Quick Stock Overview

Fortescue Metals Group

Ticker: FSUGY

Source: www.stockrover.com

Key Data

Rio Tinto Group

Ticker: RIO

Source: www.stockrover.com

Key Data

Investment Thesis

Betting on atoms

As the S&P500 and Nasdaq have regularly hit new highs, it’s become a pretty standard position for value investors to warn of a bubble. Other investors even say value investing is dead. As if stock market valuations weren’t enough, there’s Bitcoin, alt-coins, NFTs, meme stocks, real estate, and countless other signs of irrational exuberance.

The big winner of this irrational optimism has been tech stocks. From profitless startups to FAANGs behemoths, it’s been a great year for software investments. Comparatively, the “real” stuff is pretty much dismissed as being too old or boring. Blockchains, data centers, and the coming all-encompassing virtual reality are where the future is.

Do you want to own a company that builds the “metaverse” or do something more mundane? Investors have already declared loudly that they prefer digital at any price. Never before in history have commodities been undervalued compared to financial assets.

Source: The Felder Report

I’m skeptical, though, that we’ll be able to do away with the material world anytime soon. Virtual reality glasses, electric cars, and computers still need real materials to make them. Our Amazon deliveries travel on real roads and go over real bridges. All our data centers are powered by copper cable hanging from steel pylons.

My first stop was to look at some of the biggest mining companies that produce the metals we need. No matter whether the BBB “Build Back Better” bill passes in Washington, the developed and developing world hunger for metal isn’t going away. Despite China’s building period ending, a lot of infrastructures are still needed in South-East Asia, the Indian subcontinent, South America, and Africa.

I discovered that mining companies are very profitable, paying out double-digit dividends and selling at fire sale prices.

This report first appeared on Stock Spotlight, our investing newsletter. Subscribe now to get research, insight, and valuation of some of the most interesting and least-known companies on the market.

Subscribe today to join over 9,000 rational investors!

Subscribe Now →

Learn More

Chapter 1: Narrowing down

Can mining be ethical?

An obvious reason for investors’ distaste for heavy industries is their public image. Mining is usually associated with devastated landscapes, pollution, and fumes that obscure the horizon. These shareholders are ruthless capitalists who destroy the environment out of greed and ruthlessness.

Honestly, some of this image is well-deserved. Over the course of history, mining has been carried out in a careless and polluting manner. There are still many unscrupulous companies operating this way, especially in poor and/or corrupt countries.

A number of mining companies are now taking steps to clean up their act. They realized that if they were to avoid further problems down the road with activists and governments, they would have to respect local communities and the environment. Additionally, technological advances have made it possible to develop safer, cleaner practices.

Those companies are recognizing that now, if they hadn’t before. As an example, the head of Rio Tinto, one of the two companies covered in this report, was dismissed in 2020 for destroying culturally significant Aboriginal sites. As for his successor, you can bet that he will be much more careful to keep his job.

Therefore, I believe that mining investing is not automatically unethical as long as we invest in companies that are large enough to be forced into adopting better practices.

The need for more metals

Apart from the digging involved in mining, the truth is that a cleaner world requires more metal. A LOT of it.

Cars with an electric motor consume 4x more copper than cars with a combustion engine. They’re often made of lighter aluminum, too.

Originally marginally produced metals, lithium, cobalt, and nickel nowadays play a key role in batteries. Renewable energy production is no different. A solar panel requires silver, a windmill requires tons of steel made of iron, and hydrogen fuel cells require platinum or palladium. Both rare earth minerals and gold are necessary for robotics and smart grids.

The demand for metals is bound to increase if we want to combat climate change and modernize our energy infrastructure. For this reason, mining is the lesser of two evils compared to fossil fuels.

The financial world is slowly catching on, with talk of a “commodities supercycle” making headlines.

Source: www.thestreet.com

Source: www.economist.com

Picking the right target

As the economy changed, it was vital to focus on the right commodities. Coal mines may be on the way to becoming stranded assets, with a negative value. As a result of the ethical and legal issues discussed above, I also wanted a company based in the West and required to conform to high standards.

