If you are considering defense industry investments, this primer will introduce the basic structure and subsectors of the industry and look at some issues and concerns that are unique to it.

Only the dead have seen the end of war.

Plato

The Case for Defense Investing

Global defense spending is on a continuous and seemingly unstoppable growth curve.

One simple for this growth is geopolitics. Conflict and the potential for conflict are simmering around the world and occasionally – as in Ukraine – boiling over. An arms race has started between the US and China and looks set to last for a while. Just to give you some perspective, here is some of the most recent news about increases in military spending:

• Germany commits an additional €100 billion to defense spending.^[1]
• China boosts defense budget again, exceeding $208 billion.^[2]
• Senate panel approves record US military budget for 2022-2023 ($858B).^[3]
• Poland to increase defense spending to 3% of GDP from 2023 ($23B).^[4]
• France to request multibillion-dollar defense budget boost in 2023 ($44B).^[5]
• Japan Begins Defense Upgrade With 26% Spending Increase for 2023 (51B).^[6]

None of these budget increases have yet translated into increased earnings for defense firms, but stock prices are already reflecting some of these expectations.

Si vis pacem, para bellum
(If you want peace, prepare for war)

Vegetius

Industry Structure

Over the last three decades, we have seen a consolidation trend in the industry, especially in the US defense industry. You can read more in this article about how many of the US suppliers to the military are now merged into just 5-6 megacorporations:

• Lockheed Martin
• Boeing
• Northrop Grumman
• Raytheon
• Huntington Ingalls Industries
• General Dynamics (we covered the General Dynamics investment case in this report in April 2021 report, with the stock up 32% since).

Most non-Western manufacturers are state-owned companies that are closed to investors. Beyond the US, other NATO countries and US allies have publicly listed defense companies, for example:

• France: Dassault, Airbus, and Thales
• Germany: Reinhmetall, Thyssenkrupp and MBDA
• UK: BAE Systems
• Italy: Leonardo
• Sweden: Saab.

The defense industry actually covers a multitude of subsectors, often categorized by technology:

• Aerospace (planes, satellites, missiles,…)
• Cyberdefense, Telecom, and AI
• Weapons (ammunition, artillery, guns, …)
• Vehicles (armored carriers, tanks, …)
• Maritime (ships, submarines, …)
• Logistics & Software
• Personal equipment (body armor, shoes, …)
• Sensors (optics, radars, etc…)

Because of consolidation, some products in these subsegments are either the monopoly of one company or a small oligopoly with 2-4 companies controlling the market, The more expensive the equipment, the smaller the number of suppliers usually is.

This gives the primary suppliers strong pricing power and a powerful moat, especially in times of crisis when governments rush to increase defense spending.

Defense Industry Advantages

The other reason for investing in this sector is the actual business case.

This is an industry with a strong focus on innovation, including technologies that can later be licensed to the civilian industry and find more peaceful applications. It is also focused on the long term and is known to be a great capital compounder.

The sector also has multiple strong moats relying on different forces:

• Substitution costs: armies often use the same basic design for several decades, upgrading it as new technology emerges: for example, the Abrams US main battle tank from General Dynamics was first designed in the 1970s.
• Regulations and compliance: procurement procedures from ministries of defense are notoriously complex and give large, established firms an advantage. It is also a factor of why lobbying and long-term relations with decision-makers (politicians and generals) can make a difference.
• Intellectual Property: trade secrets and patents are hard-to-replicate advantages favoring the incumbents.
• Unique manufacturing infrastructures. If a company has built nuclear submarines for decades, it will be almost unbeatable at this activity and might be the only one with the right shipyard and certifications to do so.

All of these factors protect established defense firms from competition.

Assessing Defense Companies

Here are some key points to consider when assessing defense companies:

National Profile

The first thing to consider when looking at a defense company is its nationality. As it will mostly depend on public spending, we must accurately assess the country’s finances and politics.

The ideal country for investors in defense would have a profile like this:

• Spends at least 1.5% to 2% of its GDP on its military budget and plans to increase it.
• Has a society-wide consensus on the necessity of military spending.
• A healthy economy and low or no deficit, with a reasonable debt load (meaning the current spending can be sustained).
• The 10-year geopolitical horizon with neighboring or competing powers is tense, implying no reduction in the military budget soon (sadly, this might be less relevant today, as it might be true for almost all countries).

Exports can be important contributors to a defense company’s bottom line. Export contracts often go on for years and include lucrative spare parts and service contracts. Still, considering how politically and diplomatically sensitive defense contracts tend to be, excessive reliance on exports might be tricky and unpredictable.

A large and healthy national economy supporting its defense champions makes for a safer investing case, with export contracts as a welcome bonus.

Business Profile

While the industry as a whole can be attractive, individual companies are a different matter. Competitive position is very important here. A good defense company should have several successful designs that have been adopted by multiple countries.

It should also be recognized as an innovator, and its new designs to be both cost-efficient and reliable. For example, recent issues with the development of (too?) complex and expensive weapons like the F-35 fighter jet or the Puma tank should be red flags, in my opinion.

Lastly, the company should be active in “trendy” sectors that reflect a growing military need (and spending). For example, sectors like space, cyber defense & AI, drones & air defense, and hypersonic missiles.

Valuation

Because the defense industry is relying on relatively constant military spending, we should not base valuation by counting on explosive growth. This means that even in the context of expected increasing militarization, valuation should still incorporate a margin of safety.

This is especially true as part of the past 2-3 decades’ growth has come from consolidation and cost optimization. With fewer targets for M&A, this might not be true in the future.

In addition, some supply problems for Ukraine might indicate that cost rationalization has been pushed too far, for example, too little spare capacity in ammunition manufacturing or the production of older designs interrupted and hard to restart from scratch.

In my opinion, this indicates that the peacetime era of ever-increasing ROIC is probably over.

So P/E ratio should be ideally in the single digits or the 10-15 range at most, not higher. Similarly, conservative ratios for price-to-free cash flow or price-to-sales should be preferred as well.

Portfolio Construction

For this reason, I would suggest that amateur defense investors should stick to a panel of large, established companies. The inconvenient truth is almost regardless of the performance of individual equipment, and the largest firms will continue to win contracts with the military. Dedicated ETFs are also an option, like the iShares U.S. Aerospace & Defense ETF or the SPDR S&P Kensho Future Security ETF.

Some geographical diversification might be good as well, as European defense spending is likely to stay way above its historical average for the foreseeable future. Their stock prices might also be lower than the more well-known US giant defense suppliers.

More knowledgeable investors might want to focus on specific subsectors or designs. If you think that the future of naval warfare will be submarines, it will make sense to focus on shipbuilders with unique experiences and shipyards in that field. The same can be applied to air, space, or drone warfare.

The post Defense Industry Industry Overview & Outlook (2024) appeared first on FinMasters.

Energy production from solar, wind, hydropower, and other sources like geothermal and biomass has a place in our energy future, and investors are paying attention. Here’s a look at some of the issues that investors in this sector have to consider.

A Growing Source of Energy

Until 2010, the large majority of low-carbon energy was made from hydropower and nuclear power. Since then, wind and solar have grown very rapidly, but still constitute less than 6% of the total world’s energy consumption.

The industry generated $692B in 2020 and grew at an annual rate of 8.9% between 2016 to 2020.

Industry Sub-Sectors

A range of very diverse technologies and capabilities have been shoehorned together under the “renewables” brand. It is important to understand the fundamental differences between them when assessing an investment in the sector.

Hydropower

This is the oldest and most established renewable energy technology. It is also the one least likely to see a dramatic improvement in yield or efficiency. It’s growing in total output, but mostly in developing countries. This is because hydropower is very reliant on geography. It needs a high enough change in elevation to be productive. So there is only a limited number of sites per country where a dam can be built, usually around very large rivers.

The main quality of hydropower from an investor’s perspective is durability. Dams last centuries, with very low operating costs but enormous building costs. They have no “fuel”, so they can produce electricity at a very predictable cost.

There are risks in hydropower as well. Climate change has driven significant changes in rainfall patterns in some areas, which can affect hydropower, and dams can be affected by siltation. Always investigate a project thoroughly!

As long as the company operating the dam has reasonable debt or an old enough park of hydropower stations and small enough overhead and administrative costs, this makes for a very safe investment. Therefore the main focus should be to buy at a low enough price, with a long-term horizon in mind.

Wind

Wind power has benefited from the push toward renewable energy, as well as tremendous cost reductions. Offshore wind is generally less profitable, as it has to deal with higher initial costs, stronger storms, seawater corrosion, long-distance maintenance, and other factors, all of which produce shorter equipment lifespans. It does produce more stable output than onshore wind farms and is less likely to incur community resistance.

Wind power, like hydropower, depends heavily on-site quality. Wind power facilities need to be built on sites exposed to reliable high-speed winds. This is especially true for onshore wind.

With the number of available ideal sites for wind power in decline, the higher flexibility of solar makes it the likely candidate to lead the future growth of renewable energy. The very frequent local opposition to new wind farms is also a limitation.

Investors in wind power will want to focus on the cost/kWh and the risk of the project stalling for years from local communities opposed to the project (especially onshore). A critical eye on the estimated lifespan of windmills (especially offshore projects) is also recommended.

Solar

Like wind power, solar power is very sensitive to weather variation. It is also highly seasonal, with high production in summer, and almost none in the darkest/snowy months in northern latitudes. Contrary to popular belief, hot temperatures (like in deserts) can harm photovoltaic efficiency, with the ideal conditions being cold but sunny weather.

Most of the installed and growing solar power capacity is photovoltaic. Another technology is concentrated solar power, which uses mirrors to generate heat and then electricity. Concentrated solar has historically been much less profitable and has led to several massive bankruptcies, and requires very thorough research before investing.

The main limitation of solar is there is no production at night and low production in winter when energy demand is at the highest. This means a world power by solar will also need massive energy storage (more on that below).

Geothermal

Geothermal power remains a very small part of renewable energy production. It has the potential to be a major energy source (up to 10% of total US consumption for example), but technology is still in very early stages. At the moment, it is confined to specific regions with very high geothermal activity, like Iceland.

