.

This is really something that should be fixed to increase the attractiveness of the shares to foreign investors.

At the same time, it really fits the company profile of being tech and business-driven rather than focused on share price fluctuation and financial markets.

Impressive Growth

The end of Chinese EV subsidies in 2018-2020, followed by the pandemic, should have been a time of trouble for CATL. Judging by revenue, net income, or profit margin and gross profit, this was not the case. If anything, revenues have exploded upward since 2021.

Free Cash Flow & Spending

While net income is doing fine, free cash flow turned negative at the end of 2021. This was due to a massive CAPEX increase. The causes are many: general inflation, investments in the supply chain with mining and lithium refining, new factories to increase production, expansion in Europe with new production lines, and many large utility-scale projects initiated recently.

R&D spending has also gone from $430M in January 2020 to $1.9B in January 2023. This is a significant drag on cash flow but a necessary investment in the long-term health of the company.

With cash on hand at $18B and total debt of $8B, the company balance sheet is solid. Especially when considering an operating cash flow of $6B, in line with the whole CAPEX ($7B) and debt repayment ($2B).

At the current burn rate, the company can run nine years of operations, and would any solvability issue occurs, it could simply slow down a little on CAPEX and R&D spending to reach profitability.

Truly, it seems CATL has fully exited the stage of a growth company needing outside funds, except for a little debt to fund CAPEX. The large cash cushion also indicates that the company has anticipated higher rates and planned ahead to have all the cash it needs for future expansion and growth.

Valuation

With a P/E of 40, CATL is by no means undervalued. And this is even after a decline in the stock price of 50% since its peak in 2021 and revenues that have doubled over the same period.

So I would qualify at most the current valuation of reasonable. With little margin of safety, the only useful valuation tool is to judge if the expectations for future growth are reasonable. And I think the growth profile of the company is as good as it has ever been.

Revenues are growing at an impressive speed, actually quicker than ever.

The next step of growth should be triggered by the mass production of the million-mile battery design. This should have the effect of both increasing market penetration, but also drastically growing the market.

EVs have been able to penetrate the Chinese market at a much higher rate than in the West because the Chinese EVs were often for city travel, tolerating lower range, smaller cars, and lower performance.

With better batteries, EVs are now going to get not only greener but also cost and performance competitive with traditional cars. The arrival of an endless stream of new designs by almost every car brand will also push broader adoption.

Currently, the US sees only 5.8% of car sales being EV or hybrid. If this ratio jumps to 10% or 20%, we would still be far from fully electrifying the whole transportation network, but it would represent a colossal number of battery packs. The same if most Chinese cars turn electric.

The emergence of massive fleets of electrified buses, delivery vans, and even trucks will add to this massive demand for more and more batteries, likely stretching to the max the capacity of the industry to provide them. One bus can need as many batteries as tens of Teslas.

In that context, CATL’s large CAPEX spending today is the spare capacity to respond to its customer demand tomorrow.

Thanks to its R&D effort and the resulting superior technology, CATL is likely to size most of this growth in China, but also in the EU, USA, and Japan.

Returns to Shareholders

I would say that the decline in free cash flow is not alarming. It mostly reflects the need for rapid production growth and supply chain risk management. This, however, raises questions about when CATL will turn durably cash flow positive and be able to distribute some of its profit to its shareholders.

For the moment, it seems that CATL will stay focused on production growth, diversification in new markets, and exponential R&D spending to stay ahead of the competition. Considering its market and competitive position, this seems like the right call.

So most of the return should be expected in the shape of share prices rising up, something a lot less predictable in the short term than steady dividends. That’s also something to be expected for a growth tech stock.

7. Conclusion

CATL’s predecessor, ATL, was a classical Chinese industrial company. It leveraged cheap labor, good engineering, and low capital costs to build a durable competitive advantage and become a key supplier in the global value chain.

CATL is a different company altogether and has a profile that’s a lot less common among Chinese companies. The company is a true innovator on the level of Intel, GE, Panasonic, or Telsa. It has demonstrated brilliant corporate strategy, correctly anticipating the market’s future demands, the end of Chinese subsidies, and the looming shortage of battery metals.

It is also a global market leader, aiming for a quasi-monopoly position in its market through scale, best-in-class R&D, and a really prescient business strategy.

In that respect, I think CATL is emblematic of a new phase in China’s development, from being just a supplier of cheaper goods to a country able to imitate the American growth story, built on innovation and industrial prowess.

So short of out of control tensions between the two countries and a full-blown new Cold War, I think CATL could provide great returns for Western investors in the future.

It could even become one of the first Chinese companies with a valuation durably above the trillion dollar mark, joining the very short list of tech giants that became world leaders in innovation.

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