Copper and lithium seem like smart picks for a market where electrification is an unstoppable trend (even if it’s slower than we would wish).

Iron is also a metal that isn’t going out of style anytime soon. This is due to its use as a building material for everything from bridges to skyscrapers, windmills to aircraft carriers. The use of aluminum could also be a viable alternative to copper given that it is increasingly used in the automotive industry.

Finally, being the value investor that I am, I wanted a company that offered a large margin of safety at a low price. Better still, if it was highly profitable, well managed, and had efficient capital allocation. With today’s technology-obsessed marketplace, there is an overabundance of choice. Most large miners are undervalued at the moment.

Therefore, I decided to do a double report that presented two companies simultaneously, each with different opportunities and risks. By doing so, you can choose what is most appropriate for your portfolio.

My attention was immediately drawn to Rio Tinto, the world’s third largest mining company. This company is trading at an absurdly low price, has a diversified portfolio, and trades at a criminally low P/E and P/FCF multiple. Upon investigating the company, I learned it had recently struggled with bad news that scared away investors. The market overreacted to the news and has now absorbed more than its share of the risk. But more on that later.

For the second company, it was a virtual tie between Lundmin Mining and Fortescue Metal. Fortescue won as a result of a lower price and a higher dividend yield.

In the report’s introduction, you will find the key metrics for Fortescue and Rio Tinto. I am sure many other mining companies could also have been a wise pick, since the entire sector appears to be on sale.

Chapter 2: The metal business

The metal mix

Prior to looking into the price and valuation of these mining giants, I wanted to understand each company’s business.

Fortescue Metals

Fortescue is by far the easiest to understand of the two. It is the 4th largest iron ore producer in the world, producing only iron.

In the Pilbara region, Fortescue operates exclusively (the neighboring mines are notably owned by Rio Tinto). With a strong rule of law and high-quality metal deposits, the country is one of the world’s best mining jurisdictions.

For exporting its iron to Asian markets, especially China, the company operates its own heavy-duty railroads and key infrastructures at the local harbor.

Fortescue has no plans to significantly expand in other metals or in other countries. Instead, it plans to expand its Pilbara operations.

In the following chapter, I’ll discuss the companies ambitions to expand into green hydrogen production.

Rio Tinto

Rio Tinto is one of the world’s largest mining companies (the third largest) and has a much more diverse profile than Fortescue. Their operations span the globe. I won’t go into detail about each, otherwise this report would sprawl to hundreds of pages.

Let me instead give you an overview of the company as a whole, and then review the company’s most significant and largest growth projects.

Source: RT Fact Book

Iron ore and aluminum dominate the company’s revenues, with the other metals making up less than 40% of the total.

Rio Tinto operates in the same Pilbara region that Fortescue does, and has 14 iron mines in Australia. Rio Tinto’s historical iron business remains its core business to this day.

The company also plans to keep expanding its iron mining operations in the area, with multiple large new mines in the works or being studied. Interestingly, most of these mines are in the lowest cost range, an important feature of the Pilbara region’s iron deposits.

Rio Tinto also operates a fully integrated aluminum business, from bauxite ore to refineries, smelters, and even hydropower plants (notably in Iceland) to generate the required energy carbon-free. Aluminum production is an extremely energy-intensive industry, hence the requirement for 4.1 GW of power.

Rio Tinto is also protected from unstable energy prices by this integrated energy production, which should give it an edge over its competitors. As an example, Alcoa plans to shut down its Spanish plants for two years due to the ongoing European energy crisis. Others are following suit. The company will be able to offer aluminum products in the meantime.

Rio Tinto also produces copper, titanium, and diamonds.

There are several mega projects being developed by Rio Tinto, including extending its copper mine in Mongolia (which garnered a lot of bad press, but more on that later), and developing a giant lithium mine in Serbia and Argentina. As a result of these projects, Rio Tinto is in position to become a key player in the field of battery metals and electrification.