Paradoxically, a way to bet on geothermal is through fossil fuel energy majors and oil service providers, mostly because of the extensive expertise of those firms in drilling to high depths. A sector to look out for is Enhanced Geothermal System, the latest and potentially the most promising sector in this industry.

The most important quality of geothermal energy is that it is renewable but also highly stable. It produces roughly the same output at all times, independently of the weather. Investors will need to triple-check how validated the technology is, and how scalable it is as well.

Biomass

Biomass energy is derived directly from plants instead.

One form of biomass energy is biofuel, derived from corn or sugar, although it can be argued that the energy spent farming is at least equal to the energy “produced”. Raising crops for conversion to fuel also competes with food production, potentially raising prices of key food commodities.

A more promising version of this is biogas, which produces natural gas from waste from agriculture and forestry.

Another is good old-fashioned wood. While not a replacement for all the world’s energy, it can be an extra option, as properly managed forests can provide carbon-neutral energy.

Forest is actually a surprisingly profitable investment, for the investors willing to wait decades for a return on investment. You can read more about forests as an investment class in this publication. Liquidity and natural risks (forest fires, pests), as well as purchase price and low management fees, should be the focus of investors in the sector.

Others

Other types of green energy exist, but most are very far from mature and have uncertain profitability. Tidal energy, sea currents, wave power, space-bound solar, and algae-based biofuels, are all potential new renewable energy technologies.

Judging by the history of investment in solar and wind, the first adopters and first innovators often do not make good investments. You’ll have to be careful here.

Other green energy investments or technology sold as such, like electric vehicles (EV), batteries, or “green” hydrogen should be taken with a critical eye. They are not per se sources of energy, but more of a way to store energy or to use it more efficiently or in a “greener” way. So they should be judged on those metrics, and not piggyback on the bandwagon of “green energy”.

Assessing Renewable Investments – Energy Producers

Energy producers are among the most visible and popular targets for renewable energy investment. Here are some factors to consider when assessing them.

Production Costs/Breakeven

I’ve mentioned this already in the industry sub-sectors sections. Each renewable project should be analyzed for its cost per kWh. It should be compared to the cost of a similar project using conventional energy sources (a good way to judge the quality of the project compared to its peers) and to the overall cost of energy in the country.

When comparing the cost to the country’s power price, it would be best to look at the pre-COVID numbers to get some margin of safety. If competing fossil fuel prices stay elevated, the profit potential is higher. If not, the renewable project stays profitable and can still distribute profits to its shareholders.

Geography, Subsidies, and Common Sense

Most renewable projects make sense if the local natural resources are a good fit. Mountains and rivers for hydropower, abundant sunlight, or wind. In the rush to boost renewable production, quite a few projects have been made that made little sense in retrospect. Wind farms far from consumers, solar fields in rainy regions, etc…

Avoid investing in any company that depends on government subsidies. While subsidies made sense to boost the initial roll-out of renewable facilities, cost reductions in renewables should allow them to stand on their own legs by now. Subsidies are politically driven and could be revoked at any time.

Generally, a company counting on subsidies to stay afloat is a bad investment. And if a project looks like it might not make sense (solar in the north of Finland?) there’s a good chance that it does not.

Debt, Capital Cost, and Interest Rates

Renewable energy requires a lot of upfront capital but has little operating cost afterward. This is very true for hydropower, somewhat less so for wind, with solar sitting in the middle.

This means that new projects are very sensitive to capital costs. This should be kept in mind in an environment of rising interest rates. A lofty growth plan might be derailed by rising capital costs. Existing debt might not be easily rolled over. Moderate debt load and conservative assumptions regarding the cost of capital are a must in an uncertain macro environment.

Assessing Renewable Investments – Suppliers

Energy producers aren’t the only part of the renewable energy picture. Suppliers are also part of the industry and are also worth considering as investments.

Producers of Energy Systems or Parts

The renewable industry relies on a large and complex supply chain for solar panels, wind turbines, motors, alternators, gears, maintenance, etc. These supplies are often dominated by a few major players, with a lot of smaller specialized or local companies fighting over the industry’s scraps. When it comes to solar and wind, most of the panels and basic components are manufactured in China, but there are several publicly traded US and European companies in the market.

Grid, Energy Storage, and Batteries

One valid criticism against renewable energy sources as an alternative to fossil fuels is intermittency. Some renewable power generation is irregular and hard to forecast. Some is relatively predictable, like solar, but largely produced at the wrong moment of the day or year.

One big problem intermittency creates is that power grids have traditionally been designed around large and stable power sources like nuclear power plants or gas power plants. Fossil fuel-powered plants are also very quick to react to changes in demand from the grid.

The only long-term solution to this problem is a radical increase in electricity storage capacity. The current solution focuses on massive lithium-ion batteries, but countless other types of batteries are looking to become THE solution for utility-scale energy storage. Other people are pushing for hydrogen or even ammonia to be used for long-term energy storage.

This is a very technical field, and promises of “breakthrough technology” should be taken with a very skeptical stance. Nevertheless, for the green transition to happen, such very large-scale storage facilities will be needed. So ultimately, the success of renewable energy production is going to rely on storage technologies.

Given the amount of research and experimentation going into energy storage, we can expect that there will be breakthroughs and superior technology will emerge. Investors who make the right bets on the right technologies early on will stand to do very well. At the same time, trying to pick THE right technology in a very complex and quickly changing industry is a very challenging and very risky endeavor, especially if you don’t have relevant high-level technical knowledge.

An alternative would be to invest in well-established, profitable renewable energy producers. These companies will be the first ones to benefit from any storage breakthrough. In effect, you are betting that there will be a storage breakthrough, without the need to predict what it will be.

Raw Resources

One last way for investors to bet on the renewable industry is to look at the raw resources needed. Lithium and copper are likely to stay at the center of the green revolution for decades. Battery metals like cobalt and nickel are also important but might fade away with new technologies taking the front seat. Rare earth metals are also very important. The entire supply chain is currently 90% controlled by China, but rare earth metals are widely found and new suppliers are emerging.

Investors in the sector will need to be familiar with investing in the mining sector. Low-cost production, large ore reserves, low debt load, and high-quality jurisdiction will make for the best picks in that sector.

Conclusion

Both climate change and the rising cost of fossil fuel will power the green transition, and the political will to back the transition up is growing. We can look at the declaration of the UN Secretary-General to judge the mood of the political elite.

Recent geopolitical tensions have highlighted the risks of dependence on fossil exporters like Russia. China is an equally important supplier for the renewable industry, but once a solar panel is sold, it does not carry the same risk as dependence on a continuing pipeline of fuel supply.

As always, company quality and the price paid will play a big role in future returns, and just being green is not enough to ensure future returns. As with any future-focused industry, the challenge is to pick the winning sectors and the winning players within them.

Industry Primers
The process of analyzing a company varies considerably from industry to industry. Many industries have their own vocabularies and specific concerns that investors need to consider. This series of articles looks at specific industries and at industry-specific factors that affect investments. The goals are to highlight specific risks, clarify confusing terminology and explain industry-specific metrics for valuation. These methods complement the usual evaluation process, they don’t replace it.

The post Renewable Energy Industry Primer appeared first on FinMasters.

Let’s take a closer look at how REITs work and at some of the special rules, considerations, and terminology that apply to this asset class.

What are REITs?

REITs are companies that own and operate real estate assets. What makes REITs special is that they are publicly traded on financial markets. This means that investors can buy real estate through the financial markets, without having to deal with any of the day-to-day operations it involves. The same way that markets allow to buy shares in tech companies without having to own and operate an IT business.

This is a very large asset class, with US REITs owning collectively $3.5 trillion worth of assets. In addition to the ease of buying and selling, and the relief of not having to manage the property, Investing in REITs provides diversification. Directly investing in real estate will lead to owning just of just a handful of properties. A diversified REIT will spread out the risk through hundreds or thousands of properties, smoothing out returns and limiting risk.

The Rules of REITs

The US Internal Revenue Code has specific rules defining what can be called a REIT. A REIT must meet these qualifications:

• A REIT must invest at least 75% of its total assets in real estate, US Treasury instruments, or cash.
• At least 75% of a REITs gross income must come from rents, mortgage interest, or real property sales.
• A REIT must pay out 90% of its taxable income to shareholders in the form of dividends each year.
• A REIT must be taxable as a corporation.
• No more than 50% of a REIT’s shares may be held by any five or fewer individuals.
• At least 100 individuals or entities must hold shares after a REIT’s first full year of operation.
• A REIT must be managed by a board of trustees or directors.

The dividend requirement is particularly important in evaluating REITs. It means that while REITs can pay substantial dividends, they do not have much income available to re-invest in operations.

Types of REITs

In this article, we will focus on publicly available REITs investing in properties. Private or non-listed REITs exist as well, but do not offer the same liquidity advantages. There are also mortgage REITs that own mortgages rather than real estate.

The most simple type of REIT is involved in the most basic type of real estate investing: owning and renting residential properties. Residential REITs are the largest part of the market and the easiest to understand.

Other types of REITs are focused on a specific type of commercial property. For example, some will be specialized in office spaces, healthcare facilities, commercial real estate (like malls), or hotels. Some REITs are even more “exotic”, for example with a focus on farmlands, timberlands, data centers, cell phone towers, warehouses, etc.

Some REITs will be more diversified, investing in multiple classes of assets, depending on opportunities and the management’s strategy.

In addition to the type of assets, many REITs will be focused on a specific region. And when evaluating REITs, the old adage of real estate holds true: what matters is “location, location, and location”.

As a result, investing in REITs allows targeted investment far beyond just the general “real estate market”. It can be used to target the growing demand for data centers, farmlands, or a booming economy in one specific state or region.

Choosing a REIT

Because there are so many REITs listed, each with its own specific details, it can be rather overwhelming to find the right ones for your portfolio.

First, you’ll need to decide why you want to invest in real estate in the first place. If it is mostly to provide diversification, a generalist REIT would be best. If it is to invest in a specific sector or region, a more focused REIT will be preferable.

REITs are required to distribute 90% of their profit in dividends. A sustainable dividend yield is really all that matters here, with little capital gain appreciation to be expected.

Once you identify a type of REIT, you’ll need to assess the size and sustainability of the returns and the overall quality of the investment. That requires a set of metrics that is somewhat different from what you’d use to assess stocks.

Assessing a REIT’s Quality

Because REITs are in essence not a company, but a pile of long-duration assets generating a yield, valuation metrics like P/E are not relevant. This can make REITs confusing for investors who are accustomed to evaluating stocks.

Here are a few metrics that you can use to value REITs

Net Asset Value (NAV)

Traditional accounting with depreciation can give a very poor view of a REIT’s real value. This is because many real estate properties will be depreciated over time, while their real value is actually stable or increasing. So instead of using the “value” of assets registered in the balance sheet, investors will need to use the somewhat subjective valuation of the properties owned by the REIT (often, by comparing it to the market price of similar properties).

They then subtract any debt to get the Net Asset Value (NAV). In theory, the NAV/share should not differ widely from the traded share price. In practice, as the NAV is dependent on a subjective value evaluation, it can differ and offer opportunities to cautious investors.

Funds From Operations (FFO)

This metric is somewhat equivalent to operating cash flow, adapted to real estate. It takes earnings and adds back depreciation, amortization, and other “costs” that are probably not accurate for real estate assets. A building is not machinery and is not likely to lose all of its value in 10 or 20 years. A well-maintained building in a good location may even gain value.

Money earned by selling properties is not included in FFO, as this does not reflect the profitability of existing assets.

FFO is useful to evaluate the real profitability of the assets owned and how stable the dividends are.

Fees

Most REITs charge a general fee and a performance fee. Other fees like acquisition fees, divestment fees, and so on are possible. Each fee eats up parts of the profit made from renting the assets. Additional salary for management can come in the form of payment in shares of the REITs.

I would consider fees encouraging buying and selling to boost management income to be a very bad incentive. Good management should be paid well, but overpaying rarely pays off, so fees in the lower range of the industry should be preferred.

Risks

One important risk is possible back-dealing. Reputable firms are unlikely to do this. Some less reputable ones might have building maintenance or service sold to the REIT by firms that the REIT’s management owns or control. This is something to pay attention to, especially for foreign REITs in countries with a weaker rule of law.

Market timing and real estate bubbles are obvious risks when investing in real estate. It is very hard in practice to time markets, but it is possible to watch out for periods and markets where real estate values are highly inflated. As a rule of thumb, REITs with manageable debt loads will be much safer, and buying after a decline in price provides more chance for the REIT’s income to rise over time.

Conclusion

REITs are a great tool to invest in real estate without getting involved with the operational side of the sector. Way less hassle, and the fees are normally worth it for the diversification and liquidity offered, on top of the possibility to invest much smaller sums than in a classic real estate deal. In addition, specialized REITs offer opportunities to invest in types of assets that would be entirely impossible for individual investors, like data centers or cell phone towers for example.

The key to successfully investing in REITs is to take a cautious approach to valuation. Real estate can provide a stable income stream and stabilize a portfolio performance, especially when you can find a REIT trading at a slight discount. Abnormally high yields should still be a red flag. So are mysterious discounts: if the REIT is persistently trading below NAV, the market may know something you do not.

Industry Primers
The process of analyzing a company varies considerably from industry to industry. Many industries have their own vocabularies and specific concerns that investors need to consider. This series of articles looks at specific industries and at industry-specific factors that affect investments. The goals are to highlight specific risks, clarify confusing terminology and explain industry-specific metrics for valuation. These methods complement the usual evaluation process, they don’t replace it.

The post Investing in REITs: Industry Primer appeared first on FinMasters.

Let’s take a closer look at this up and coming sector and some ways to assess companies in it.

One of the things that launched the strength in biotech is when the pharmaceutical industry itself got a little slow.

Louis Navellier, Chairman and Founder of Navellier & Associates

Biotech vs Pharmaceutical

Pharmaceutical companies are an offshoot of the chemical industry. They use chemical molecules to address health issues.

Biotechnology companies use biological compounds and processes to achieve their goal. This means that biotech products are much more complex than pharmaceutical drugs. When the average drug might be made of a few dozen atoms, a protein or a DNS strand will be made of tens of thousands, sometimes millions of atoms. Cell therapies even use entire cells, several billion times more complex than pharmaceutical products.

Because biotechnology is defined by its method first, it extends beyond healthcare applications. It can include the production of biofuels, bioplastics, fermentation, pollution control or remediation methods, farming technologies, etc. Still, the largest part of the sector is dominated by human health applications, as this is a very large and high-margin sector.

Because of the difference in its products, biotech can address problems that pharmaceutical companies could not. Notably, the industry went beyond industrial applications like fermentation when Genentech first produced artificial insulin. This invention would go on to save millions of lives.

Regulation and Clinical Trials

When it comes to human health, the process for biotech companies is very similar to the one followed by the pharmaceutical industry. Before reaching a patient, a new treatment goes through an extensive clinical trial. If the trials are successful, the FDA (Food and Drug Administration) may approve the new treatment.

I described each stage in more detail in the pharmaceutical industry primer, but here is a quick reminder:

Clinical Trials 101

To limit the risk of potentially lethal surprises, all new drugs must pass through a strict sequence of clinical trials. They go through the following successive phases:

• Preclinical: Tested on cells or animals only, to avoid a lethal error in human trials.
• Phase 0: Tested on just a few healthy humans, low concentration if possible, to check if animal and lab safety profiles apply to people as well.
• Phase I: Tested in a medically relevant concentration on a larger number of healthy people.
• Phase II & III: This is when actual patients suffering from a medical condition join the trials to determine the effectiveness of the product. The results of these tests determine whether the FDA will approve the product.
• Phase IV: Also called surveillance, this happens after the drug is approved. Ongoing surveillance aims at detecting any issues that were not detected in the clinical trials.

Intellectual Property and R&D

Both pharmaceutical and biotech companies rely heavily on patents to defend their innovations, acquired through prolonged and very expensive R&D.

Because biotech companies are usually built on scientific discoveries, the sector tends to be more startup-heavy than pharmaceuticals, which are dominated by huge corporations. This also results in the sector spending even more of its money on R&D than the pharmaceutical industry, with R&D spending typically in the 40%-60% range.

Most biotech startups will have one idea or technology they try to develop. The success of the company will therefore heavily rely on how solid the science is.

Because of this, this may be a field even more technical than classical pharmaceuticals. It also means that production can be a lot more complicated and expensive, unlike chemical drugs where the cost per unit excluding sales and R&D is very small. Because of the inherent complexity of the processes, biotech patents are also granted for a longer period than pharmaceutical patents.

On the good side, this reliance on unique technology has the advantage of making the competition a lot less intense than for classical drugs. Replicating the effect of a drug can be done with slightly different compounds, or even the same one once the patent expires. But a very complex protein or a proprietary cell line can be almost impossible to replicate or imitate.

Sales of chemical drugs are always at the mercy of generic drug manufacturers as soon as their patents expire. But biotech products are generally safer from patent expiration, even if the analog to generic drugs, biosimilars, exists.

Investing in Biotech

The key metric for most biotech companies will be their expected burn rate. Because most will be pre-revenue and spending on unproven treatments, they are far from making any money. The sector is usually first supported by VC (Venture Capitalist) money, and then by public capital after an IPO. A proper calculation of future costs and dilution of shareholders will also be important.

Due to this, the sector is also sometimes criticized for harboring too many “scam” companies, perpetually raising money before publishing disappointing results. I would not call this criticism completely unfounded, but it is often blown out of proportion. Incertitude is simply the price we pay for investing in such a speculative sector. Even the most honest companies and the most promising ideas can hit unexpected issues.

Another metric should be the size of the total addressable market (TAM). A treatment that may be used by 10,000 people per year has radically different profit potential from a treatment that could be used by 10,000,000 people a year. Of course, unrealistic TAMs are often the target of critics of the biotech industry.

For investors, an extra difficulty is that clinical trial results will often be binary:

Good = next phase can be launched or even better, treatment should be approved by the FDA soon.

Bad = this is a scientific dead end, and most of the money invested is lost.

Such binary outcome result in extreme volatility, with individual stock often going up or down by 30%-70% in a day, depending on how good or bad the latest published news are. This is definitely not a sector for the faint of heart or beginner investors.

Biotech companies are often very specialized on the scientific side. Most will prefer to keep advancing the science rather than handle the difficult task of commercializing the treatment themselves, which requires dedicated salespeople, contacts with doctors and hospitals, negotiation with health insurance companies, etc.

So it is quite common for successful biotech companies to follow one of these paths:

• Get acquired by a large pharmaceutical company.
• Sell the intellectual property for a specific discovery to a large pharmaceutical company.
• Sign a licensing agreement for the discovery, sharing future revenues in exchange for support on finishing trials and commercialization.

Many biotechs will search for such a partner just before phase III clinical trials, as this is the most expensive stage, but also the least likely to lead to failure. This reduces the risk for the pharma partner while avoiding dilution for the biotech’s shareholders.

Promising Sectors and Technologies

When looking for promising biotech, I feel there are a few fields more promising than others.

Orphan Diseases

Some diseases affect just a few people and have been so far impossible to treat well with conventional medicine. Treatments for such diseases are offered preferential pricing, or sometimes research grants and patent exclusivity by the FDA. Because they are not concerning a large population, it might also be a less competitive segment.

The main thing here is to look for truly innovative, life-saving treatment, usually leveraging a technology that did not even exist 5 years ago. If older technology could have solved the problem, it would have likely been done already. Still, stay aware that by definition, unproven new ideas will also have outcomes that are very hard to predict.

Very Common Unsolved Problem

I said the same for pharmaceutical companies, and it holds as well for biotech. Some sicknesses might be treatable with biotech, which can mimic, enhance or fully replace faulty biological mechanisms, instead of just chemically activating the body’s cells.