The iron market

Demand

Given the importance of iron to both companies (the only one relevant to Fortescue), I had to delve deeper into iron markets. Iron ore prices have increased dramatically in recent years, from an average of $60-$70 to $200. This needs to be considered when valuing both companies. Even so, they were both profitable and doing well at the price of a few years ago, though not as massively so as they are today.

Source: www.riotinto.com

Regardless of iron market prices, the Pilbara iron unit cost is much lower than the historical average and below recent prices.

Source: www.riotinto.com

Steel is primarily made from iron. The Chinese demand for construction and infrastructure has continuously grown and accounted for a large part of this growth. As a result of Evergrande’s bankruptcy and the broader Chinese real estate market unraveling, the iron price might decline significantly.

Source: www.statista.com

In part, this could be compensated for by better quality in the construction sector, which is well known in China for its fluctuating quality. In addition to green construction, advanced building design should also increase steel usage in new buildings.

Source: www.riotinto.com

Supply

Demand is hard to predict in commodity investing. Since mining has a very long lag between exploration, development, and starting up new mines, it is much easier to forecast near- and medium-term offers. Often, a project takes between 10 and 15 years to be completed.

The mining industry has kept strong discipline on capital expenditure the last 5-7 years, and spending has not recovered to early 2010s levels. You can see Rio Tinto’s historical capital expenditures below. Rio Tinto is quite consistent with the rest of the industry in this regard.

As a result, new mines and supplies are unlikely to enter the market anytime soon. As long as demand doesn’t collapse completely (reaching a level comparable to the Great Depression), iron prices should remain relatively high for some time.

Source: www.riotinto.com

Other metals

Metals other than iron also display the same profile, with a sudden and strong increase in prices in 2020 and 2021. This resulted largely from too low capex within the industry as a whole, causing the sudden shortage. Moreover, Covid-related stimuli have increased demand.

Copper and lithium demand is likely to remain high in the long run due to electrification, especially for copper.

Titanium is used primarily as a pigment in paints, but it has significant potential in manufacturing as well. Thanks to its corrosion resistance, high temperature resistance, and high pressure tolerance, it is becoming increasingly popular in aerospace and other high-tech applications.

Source: www.riotinto.com

Copper & lithium

Copper is already a large part of Rio Tinto’s offer and future plans, so let me provide a more detailed overview of the copper market. Rio Tinto’s development of the Jadar lithium mine in Serbia is also of special interest.

In the next three decades, the demand for copper is expected to grow by no less than 20 million tons per year, driven by the shift to electric vehicles, grid upgrades, and renewable energy. Rio Tinto only produces 500,000 tons per year, despite being one of the largest copper producers in the world. By 2050, a net-zero scenario would require 15,000,000 tons of resources!

So yeah, there’s a lot of demand.

Even more dramatic are the effects of electrification on lithium. It is estimated that current mines in operation and the planned expansion will not be able to satisfy a large percentage of the demand in 2030-2040. Considering the time it takes to start a new mine, this could cause a chronic shortage of lithium and elevated prices from 2025 onward.

Source: www.rinconmining.com

Rio Tinto reserves

A crucial aspect of mining is checking reserves. Mines have a limited lifespan after which they run out of ore reserves. Therefore, every mining company has a ticker on their heads, and they will run out of metal at some point.

A miner’s reserves are usually enough to last 10-20 years at most. Most oil & gas companies have reserves of seven to ten years.

I am glad to report that Rio Tinto deposits are so vast that lifespan is not a concern. For most investors, Rio’s existing mines will still be operating when their children inherit their portfolios!

By the end of the century, the iron mines will likely still be in operation at their current depletion rate. Additionally, bauxite mines last about 40 years.

The Oyu Tolgoi copper deposit is one of the largest copper deposits in the world, yet it has the shortest lifespan at “only” a quarter century, and probably less once production ramps up.