Some of the most promising sectors that are both unsolved and affecting millions of people are for example:

• Diabetes
• Alzheimer’s
• Parkinson’s
• Cardiovascular diseases
• Cirrhosis (liver damage)
• Dementia
• Paralysis

Successful therapies of any of these would be enormously profitable.

Non-Medical Biotech

Biotech is larger than medical applications. Other fields can offer very large potential markets with far less regulation.

Here is a list of sectors I think can be completely disrupted by biotech innovation:

• Biofuel production (notably from algae or cyanobacteria)
• Farming and Forestry (vertical indoor farming, biocontrol for crops diseases, soil biology, etc…)
• Material sciences (vegan alternative to leather, bioplastics, factory-made silk, recycling process, etc…)

Because they seem more “mundane” or “boring” compared to solving cancer or Alzheimer’s, these efforts could be more likely to provide undervalued stocks.

Specific Technologies

Lastly, a way to invest in biotech could be to focus on the promises of a specific technology instead of an application. For example:

• Genomics (a topic we covered extensively in our last Illumina report)
• RNA technologies: this includes mRNA vaccine and other RNA technology, but also RNAi.
• Cell therapy: using healthy or modified cells to replace deficient ones.
• Bioprinting: the artificial assembly of cells, tissues, or even full organs.
• Gene editing: this includes “trendy” tech like CRISP, and other methods to modify the genome of living cells as well.
• Synthetic biology: the creation of biomaterial or compounds not found in nature.

This is a strategy that lends investors who are quite well-versed in the science part of the equation, which might help them pick a winner in the sector.

Possible Investment Strategies

There are a few large independent biotechnology companies, notably Amgen, that have a diversified portfolio of new products in the R&D pipeline. The list can include also other companies we previously covered in our reports, notably Regeneron and Vertex.

Still, as most biotech investments will be for pre-revenue startups, diversification is crucial to building any biotech portfolio, especially when considering the very high failure rate of clinical trials. Untested technologies, new materials, biofuels, and other biotech products are equally risky.

In that respect, the biotech sector is very similar to VC investing. The idea is to spread the portfolio over dozens of different companies and aim for a few to do a 10x or x100 return.

The good news is that in 2022, biotech is rather out of favor, after a period of feverish speculation. This means that valuations are probably more reasonable than they used to be.

Another way to bet on biotech is to invest in pharmaceutical companies with a large biotech portfolio. For example, the first large biotech company, Genentech, is now part of Roche.

Or you could also bet on equipment manufacturers and suppliers to the industry. This can even be narrowed down to specific technologies, like genomics or cell therapy.

In any case, because of the highly technical nature of the industry, it will be best to either diversify massively (directly or through a fund or an ETF) or learn enough about the science to make more enlightened choices. Accredited investors might also back VC funds specialized in early-stage biotech startups.

Conclusion

The biotech industry is a highly profitable one as a whole. It is also growing very quickly and providing tremendous improvement to millions if not billions of lives. It also benefits greatly from the digital revolution, which provides access to cheap genome data, imagery, and computing power.

The difficulty for investors is that this profitability comes from extremely variable and hard-to-predict individual outcomes. So maybe more than finding the right individual idea or making a good analysis, biotech investors will need to sharpen their risk management skills.

Nevertheless, this can be a highly rewarding sector. Biotech companies are also not particularly sensitive to overall economic conditions, as most of the sector income is from health insurance payments or niche industries.

Valuation and enthusiasm for the sector are known to ebb and flow over long 5-10 year cycles, so a degree of market timing can help as well. If biotech valuations are reaching an all-time high across the board, better stay away for a bit.

Currently, biotech valuations remain in a slump, so this might be the time to pay attention again to the sector, especially considering a generally gloomy macro outlook.

Industry Primers
The process of analyzing a company varies considerably from industry to industry. Many industries have their own vocabularies and specific concerns that investors need to consider. This series of articles looks at specific industries and at industry-specific factors that affect investments. The goals are to highlight specific risks, clarify confusing terminology and explain industry-specific metrics for valuation. These methods complement the usual evaluation process, they don’t replace it.

The post Industry Primer: Biotech appeared first on FinMasters.

The greatest wealth is health.

Virgil

This is often a sector avoided by retail investors, as it feels overly complex. It also shows some attributes of a hated sector: “Big Pharma” is right up there with oil companies and banks as one of the most disliked industries in the country.

This industry primer will explain the basics of investing in the pharmaceutical industry.

What Are Pharmaceutical Companies

Pharmaceutical companies produce drugs for the benefit of human health. Pharmaceuticals are usually considered separate from other health-related industries, like manufacturers of medical items, referred to as “medical devices” (pacemakers, prostheses, diagnostic tools, surgery equipment, etc…), or veterinary medicines.

The biotechnology sector is also usually considered a separate sector. The difference is that the pharmaceutical is an outshoot of the chemical industry. It synthesizes or purifies artificially different drugs/molecules to solve medical problems. Biotech uses biological processes.

So drugs and pills will be considered pharmaceuticals, but gene therapy, antibodies, and stem cell treatments will be biotech. Of course, the line between the two can be blurred, like with mRNA vaccines for example, and there will inevitably be some overlap.

Regulation and Clinical Trials

The pharmaceutical industry evolved progressively with medical science. From often ill-conceived primitive remedies, the sector progressively became more scientific in its approach. This also means the industry has a long history of mistakes or treatments that were discovered to be dangerous in retrospect. To add to this, the difference between helpful and harmful treatment can be pretty thin, depending on the patient and dosage.

The dose makes the poison.

Paracelsus

The history of medical errors has led to an extremely high level of regulation. In the US, these regulations are under the control of the Food and Drug Administration (FDA). Pharmaceutical companies sell their products all over the world, so they also have to pass the scrutiny of regulators in other markets, who often have different standards.

Clinical Trials 101

To limit the risk of potentially lethal surprises, all new drugs must pass through a strict sequence of clinical trials. They go through the following successive phases:

• Preclinical: This is the phase where the potential drug is tested on cells or animals only. This is done to detect problems early and assess the potential for medical treatment. It comes after the drug discovery, which tests thousands of molecules for possible medical effects.
• Phase 0: The drug is given in small doses to a few (less than 10-15) healthy people to see how humans react to it. This is to test the potential toxicity of the compound.
• Phase I: The drug is now given to more healthy people in the expected concentration needed to treat patients. Here too, the goal is to assess the toxicity risks first.
• Phase II & III: This is when actual patients suffering from a medical condition join the trials. Phase II has generally a few hundred participants. If phase II is promising enough, the product moves to Phase III, with several thousand participants. This is also when the ideal concentration and treatment method are determined. Approval of the drug by the FDA will depend on Phase III results. In general, the company needs to prove that the new drug offers superior benefits compared to existing treatments.
• Phase IV: Also called surveillance, this happens after the drug is approved. It involves tracking over several years, or even decades, thousands of patients, to detect any problems that could have not been found during the previous phases.

Trials and Investing

Because each clinical trial phase can spell the difference between marketability and doom for a new drug, investors tend to follow them very closely. They are also extremely expensive.

The success rate of trials can vary greatly depending on the specialty. In any case, a failure rate (as defined as “not being approved by the FDA”) of 70-90% is the norm. It can be as high as a 96.6% failure rate for oncology drugs (treating cancer).

Probability Of Success² by Clinical Trial Phase and Therapeutic Area

With such high failure rates, most investors will be better off investing only in one of the largest pharmaceutical companies (nicknamed “Big Pharma), which have dozens of commercialized molecules and hundreds in trials.

Small companies with only a few compounds in the trial process run the risk of ending up with no marketable product or not having the resources to complete their trials.

Even the scientists directly designing the clinical trials are unable to forecast the outcomes with any degree of certitude. So I would not recommend relying on predictions of clinical trial results, even though this is common among pharma and biotech analysts. People with a stake in a company want a positive clinical trial result, and that desire can easily cloud judgment.

Intellectual Property and R&D

One key difference between pharmaceutical companies and other sectors is their reliance on intellectual property. Patents for drugs have their own rules, which can be rather complicated.

Normally, pharmaceutical companies will communicate clearly when their patents for each commercialized drug are expiring. After that, competitors can start producing “generic” drugs, using the same molecule but without incurring all the R&D and clinical trial costs. The selling price approved by the FDA might also change once the patent expires.

A pharmaceutical patent lasts for 20 years, but must often be registered during clinical trials, so 5-10 years can be “lost” before commercialization. The registration date of the patent can also vary depending on the region, for example being 2 years later for EU markets than in the US.

It should be noted that in most cases, the patent can be prolonged by a few years, using some of the drug-specific rules of intellectual property law. This is especially true if the drug is saving lives, targets a small number of patients, or is especially innovative and unique. You can learn more about patent expansion strategies here.

As a rule of thumb, profits drop 60%-80% as soon as a drug loses patent protection. This is less true for drugs addressing a very small niche or chemically very complex, as competitors might not bother to set up an entire production facility for a small market.

A company that depends on a few “blockbuster drugs” (drugs that generate $1 billion or more in annual sales) may see its valuation drop steeply as the patents on those drugs near expiration, especially if they don’t have new potential blockbusters in the pipeline.

R&D (which includes clinical trial costs) is unavoidable for the continuous operation of a pharmaceutical company. In such an innovative sector, R&D costs should ideally be listed in the income and cash flow statements as a recurring cost, not as an investment or CAPEX.

Promising Sectors and Technologies

In today’s market and regulatory environment, I feel that the highest chance of financial success is at 2 ends of a spectrum.

On one hand, the very niche, rare diseases with no good treatment, or no treatment at all. Because they are usually deadly or generally horrible afflictions, national insurance policies and regulators are ready to effectively subsidize research in the field and give higher selling prices and longer patents. And because they are complex diseases and small markets, competition is often reduced for such “orphan” diseases.

On the other hand, treatment for very common problems with no good treatment yet could become the new generation of blockbuster drugs. For example:

• Diabetes
• Alzheimer’s
• Parkinson’s
• Hypertension
• Cardiovascular diseases
• Cirrhosis (liver damage)
• AIDS
• Dementia
• Paralysis
• Flu (not sure I really need to add this one…)

Any reliable treatment for any of these issues will bring (well-deserved) tens of billions in profits.

Investors pay a lot of attention to oncology (cancer). Cancer drugs can be legally sold at incredibly high prices and curing any type of cancer would be a big money maker. This is also the field with by far the worst trial success rate. This is because cancer is not a single disease: it is more like 1000 different related diseases. So I would warn of caution in investing in this field. Success would be highly rewarded, but it’s also a very low probability.

Possible Investment Strategies

As I said before, diversification is an absolute must in a sector where new products cost billions in R&D and end up at a dead end 70%-95% of the time.

One way to get that diversification is to stick to large companies. They will have a lot of products commercialized and many ongoing clinical trials. Here, buying at a good price will be the most important. You can find here the top 20 largest pharmaceutical companies by revenue.

Another way is to specialize in one pathology or specialty. Even non-doctors or biologists can develop considerable expertise in one narrow field. That knowledge might give you an advantage in judging what method could solve the problem and the best companies in the sector. By betting on several companies all focused on one pathology, you increase your chance to grab a share in the winner that grab this new market.

You could also buy a very large portfolio of multiple smaller pharmaceutical companies. By spreading the risk large and wide, you can capitalize on the success of the pharmaceutical industry at large, while still benefiting from the growth of small caps. Dedicated ETFs can provide help for this method.

Lastly, you can focus on generic producers. These less glamorous than innovative companies are still saving lives and generating profits. They can be cheap at times and are not exposed to patent expiration problems or large R&D costs, and uncertain trial results. If they are well-run and cost-efficient, they can be very good businesses selling somewhat commodified products.

Conclusion

The pharmaceutical industry is a large part of the global economy and should not be ignored by investors. It is also a sector that is relatively defensive, not really in sync with the market cycles. Medicines are an inelastic cost: even if they get more expensive, people still buy them, because health is always a top priority. Even during a recession people still get sick and need treatment.

The pharmaceutical industry benefits from secular trends like aging populations in developed countries (older people use more medicines) and improving access to modern healthcare in developing nations.

Extensive knowledge of medicine or biology can be an advantage but is not required. Experts might also be tempted to overestimate their knowledge and try to forecast clinical trial results. This is a very risky and uncertain endeavor.

A safer approach is to diversify enough, either through major “big pharma” companies or a large selection of smaller companies. If you think one specific medical problem is more likely to be solvable soon or more profitable, you can also specialize your pharma investment in this field.

In any case, I hope this article helped to demystify investing in the pharmaceutical sector and encourage you to give it a second look!

Industry Primers
The process of analyzing a company varies considerably from industry to industry. Many industries have their own vocabularies and specific concerns that investors need to consider. This series of articles looks at specific industries and at industry-specific factors that affect investments. The goals are to highlight specific risks, clarify confusing terminology and explain industry-specific metrics for valuation. These methods complement the usual evaluation process, they don’t replace it.

The post Industry Primer: Pharmaceuticals appeared first on FinMasters.

Let’s see what makes e-commerce unique and how investors can look at this sector to ensure the highest chance of good returns.

Key takeaways

• E-commerce companies are retail companies that do all or most of their business online. Brick-and-mortar stores that also sell online are not included.
• E-commerce companies have advantages over traditional retailers. They require fewer staff and facilities can be in low-cost areas, reducing overhead costs.
• Dominant companies have large advantages. It’s very difficult for newer competitors to challenge established giants like Amazon or Alibaba.

What Are E-Commerce Companies

In this article, I will define e-commerce as retail companies doing the majority of their sales online or supporting the online sales ecosystem. This means I will exclude companies making some online sales but still relying on their brick-and-mortar shops. I will, however, discuss at the end the competition risk from every company turning into an online seller.

A Different Industry Structure

Most retail companies have relied on the same business model for almost 2 centuries: buy products and sell them in a physical shop, if possible, ideally placed geographically. This required a lot of personnel to fill up the shelves, assist customers, check goods out, etc. It also required large expenditures on facilities in the right locations.

Each shop’s sales were limited to at most a few tens of kilometers radius around the shop building.

Traditional retail is a very capital-intensive business, with the need to own large shops and inventories. It’s also a very low-margin business, as customers seek out the lowest prices and stores compete largely on price.

This led the sector to slowly base itself on 2 possible models to optimize costs:

1. Specializing in one product category only (like clothes retailers, for example)
2. Scaling up to be the shop for everything (the Walmart model)

E-commerce changed things drastically for retailers, with a few key differences in how e-commerce operates:

• There’s no geographical limit to a shop’s reach. Retailers can sell to a whole country from one centralized online shop.
• Lower physical CAPEX, with industrial warehouses in low-cost areas replacing much nicer looking and much more expensive physical shops in prime locations.
• Inventory and supply-chain optimization through real-time tracking of orders and centralization of inventory.
• The ability to have “long-tail items” in stock, like rare books selling just a few thousand copies per year for early Amazon, unlike traditional bookstores.
• The struggle for the best retail location for foot or vehicle access is replaced by a struggle to get online attention and traffic.

In many ways, this made e-commerce more similar to direct marketing catalog businesses than to traditional retailers. Traditional retailers were slow and inefficient at adapting to this new threat.

The Rise of Marketplaces

At first, e-commerce had to iron out multiple technical difficulties, including building safe and trustworthy online payment systems. This caused an initial disappointment in online sales, one of many factors driving the bursting of the tech bubble.

As the technical obstacles were solved, e-commerce emerged as a real threat to traditional retailers. A leaner cost structure allowed for lower prices. Better inventory meant more satisfied clients. The ability to reach an entire market in an entire country helped create economies of scale as well.

Currently, e-commerce is a $1T market in the US and $5T globally.

Marketplaces operate a business with two separate sets of “clients”, the sellers bringing products to the marketplace and the buyers, with the marketplace operating as the unavoidable middleman.

Marketplaces are very hard to get started, as you need sellers to get users, and you need users to attract sellers. But once the initial push is done, they solve the hardest part of e-commerce: bringing online traffic. Sellers on Amazon have immediate access to hundreds of millions of eager buyers.

The Internet’s global scale induces a “winner-take-all” logic where just a few actors end up dominating a whole sector.

To this day, e-commerce is still dominated by the few early successful marketplaces that managed to carve themselves a durable niche: eBay for second-hand items, Amazon for consumer products, Etsy for gifts and handicrafts, AliExpress for China-made goods, etc.

Stand-alone websites provide an alternative to marketplaces. These websites might rely on software providers (Shopify, for example) and payment processors like PayPal and Stripe.

These usually rely on bringing in traffic through ads and other marketing strategies like SEO (Search Engine Optimization). This makes them independent from marketplaces but highly dependent on other tech companies, like social media (Facebook) or search engines (Google).

Still, being able to control your own traffic and gain buyer loyalty to your brand instead of a marketplace, with competitors just one click away, can be a very durable way to build an e-commerce business. So we should expect that both marketplaces and stand-alone sellers will persist in the e-commerce ecosystem.

Investing in E-Commerce

E-commerce businesses can scale to size and at a speed impossible for brick-and-mortar retailers to match. This is why a company like Amazon went from an online bookstore to dominating the Western world’s retail trade in such a short time.

As a result, e-commerce businesses have to grow fast, outpacing their competitors in the winner-take-all game. It often means price wars and expensive marketing spending to acquire a lot of consumers fast.

The consequence is that successful e-commerce might be unprofitable for a very long period of time: Amazon only started to show a profit because of its “side business” of cloud computing.

One of them is the customer lifetime value (LTV or CTV). This is the estimation of the value of buyers from their first visit to the website. Because the acquisition of new users is expensive, the first purchase is usually not enough to cover the marketing cost. If the client keeps coming back, the marketing cost will be worth it in the long term.

Another metric used a lot by marketplaces is Gross Merchandise Value (GMV). It allows for measuring the value of all the goods and services sold on the marketplace, including by third-party sellers. A stagnant or declining GMV is a massive red flag for an e-commerce company, especially a marketplace.

If possible, the average order value (AOV) is another interesting data to analyze. A rising AOV could indicate increasing trust or satisfaction from the user.

As for all not-profitable-yet growth stocks, cash on hand and how long it will last at the current spending levels is a very important metric. So a careful study of the balance sheet and cash flow statement is key to accurately predicting possible troubles or shareholders dilution in the future.

Lastly, Internet metrics like “website traffic checkers” or Google Trends data can help us see if an e-commerce company is getting more popular or is benefiting from an overall trend in the market.

Possible Investment Strategies

One method for investing in e-commerce that has proven very lucrative has been to invest early in promising companies. The benefit is the ability to invest before a company grows 100 times in size. The downside is that picking the right company is very hard. For example, very few people believed in Amazon in 2000 when the dot com bubble had burst and the company was bleeding money.

It is a strategy that is somewhat outdated in countries with a well-developed e-commerce sector. It is especially hard to imagine how a newcomer could dethrone Amazon in the West or Alibaba in China. The “next Amazon” is probably NOT the next anything.

This, however, can be an option for younger markets, like South America, Southeast Asia, the Middle East, or Africa (companies like MercadoLibre or SEA have been the focus of investors interested in that idea).

Investors using this method will need to be ready to hold their investments through periods of extreme volatility, counting on long-term growth and ignoring short-term fluctuations.

Another option is to bet on the dominant actors. While this might sound “boring”, investors in dominant players like Amazon or Shopify gained from excellent performance up to late 2021. The recent underperformance of these stocks might indicate that an extended period of stock price decline is forthcoming or that the 2020-2021 pandemic effect had pushed e-commerce stocks too high too quickly.

And this brings me to the last possible strategy to invest in e-commerce, using cyclicality. The tech sector in general, including e-commerce, is prone to getting periodically overvalued and then undervalued.

Investors in e-commerce after the bankruptcy wave of 1999-2000 would have consistently outperformed markets in the two decades after. This is, of course, if they had sold before the bubble burst. The same situation occurred again during the 2020-2021 vertical climb of tech stocks related to the pandemic.