Regardless, this means that Rio Tinto is an asset you can hold for a very long time if prices remain above production costs. Unlike Shell or Total, as well as many of the other energy majors, its current price does not reflect a problem with the reserves.

Chapter 3: The troubled past and the bright future

Rio Tinto troubles

A copper motherload

This report has already referred to Rio Tinto’s difficulties in Mongolia with its Oyu Tolgoi mega copper mine project. Rio Tinto is mining the world’s biggest copper deposit and gold deposit.

Rio Tinto owns the mine through a complicated ownership structure. It is owned by Turquoise Hill to the tune of 66%, and the government of Mongolia to the tune of 33%. Rio Tinto owns 50.8% of Turquoise Hill, and therefore owns 34% of the Oyu Tolgoi mine.

Rio Tinto has produced 150,000 tons of copper and 61,800 ounces of gold as well as 300,000 ounces of silver from the open-pit mine. All is well so far.

The struggle with the Mongolian government

Things started to take a sour turn with Mongolia in 2018, with a $155M tax bill and the arrest of officials involved in signing agreements with Rio Tinto.

Things got worse, with the underground extension of the mine being delayed by 30 months and costing $1.9 billion more than expected. Rio Tinto’s management has been criticized in independent reports, and the Mongolian government began to lose patience with the company.

During the majority of 2020 and 2021, Oyu Tolgoi has been the source of alarming headlines on www.mining.com, and the share price has reflected this negative publicity. In addition, Oyu Tolgoi appeared to be more significant to Rio Tinto than it actually is.

Turquoise Hill’s debt was also a point of contention between the company and Mongolia. Turquoise Hill owes a lot of money to its parent company Rio Tinto and would not be able to pay a dividend until the debt was fully repaid. It meant that Mongolia’s government wouldn’t see any profits from Turquoise for years to come.

“As it stands, Mongolia is paying for its stake in the project and its share of construction costs, which have been accumulating interest at 6.5% per year since 2009, by deferring dividends and it is not due to see any payout before 2041.”

Considering how poor a country Mongolia is, Oyu Tolgoi, once expanded underground, should represent as much as 30% of the whole country’s GDP. Hence, political pressure on the government to obtain cash before 2041 was enormous.

In my opinion, 2041 was an absurd timeframe. The result is that Rio Tinto tried way too hard to negotiate with Mongolia and ended up risking a full expropriation as a result.

A light at the end of the tunnel

As a result of Mongolia’s rich but unexplored underground, its government has no interest in tarnishing its image as a top mining destination. Despite the short-term gains, Turquoise Hill would have lost much more if it were nationalized. This country desperately needs foreign investment.

In recent weeks, Rio Tinto offered to cancel Turquoise Hill’s $2.3B debt. In addition, it will cover the cost of the underground extension of Oyu Tolgoi, which should be completed in 2023.

Rio Tinto was forced to accept a fairer deal by the Mongolian government, on the surface a defeat for the mining giant. Personally, I see it as an excellent outcome.

In addition, it almost eliminates the possibility of a full expropriation, which is always possible in countries with weak rule of law.

The second lesson is that Rio Tinto management needs to learn that exploitative and abusive deals have negative consequences over time. Tricks like loading Turquoise Hill with debt to keep dividends away do not pay off. Even in a poor country like Mongolia. Consequently, long-term investors should be less likely to experience similar problems in the future. As a result, the company would not need to post defensive statements online ever again, as they did with Oyu Tolgoi…

Rio Tinto other mega-projects

While Rio Tinto focuses on Mongolia, its other projects and its growing profitability have been overshadowed. The other flagship project, Jadar in Serbia, is also facing opposition from investors.

Jadar, Serbia’s lithium

With a planned annual production of 55,000 tons of battery-grade lithium carbonate, Jadar is Rio Tinto’s flagship entry into the lithium market. It will also produce 160,000 tons of boric acid each year.

In the current market, this would put the project a bit below the 5th largest lithium producer, SQM (which produces 70,000 tons annually). As a side note, Rio Tinto attempted to acquire a $5B stake in SQM in 2018, demonstrating the company’s commitment to expanding into the lithium market.