So it is possible that once the current “tech crash” is over, the sector will again offer great buying opportunities to hold for a decade or two, or at least until the next tech bubble?).

Threats to the E-Commerce Sector

Traditional retailers have finally started to react to the threat of e-commerce. Companies like Walmart have leveraged their pricing power and existing logistical networks to quickly become large e-commerce actors (25% of US grocery e-commerce) after ignoring the sector for years.

So it is possible that traditional retailers are ready to stage a comeback, leveraging their shop networks as logistical centers and delivery points and capitalizing on their existing user base. This could drastically reduce pure e-commerce companies’ ability to keep growing at the rate they did over the last 30 years.

In addition, every SME is now an online seller as well, developing their expertise and network in small niches to beat the larger generalist actors. Many customers in specialist niches would rather buy from a specialist retailer than from Amazon.

The trend of the hybrid e-commerce/physical shop model has not been missed by e-commerce leaders either, with, for example, Amazon acquiring Whole Foods in 2017.

One last threat stems from the “winner-take-all dynamic. This can lead successful companies to fall under the scrutiny of anti-trust regulations. For example, Amazon has been exposed to this risk both in the US and abroad, and Alibaba is coming under fire from Chinese regulators.

Conclusion

E-commerce is now a central part of the retail industry and is unlikely to ever go away. Even if it might never fully replace traditional retail, it is a sector investors should not ignore.

E-commerce, along with all Internet sectors, has a structural tendency to have a few companies turning into quasi-monopolies, usually a very profitable setup for investors who choose the right company at the right time.

The e-commerce market is maturing, and in developed countries, the turn to a hybrid model and slowing growth should be expected. In developing markets, companies replicating the business model of developed countries’ giants are likely to do well, even if it might tricky to pick the winner at an early stage.

In any case, attention to fundamentals and caution regarding the cyclicality of tech investing will be useful to protect investors from a general downturn in the sector. We seem to be in the midst of such a downturn, even if it is hard to tell when it will be over.

Industry Primers
The process of analyzing a company varies considerably from industry to industry. Many industries have their own vocabularies and specific concerns that investors need to consider. This series of articles looks at specific industries and at industry-specific factors that affect investments. The goals are to highlight specific risks, clarify confusing terminology and explain industry-specific metrics for valuation. These methods complement the usual evaluation process, they don’t replace it.

The post Industry Primer: E-commerce appeared first on FinMasters.

We often don’t think of the infrastructure that makes all of this possible. In this Industry Primer, we will look at how the telecom industry works and how you can evaluate investments in it.

An efficient telecommunications network is the foundation upon which an information society is built.

Talal Abu-Ghazaleh

Industry Structure

The telecom industry has seen a great deal of evolution from the old phone companies to the satellite communication and Internet providers of today. The industry has split into several groups.

Telecom Equipment Manufacturers

Before any company can sell communication services, the infrastructure needs to be there, which requires equipment like phone lines, servers, optical fiber, antennas, and much more. This is a sector with very specialized manufacturers, with usually just a handful of companies controlling each technical niche.

Some companies worth mentioning in this sector are:

• Motorola: a former mobile phone manufacturer, the American company is still a vital telecom equipment provider today.
• Ericsson: This Swedish company is one of the leading global equipment providers for advanced telecommunication, including 5G.
• Cisco: The leading provider of routers and switches.
• Qualcomm: The leading US supplier of connectivity for IoT (Internet of Things) and 5G equipment.

Services and Infrastructure Operators

In the last two decades, a new type of telecom company has emerged. They are not manufacturers but also do not provide direct internet or phone to consumers. Instead, they operate infrastructure for the Internet provider.

A perfect example is the cell phone tower business. A service provider operates the towers and rents access to them to 3-4 different mobile operators. This spreads the costs of one tower between multiple clients and makes the mobile providers more efficient.

In that sense, the mobile tower company acts like a very specialized industrial real estate landlord. That’s why they are often organized as a REIT.

American Tower is a good example of such a company in the US. More adventurous investors might be interested in foreign operators with more growth opportunities, like Africa-based Helios Tower.

Network Operators & Providers

These are the companies the final consumers usually interact with. They provide their users the actual mobile or Internet coverage or maybe cable TV.

They are usually very large companies, with valuations in the hundreds of billions of dollars. They often operate as monopolies or oligopolies, with no more than 2-3 providers usually dominating a country. Good examples of this sector are companies like AT&T, Verizon, Comcast, and Vodaphone. Foreign markets can also be attractive to investors, like Deutsche Telekom (Germany), Orange (France/EU), or Nippon Telegraph & Telephone Corp (Japan).

SaaS

A new type of telecom company has emerged in the last ten years: SaaS (Software as a Service). They replace some of the older options with Internet-based systems and blur the line between the telecom and tech sectors.

The pandemic made them a lot more popular and sped up the adoption of these solutions. A good example is Zoom, but there are also older solutions like Skype (part of Microsoft). Streaming device maker Roku is another one.

New segments like telemedicine software or remote education solutions are also possible opportunities in this sector.

Specialized Communication

The last sector is the telecommunication segment which responds to niche demand. This sector has two components.

The first part is satellite communication for remote regions. We covered this sector in our “Gilat Satellite Network” investing report of November 2021.

This is an interesting sector, but intense competition is expected to come from billionaire-owned space companies like the Starlink network from Elon Musk’s SpaceX or the project Kuiper by Amazon/Blue Origin from Jeff Bezos.

Overall, the older technology based on geosynchronous satellites might need to adapt against broadband provided by low-Eart orbit satellite constellations.

The second part is secure military communication. The defense communications equipment market is expected to grow at 10% annually from 2019 to 2029.

The increasing usage of drones, network-centric armies, and electronic warfare will all boost the need for robust and secure military communication. Some of the most active companies in this sector are large defense contractors like BAE, Thales, or Raytheon, but smaller companies might be able to provide unique services for specific applications.

This can overlap with the first sector, as the intensive usage of the Starlink system by the Ukrainian army illustrated. SpaceX is also active with the recently revealed Starshield constellation.

Assessing Telecom Companies

Income investing: Large Operators & Manufacturers

The largest telecom companies are mostly defensive, income-focused investments. They are already dominant and have little room to grow their market share. They will mostly grow with the overall sector and the country’s economy. This is also true for mature, large mobile tower companies.

These companies make good investments if they are priced relatively cheaply. A not-too-high level of debt and good service quality will be the selection criteria as well.

Manufacturers of equipment are a little riskier than companies like AT&T. Their technology might slowly become outdated, and they must keep reinvesting in R&D to stay ahead.

In addition, telecom is a politically sensitive topic, and some companies might be unable to access some markets in case of trade wars, as the ban on Huawei equipment in most of the West has shown.

Growth Investing: Foreign Operators & Innovators

Not all of the world is perfectly connected. Operators in emerging markets or outright under-developed regions like Africa can display strong growth profiles, similar to the one Western telecom companies had in the 1990s.

The difference is that, in this case, investors have the advantage of insight of knowing the path forward from past experience in the West. Especially interesting are companies focusing on mobile networks, as most of the developing world has gone directly went to smartphones without passing through the landline or cable network stage.

These markets also profit from a young population eager to communicate and bypass inefficient and outdated local institutions like banks, taxi monopolies, universities, etc.

The other sector of growth is companies with unique technological advantages. This might be very hard to quantify for investors without a technical background. Nevertheless, if a company holds unique patents or technology, it could experience explosive growth and capture market share for the incumbent manufacturers.

Specialized Providers

Suppliers to the military are likely to have a stable source of income from military contracts and are more like defense companies than pure telecom companies.

Satellite companies should be analyzed with caution to estimate if their specific business model and client base are threatened by the rise of Low-Earth orbit constellations. A fair level of understanding of the sector will be needed to avoid buying into value traps.

SaaS

SaaS companies have been treated by investors as tech companies more than telecom companies. This led to very pricey valuations during the pandemic, which has dramatically cooled off. That was predictable: a P/E of 235 for Zoom in 2020 never made any sense from a risk/reward perspective.

For SaaS solutions, the strength of the competitive moat is of prime importance. Before Zoom, there was Skype (which is still widely used for that matter), and after Zoom, something else might come.

The risk of tech giants launching their own competing products should also be remembered. When a company is already operating on Microsoft-provided cloud and Microsoft-provided email, it might as well prefer to stick to a Microsoft-provided call and meeting system.

The post Industry Primer: Telecom appeared first on FinMasters.

Let’s take a closer look at some key considerations for investing in semiconductor companies

Semiconductors Explained

Instead of giving a scientific explanation, I will give you a more practical one. Semiconductors provide instructions or computing power to electronic components. They are made from silicon wafers, which are engraved to create the final chip.

Types of Chips

Semiconductors have been around since the 50s. Over time, the trend is miniaturization, with more and more transistors (the base component of a chip) pilled up in one spot. The industry operated under the empirical Moore’s law: transistor density doubles every 2 years.

For this reason, chip generations are traditionally labeled according to the scale at which the manufacturing is done. The smaller, the more advanced the chip. So a 28nm chip is a lot less sophisticated than a 10nm or 7nm chip. Also, the smaller the chip, the harder it gets to reach the next step and keep Moore’s law valid.

Currently, most of the chips being used outside of IT and the computer industry are from older generations, chips in the 28nm range or more. This is because those chips deliver enough computing power for most applications, while also being older and much cheaper technology.

More advanced chips, at 14nm and lower are considered the most advanced. The industry peak is currently 5nm chips, with massive efforts made to reach the 3nm or even 2nm level and manage to mass produce these ultra-small chips^[2].

The most advanced chips require new and unique manufacturing techniques, notably Extreme Ultraviolet Lithography (EUV). This is currently the monopoly of only one equipment manufacturer, the Dutch ASML.

Export of this technology to Chinese manufacturer have been banned under the Trump administration, in order to keep China lagging behind and dependent on Taiwan’s chip manufacturers for applications like AI, cloud computing, or self-driving cars.

This ban is still ongoing and is being reinforced under the Biden administration, making it a bipartisan consensus position. Currently, China is judged to be lagging several years behind the US and Taiwan in chip technology.

Still, China seems to have managed to produce a 7nm chip without EUV technology. There is some doubt over whether they can produce these chips at any scale. Still, the race for semiconductor dominance is clearly on between the two superpowers.

Despite these breakthroughs, China remains the world’s leading importer of semiconductors, and China spends more on importing semiconductors than they do on importing oil. This reversal of China’s typically export-intensive economic base underscores the dependence of manufacturing industries on a steady supply of semiconductors.

How Are They Made?

The production of semiconductors requires extreme precision. Many modern chips are manufactured at the nanometer scale (one millionth of a meter). This means working literally at the atomic level, and in a situation where one atom at the wrong spot can spoil the whole chip.

This work needs to be done in a “clean room” environment with absolutely no dust or pollutants of any kind. Keeping such conditions requires very expensive facilities.

This also requires very specific machinery, each working at one step of a very long and complex process. In this context, R&D and manufacturing are the hard part: the raw material costs count for almost nothing.

A key metric in the manufacturing of chips is yield. This is the measurement of how many functional chips are made from each wafer. While this is inevitable that a few chips have defects, high yields are crucial in keeping a facility productive enough to keep costs low.

Overview of the Semiconductor Industry

The Semiconductor Value Chain

Over time, the actors in the semiconductor industry have specialized in just a few steps of the whole value chain. It can be summarized as such:

theoretical research > machinery > design > foundry

Theoretical research is something done either at the university and research institute level and/or in partnership with the industry. The sector is spending a lot on R&D and is highly competitive. Many patents and intellectual property rights are currently held by the US government or American companies.

The machinery used to manufacture semiconductors is produced by a few specialized companies that sell their equipment to all the manufacturers, subject to restrictions from governments that increasingly see chipmaking as a strategic industry that requires export restrictions.

The chip design industry is split between two types of companies.

• Design-only or “fabless” companies like AMD or Nvidia focus exclusively on the design and subcontract all production to specialist foundries. These are often companies that specialize in a specific sub-sector of the chip sector, like Nvidia for graphic cards/parallel calculations.
• Design+foundry companies, like Intel, design and manufacture chips. They may handle all of their manufacturing or outsource some to specialist foundries.

The trend in many major companies has been toward the fabless model. For example, AMD spun off its manufacturing business into a new entity, Global Foundries, in 2008, and has been fabless ever since.

Finally, the foundry segment is the actual manufacturing of the chips. The companies doing only manufacturing are called “Pure-play” foundries. Some of them might even offer just a part of the steps needed to produce a chip, outsourcing the rest of the process to another company.

When companies are both designers and manufacturers, they are called Integrated Device Manufacturers or IDMs. This includes for example Samsung, Intel, or Texas Instruments.

The Semiconductor Industry Structure

Because making chips is so complex and expensive, this is an activity that benefits immensely from economies of scale. This has led the industry to turn into essentially an oligopoly, with a few companies holding a dominant position.

The elephant in the room regarding semiconductors is TSMC (Taiwan Semiconductor Manufacturing Company). By revenue, it controls more than half of the total income of all foundries. The rest of the foundry business is controlled by a few other firms in Korea, Japan, and China, with Western countries lagging far behind.

Semiconductor Geopolitics

As mentioned before, semiconductors have become a geopolitical topic, with the US ban on advanced technology exports to China serving as a prime example But if the US can use semiconductors as a weapon in its rivalry against China, two can play this game.

Currently, most of the world’s semiconductor manufacturing capacity is in Taiwan, an island nation that China officially considers a breakaway province that will be reunited with the mainland sooner or later, peacefully or not. An island which just a few days ago, the USA has warned would be defended by US troops if needed.

So the new big thing for investors in semiconductors is not a new technology, but the need to take geopolitics into account or risk being hurt the way investors in Europe were hurt by the Russian invasion of Ukraine.

92% of 10nm or smaller chips are made by TSMC in Taiwan. The same chips are required for the production of military equipment like satellites or F-35 fighter jets. So Chinese threats on the island are making the Pentagon nervous. A recent naval drill simulating a complete blockade of the island made it worse.

In his meeting with U.S. Defense Secretary Lloyd Austin on the sideline of the Singapore conference, Wei (China’s defense Minister General) declared, “If anyone dares to split Taiwan from China, the Chinese army will definitely not hesitate to start a war no matter the cost.”

He further vowed that China’s People’s Liberation Army (PLA) would “smash to smithereens any Taiwan independence plot and resolutely uphold the unification of the motherland.”

Source: The Federalist

One consequence of this mounting tension is the push to restore chip production to the West. To make it happen, the US Congress voted in August 2022 the CHIPS act, allocating $280B to solve the problem.

On a side note, this is why the Stock Spotlight report of this month is focused on a leading company in the semiconductor industry with production facilities out of Taiwan, that would benefit in the case of a worsening situation.

Investing in Semiconductors

The sheer complexity of the product and the process make investing in this industry a daunting task for investors. There are a few strategies that can help you overcome this obstacle.

Focusing on a Narrower Section of the Industry

Short of being an engineer with extensive knowledge about semiconductor manufacturing, it will not be possible for an investor to truly understand the industry as a whole.

It is however possible to learn enough about a subsegment. Maybe focus on learning how just one type of chip (memory, processor, graphic cards, etc.) works and who makes them best. Or focus on a specific level in the value chain. This does not make the learning process much easier, but it’s possible to gain a better understanding than most investors this way, which gives you an edge.

This will also make the competitive analysis a lot simpler, as each of the sub-segment of the semiconductor industry tends to be dominated by 2 to 5 companies at most.

Investing in Semiconductors as a Whole

Because the whole sector is growing strongly, “semiconductors” as a general investment idea can be a winning strategy. Plenty of ETFs and funds offer diversified exposure to the industry. Some will be focused on only US manufacturers, some on Asia, and some on global.

In the same way, you can build a portfolio including all the major actors and count on the winner(s) to be part of your portfolio.

Betting on the Strongest Horse

The industry has a strong flywheel rewarding past success with even more success.

More efficiency or better design leads to more money. The money can be reinvested in more efficient factories or more R&D than the competition. This leads to an even stronger competitive advantage, generating even more profit.

The cycle can repeat again and again until just a few companies are standing.

Such a strong moat makes a compelling argument for investing only in the market leaders.

Conclusion

At first, investing in semiconductors might feel too complex to be analyzed by individual investors. Constant innovation makes it even harder to keep up.

On a second glance, the sector is very structured around just a few key companies, with a strong winner-take-all dynamic. This is together with persistent growth for the industry as a whole for decades past and to come. So investing in semiconductors could prove very rewarding for the patient and astute investor.

Because the industry is so strong, the upside is ultimately taken care of by the growing demand for chips.

Avoiding risk should be the main task of investing in semiconductor companies. Avoiding geopolitical risk means diversifying beyond China and Taiwan. Avoiding technology risk means not betting everything on just one company or one innovation. Avoiding financial risk means balancing the oligopoly structure of the industry with moderate valuation, and avoiding overpaying.

Industry Primers
The process of analyzing a company varies considerably from industry to industry. Many industries have their own vocabularies and specific concerns that investors need to consider. This series of articles looks at specific industries and industry-specific factors that affect investments. The goals are to highlight specific risks, clarify confusing terminology, and explain industry-specific metrics for valuation. These methods complement the usual evaluation process, they don’t replace it.

The post Investing in Semiconductors: Industry Primer appeared first on FinMasters.

Industry Structure

The oil & gas industry is commonly divided into 4 parts:

Upstream: The segment directly involved with drilling and extraction of oil or gas.

The upstream sector is characterized by high volatility. Production costs are relatively constant but the value of the products fluctuates widely with little to no pricing power. The sector is capital intensive and is known for its boom and bust cycles.

Midstream: This segment transports crude or refined material from point A to point B. While midstream often involves pipeline companies, it can also include trains and tankers.

The midstream sector uses very long-lasting assets: a pipeline can stay operational for 30-60 years if well maintained. Investors in this segment will want to focus on buying at a discount, as income is more steady and predictable. Growth is minimal and returns will mostly come from dividends.

Downstream: This segment transforms the raw fossil fuel resources into useful products and distributes them to the final users. This includes refineries turning crude oil into fuel, but also gas liquefaction facilities or the petrochemical industry producing plastic, fertilizers, and other chemicals.

The downstream sector features low margins and is very capital intensive. This sector is most relevant for investors when integrated vertically in a corporation also handling upstream and midstream operations

Services: the O&G sector is a highly technical one. There are many specialized companies providing expertise and tools to the industry. These can be drilling rigs, geological surveys, pipes, valves, pumps, sands, chemicals, and many more

The O&G Upstream Sector

International majors: Large vertically integrated companies operating all over the world.

National giants: Large companies with a monopoly on one country’s resources. Often comes with large state ownership and higher political risk with less emphasis on minority shareholders’ rights.

Small producers and juniors: Usually focused on only one region. Juniors are very speculative, as many are not producing yet and are consuming capital trying to find new deposits.

Measuring Oil&Gas

Oil is usually measured in barrels of oil (bbl) and production in barrels per day (bpd) or million barrels per day (mmbpd). Many deposits contain both oil and gas at the same time. Reserves are then expressed in barrels of oil equivalent (boe) where the gas part is calculated “as if it was oil” to make it more understandable. Many other units are sometimes used, notably cubic feet or cubic meters of gas, metric tons of oil, gallons, or BTU (British thermal units).

Assessing O&G investements

Production costs/Breakeven

Each O&G deposit has a specific geological profile that determines its exploitation costs. While this can fluctuate slightly depending on management’s skills and technology, breakeven costs tend to be somewhat stable due to unchanging geology. To be commercially viable, an O&G deposit’s breakeven costs will need to be at least 30-50% lower than the market price for oil or gas.