Jadar’s lithium reserves are huge, and the mine should be able to operate for at least 40 years. Additionally, the deposit is of high quality, with costs expected to be in the bottom 25% of the industry (both for lithium and boric acid).

At present, most of the world’s lithium is mined in South America and Australia. Therefore, its location in Europe is also advantageous, as the region is aggressively ramping up its efforts in electric vehicle manufacturing and is looking for local suppliers.

So what is the problem with Jadar? Mostly local opposition from nearby residents. Local municipalities have canceled plans to assign land to the mine, and thousands of protesters have rallied against it. The Serbian parliament has also abandoned some reforms that would have made the country more miner-friendly after nationwide protests.

Protests like these are not unique to Rio Tinto. Most ecological activists worldwide oppose the opening of any lithium mine, or any new mine of any kind for that matter.

It seems a touch paradoxical when the same activists want to phase out fossil fuels and switch to electric vehicles instead. These changes are anticipated to consume a great deal of copper, lithium, and other metals.

Serbian protests may have a negative impact on the Jadar mine, but it is too early to tell. Nonetheless, given that lithium is in short supply, and that a lot of more is needed to manage the green transition, pressure for approving the mine should grow. Serbia is also experiencing poor economic conditions, and the project’s income and tax revenue are likely to be required by both the local and national tax authorities.

The project was to begin construction in early 2022 and last four years. In general, I expect delays and additional drama, but I still expect the mine to go ahead. Serbia will need to increase its tax revenues in order to increase lithium supply in Europe. A production start in 2027 or even 2028 is more likely than 2026, but it should happen eventually. Mining is in any case a long-term game, where “new product launch” means waiting for 5-7 years. As part of its long-term strategy, Rio Tinto also invested in Slovakia-based battery manufacturer InoBat Auto.

Rincon Mining, Argentina’s lithium

Acquisitions, on the other hand, are more of a surprise to shareholders. New mines are easy to forecast years before production begins, but acquisitions are less predictable. In order not to tip off competitors and start a bidding war, management often keeps them secret. This was the case with the acquisition of Rincon Mining for $825M.

The company’s website says the mine should be the world’s lowest-cost manufacturer. The region is also expected to have one of the lowest carbon footprints in the world due to its reliance on renewable energy sources (including hydropower in the region).

The plant should have a production capacity of 50,000 tons/year for 40 years. In addition to Jadar, this would catapult Rio Tinto into the top 3-5 lithium producers in the world.

A small test plant should be up and running by 2023, and a 50k/year plant by 2026. About the same time the Jadar mine is set to start up.

In addition to becoming a large lithium producer, Rio Tinto will also have some of the lowest production costs in the market and 40+ years of lithium reserves.

Simandou, Guinea’s iron

Rio Tinto is developing a large and higher grade iron deposit in Guinea called Simandou. It won’t be as cheap as Pilbara ($35-$40/ton compared to $15-$25/ton), but still well below 2019 prices.

Source: www.riotinto.com

Rio Tinto owns 45% of the project. The mining rights have been held by Rio Tinto since 1997. Up until higher prices and the Chinese government’s interest in more supplies pushed the company to develop more iron mining, the company was not eager to do so.

With iron ore prices now 4x higher than Simandou production costs, Rio Tinto has a solid margin of safety to launch the project. This is an extreme case of long-term capital planning.

Fortescue growth plans

Iron production growth

Fortescue produced 176 tons of iron last year and plans to increase production to 220-230 tons per year as it expands its existing mines and develops the new Iron Bridge mine.

The company has managed to keep production costs at an astonishingly low $13/ton. It is so low compared to the existing market price that even a massive drop in iron demand would not make the company unprofitable.

Dig it for $13 and sell it for $100-$200. Simple as that. Moreover, the company has reserves of at least three decades, so it can stay in business for a long time to come.

Other metals?

Fortescue’s annual report mentions in passing some copper and lithium exploration projects in South America and Kazakhstan, but doesn’t provide any details. As they stand, I would not consider them of any value to the company, and I would keep them as an unknown potential for the very long term.

Green hydrogen lofty plans

Fortescue seems to be the least interesting of the two companies in this report at first glance. It focuses on one metal and one region in one country. You dig it for a low price, sell it for a high price, and pocket the difference.

Both Fortescue and Rio Tinto are putting considerable effort into communicating how green their operations are. This includes using electric trucks and using solar panels for electricity. All of these initiatives are worthwhile, but they are more token ESG efforts than core business initiatives.

Perhaps pure greenwashing, it’s difficult to tell. See the slide below from Rio Tinto as an example. Good efforts, but they won’t change the core of Rio Tinto’s operations:

In the beginning, I thought Fortescue’s comments about focusing on hydrogen generation as the future of the company were also just ESG distractions/greenwashing.

Upon further examination, it appears that the company’s management is serious about it. I considered this to be a serious threat to the company’s future. Fortescue has experience handling mining equipment, not energy infrastructure. In spite of the fact that mining and utilities handle some heavy machinery in common, they are very different industries. I feared that it would distract the company and waste a great deal of cash.

Furthermore, I am not optimistic about the prospect of hydrogen as a fuel in general. I won’t go into too much detail, but hydrogen is just energy storage, not really a fuel. Hydrogen must be produced from electricity, and this electricity must also be green in order for the hydrogen to be environmentally friendly.

This process of hydrogen generation, liquefaction, storage, and transportation wastes a great deal of electricity. In almost all use cases, it is better to use this electricity directly rather than making hydrogen from it.

Hydrogen is a perfect match for an iron miner

Only after reading Fortescue’s explanation did I understand why they were interested in hydrogen. The solution is not, as I first thought, to become a hydrogen producer and export it overseas. It can also be used locally for transportation. Instead, it is intended to capture more of the iron ore value chain.

Prior to being used to make steel, iron ore must first be purified. Throughout the industrial era, coking coal has been used in this process. There is no substitute for this type of coal in the production of steel. Thus, steel production is a very carbon-intensive industry, and it is difficult to avoid such emissions.

Or so I thought.

In the past, only “low carbon” options were considered. This meant using “sustainable biomass” instead of coking coal. Most likely, biomass here meant a lot of wood. It might have been very large forests that were burned. The act of burning might have been carbon-neutral, but not so environmentally friendly.

Recent innovations have allowed iron ore to be purified without burning coal by using hydrogen instead. This has quickly evolved from a theoretical possibility to a rush to upgrade iron smelters across Europe. In fact, the first deliveries of this “hydrogen steel” to carmakers were made last summer.

Fortescue’s focus on hydrogen is not a distraction or a diversification out of Fortescue’s area of competence, as I had thought. The problem has nothing to do with hydrogen, but with iron, which Fortescue knows very well.

In the future, instead of shipping iron ore as it does today, the company will perform the ore reduction process. This will enable it to capture more of the value chain along the way. Getting green energy in the outback of Australia will be easier due to its dry climate and sunshine.

Whether this activity will be profitable is something I am unsure of. At the very least, it will not produce a loss. Additionally, it will produce goodwill and carbon credits for the company.

The most likely place for hydrogen in the energy mix is in steel production. And if I am wrong about hydrogen’s other uses, Fortescue will have a good chance of selling green hydrogen to foreign countries as well.

Chapter 4: Financials

I am fairly satisfied with both companies’ reserves and outlook. Each is also positioned in metals that are in demand and will continue to be in high demand for decades to come.

Additionally, both are trading at very low valuations. This may be due to the fact that the entire commodity sector is somewhat discounted. To be sure, I needed to check the companies’ financial statements. There may be other problems contributing to the apparent cheap price, such as high debt, poor cash flow, or other factors.

Fortescue

Fortescue saw revenue rise from $12.8 billion in 2020 to $22 billion in 2021. This translates into very large earnings of $10 billion.