The lowest breakeven costs provide a larger margin of safety, as other producers with higher costs will be forced to shut down production first in case of a downturn. This was for example the case of Canadian oil sands in the late 2010s, which were unable to keep producing as oil prices fell. Low breakeven costs also allow a producer to maintain some positive cash flow when the industry as a whole is losing money.

Reserves

Reserves are a key metric for upstream companies. Each O&G deposit has a limited lifespan determined by the resources available in the ground. An oil field producing 100,000 barrels/year with 1.5 million barrels in reserves will be depleted in 15 years. This means the current valuation of the company must cover much more than the value of the resources in the ground to produce a profit.

To use the example above, let’s imagine the 1.5m barrels have a breakeven cost of $40. At an expected average of $80/barrel for the next 15 years, this makes 1,500,000 x $40 = $60M of expected profit.

Considering the variability of future oil prices and possible production cost inflation, a solid margin of safety can only be achieved if the company owning this oil field is valued at less than $20M-$30M.

CAPEX, cash flow, and write-downs

The Oil & Gas industry needs heavy and expensive infrastructure and equipment to operate. This makes analyzing O&G financials tricky.

CAPEX is necessary and will always consume a large part of the cash flow generated. The same is true for exploration budgets to find new deposits.

The value of the O&G deposits themselves is an asset on the balance sheet. Together with the attached infrastructure, they can be written down in case of long-term low prices, leading to large “paper losses” in earnings but not in cash or cash flow.

For all the reasons above, the preferred metric to value O&G companies has to be Free Cash Flow, instead of earnings, as it reflects better the cost of CAPEX and ignores “paper losses”. It is also important to check that exploration budgets are counted as part of total CAPEX. Without new exploration, the company will run out of resources at some point in the future.

Cyclicality

Launching new O&G exploitations takes between 5-10 years, sometimes even more in jurisdictions with high regulatory burdens or for very technical projects like ultra-deepwater drilling or arctic deposits. This is the time it takes to find the oil, get permits, find suppliers, attribute tenders, build the infrastructure, hire, ramp up production, etc.

As a result, new projects tend to be approved only when market conditions seem favorable to future profitability and cash flows are high enough to finance them. So the industry tends to have periods of drastically low investment in CAPEX, followed by a wave of large projects. The consequence is regularly unbalanced production, either too little (after a long period of low CAPEX) or too much (when all the new projects come online at once). This leads to persistent cycles of boom and bust in O&G prices.

Investors in O&G need to consider this risk. Record cash flows and earnings are often a sign of an incoming market top. Alternatively, buying after years of low prices tends to be highly rewarding, even if current cash flows are not that great.

Debt

Due to the capital-intensive nature of the industry, many O&G companies tend to accumulate a lot of debt when launching new projects. This can result in catastrophic failures and bankruptcies in case of a prolongated downturn in oil price. A high-quality balance sheet is a good way to reduce risk when investing in the sector.

Management

The cyclical nature of the industry is an investment concern. Bad management tends to squander profits from good times into growth at the worst part of the cycle. This ends in companies with unprofitable assets and high debt and ends in dramatic shareholder dilution or bankruptcy.

The discipline to raise dividends and improve the balance sheet during good times is a good indicator of management quality. The patience to wait for a downturn to pursue mergers and acquisitions and launch new projects is also a good opportunity to acquire valuable assets on the cheap.

Transportation

Transport bottlenecks can hurt O&G producers’ margins. A good example is Canadian production, which is mostly landlocked and constrained by insufficient pipeline capacity. At times, this can lead to up to a $10-$20 discount on international prices and put a cap on possible growth.

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Interest in nuclear power is currently surging. The imminent threat of climate change and the volatile prices and geopolitical threats affecting traditional energy sources are driving a search for alternatives, and renewables are still limited by non-continuous production and limited storage capacity.

That opens a window for nuclear power, but what does that mean from an investment perspective?

Let’s look.

How Does Nuclear Energy Work?

Uranium is an abundant resource, with reserves estimated at double the entire production since 1945. It is also extremely dense, with the energy in 1g equivalent to 16,000g of coal. This very high level of energy allows the use of uranium to turn water into steam, which is then used to turn a turbine, producing electricity.

Due to the nature of its fuel, nuclear energy is considered a low-carbon energy source. The only carbon emitted is during the mining of uranium and the construction of nuclear plants.

Nuclear energy produces nuclear waste, which can be dangerous for a very long period of time. How to treat nuclear waste is debated, with the majority of them calling for waste to be rendered inactive in vitrified form, as in the schematic below. Thanks to these solutions, the nuclear waste problem is increasingly seen as manageable.

The Case for Nuclear

The reason for the recent lack of enthusiasm about nuclear is its relative stagnation. In the 70s nuclear technology was expected to power the future, and massive building efforts were undertaken in the most powerful nations. The 1986 Chernobyl disaster dampened this enthusiasm dramatically. Just when global warming concerns could have helped nuclear to restart, Fukushima happened.

After several unpredictable crashes, investors became justifiably wary of nuclear. The sector stopped growing and stringent regulations slowed down innovation as well.

Still, a look back at the world energy mix shows how hard it will be to replace fossil fuels. To this day, 84% of the world’s energy still comes from fossil sources. Solar and wind are by nature intermittent and should be supplemented by more steady power sources, which keep producing when the wind does not blow and the sun does not shine.

High energy prices and the ongoing issues with Russia’s supply are creating a very tense situation in energy markets. Short of an end to the Ukraine war AND an unlikely return to the status quo, this is a situation here to stay. Even if the Russian situation resolves, conflict potential in the critical Arabian Gulf remains high.

Higher energy prices in Europe and Asia, increasing public awareness of climate change, and the limitations of renewables make fixed-cost nuclear a lot more attractive than before, and new technologies promise a higher level of safety. Those factors are driving a nuclear comeback.

Nuclear Companies

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

Uranium Miners

While it is technically possible to use other fuels, almost all current nuclear technology runs on uranium. The sector is dominated by 2 companies, Kazatoprom and Cameco.

Kazatomprom operates in Kazakhstan and is by far the larger miner of uranium in the world, producing 45% of the world’s supply. Cameco produces 18% of the world’s supply. The rest of the production is at the hands of state companies or smaller actors, notably in Australia, Russia, China, Niger, and Namibia.

Uranium experienced a price spike in 2008, in the midst of a commodities boom. The sector has since been marked by years of overproduction and low prices, close to or below production costs. This led both Cameca and Kazatoprom to suspend operations at several mines they still own today.

Nuclear energy is not fuel-intensive and even a surge in new plant construction is not likely to result in a uranium mining boom.

Manufacturers

These companies make components for nuclear reactors, whole reactors, or complete power plants. Here, too, we find a lot of state-owned companies and a few private and publicly traded.

Companies making components for nuclear power (like for example, only turbines) or whole reactors tend to be part of larger industrial conglomerates (for example, GE, Westinghouse, or Rolls Royce). So there are relatively few stocks in the market that are established pure players in the nuclear industry.

One of these pure players will be covered in our next premium report, analyzing the nuclear industry prospects and 3 different stocks in the sector (a pure player, a startup, and a dividend stock). Sign up for Stock Spotlight if you’d like to read it as soon as it’s published.

Utilities

Utilities are the electric companies operating the nuclear power plants They are often partially owned or heavily regulated by the local or national government, with only a small portion of the company publicly listed.

Utilities using nuclear power tend to have a similar profile to other utilities. This includes a focus on large CAPEX on long-duration assets, conservative financial management, and distributing a large part of their free cash flow to shareholders as dividends.

In the US, utilities typically serve defined areas, giving them limited growth potential. Investors treat them primarily as dividend generators.

The main risk for nuclear-operating utilities is political interference. Several countries, notably Germany, have aggressively phased out power plants that could have been still running for decades.

Nuclear’s Future

Nuclear manufacturers are aware of the limitations of traditional nuclear power plants:

• They are very expensive to build, with billions in upfront costs.
• They are very large, complicating their integration into an existing power grid.
• There is a significant risk of accident, with large-scale plants creating risks of a reactor meltdown.

In response, a new concept has emerged in the form of Small Modular Reactors (SMRs).

SMRs have a passive cooling design, allowing the reactor to automatically shut down safely even without human intervention or after a catastrophe like an earthquake or a tsunami.

This is now the center of development for the nuclear industry. Most established actors have either a partnership with a startup or their own SMR program ongoing.

SMRs don’t have to be built on-site. They are built in a factory and shipped as complete modules to the location where they’ll be installed, dramatically cutting design and construction costs. They are flexible: a power user can install as few or as many modules as they need.

Thanks to their smaller size, SMRs are also expected to be more widely used for industrial applications requiring a lot of power, as demonstrated by the project of KGHM, a large copper producer in Poland, to power its factories with its own nuclear reactor.

Conclusion

Fossil fuels are now expensive, both in absolute price and environmental effects. They are also highly vulnerable to supply disruption. This increases the need for a reliable low-carbon alternative. With its predictable and reliable power output, nuclear will have to be part of the energy mix of a low-carbon economy.

In addition to this renewed support, new designs are coming to help power a new nuclear boom. SMRs reactors offer a previously unreachable safety profile, while also permitting lower costs and quicker projects. Their flexible power plant design can also help decarbonize multiple industries: power-intensive industries can install their own power plants using SMRs.

Nuclear power is clearly back in the energy mix: there is currently no other way to significantly reduce oil and gas use as a source of stable, reliable electric power generation.

The implications of that fact for investors are still emerging. Accident risk is still significant, and even an accident in an older reactor could affect the entire industry: public perception does not differentiate among reactor designs. The potential of the business still deserves attention as new technologies and companies emerge.

Industry Primers
The process of analyzing a company varies considerably from industry to industry. Many industries have their own vocabularies and specific concerns that investors need to consider. This series of articles looks at specific industries and at industry-specific factors that affect investments. The goals are to highlight specific risks, clarify confusing terminology and explain industry-specific metrics for valuation. These methods complement the usual evaluation process, they don’t replace it.

The post Investing in Nuclear Energy: Industry Primer appeared first on FinMasters.