For such a capital-intensive business, the debt is low, reflecting management’s prudence. In addition, most of the debt is due in 2027 and 2031, and at rates that are below the current inflation rate (4.3%-5.1%). Finally, the mining industry appears to be learning how to manage the price cycle better and pay off debt at the right time.

With $6.9B in cash and $10.6 in total liabilities, the balance sheet is solid. There is no net-net, but it’s not bad.

The cash flow from operations stands at $12.6B, while $3.6B was spent on maintenance and growth capital expenditures. In total, cash increased by $2B, with dividends paid to shareholders adding $5.6B to the amount.

Therefore, even while repaying debt and investing in growth, the company could cover the very large dividends. Dividend yield is 18.2%, which is insane!

Overall, all indicators are flashing green.

As long as there is no worldwide recession, they should be fine. This can be said of almost any company, so I will not hold it against Fortescue. Fortescue’s low multiples, as well as its high dividend yield, should provide some safety compared with overvalued and popular stocks.

Fortescue’s largest client is by far China, accounting for $20B of its $22B revenue. China’s demand might slow down in the wake of Evegrande’s bankruptcy, which would threaten the company’s cash flow.

The very low debt and the very low production costs make me wonder what could actually threaten the company. At worst, the company could mothball some mines and weather a storm comfortably, even with reduced cash flow.

Rio Tinto

Rio Tinto’s financials look a lot like Fortescue’s. As of 2021, the company has negative net debt (down from $14B in 2016), massive cash flows, and an extraordinarily high return on capital.

Free cash flow of $19.4 billion was partially used to pay dividends of $9.1 billion, for a dividend yield of 10.2%. Current metal prices cover the dividends very well. The company typically distributes 40%-60% of earnings as dividends, and more during times of strong earnings.

The rest of the cash flow was used to cover capital expenditures and debt repayments. The long-term debt of Rio Tinto now stands at $13.4B. Rio Tinto’s balance sheet is less pristine than Fortescue’s, but still very strong. Most debt maturity is relatively soon (for a miner) in 2023-2025, and probably should be pushed forward sooner than later.

Additionally, cash flow was used to add to a large $12.9B cash treasure chest. I expect some of the treasure chest to be used for more aggressive acquisitions of smaller lithium and copper mining companies.

In contrast to Fortescue, Rio Tinto is planning aggressive growth with its mega projects in Mongolia, Guinea, and Serbia. Part of this explains why it focused on growth instead of solely paying off its debt.

It is pertinent to keep an eye on the capital expenditures forecast and see how much free cash flow it will absorb with so many new mines coming online.

As compared to 2021, capex should increase by $3B to $4B in 2024. This is barely going to affect the company’s free cash flow, which is expected to stand at $19.4B in 2021.

Moreover, this could even have been covered by the 2016 free cash flows, a period of low commodity prices. Cash on the balance sheet could also cover the extra capex for the next three years.

Rio Tinto’s other concern is the impact of the multiple issues it has with local governments and ecologists. To renegotiate its deal with the Mongolian government, the company had to fork over $2.3B.

Even though this is not much, the company still had $9B in free cash flow after dividends. It is unlikely that Jadar in Serbia would incur the same extra costs (for example, more stringent environmental regulations).

Is it fair to say that Rio Tinto’s stock barely gained anything in the last 2 years (+11% in 2 years)? Especially when the general commodities ETF spiked by 46%? I don’t think so.

Investors tend to overreact to bad news, which provides value investors with lucrative entry points. Rio Tinto’s margins are exploding, their balance sheet is strengthening, but their stock price is declining.

Chapter 5: Valuation

My standard calculation for miners would have been to consider the total value of the ore until depletion. In the past, I valued Kirkland Lake like that. With Rio Tinto and Fortescue both having mine lifespans in the range of three to seven decades, I will do a simple discounted cash flow calculation.

Discounted Cash Flow

Fortescue

Historically, the price to free cash flow ratio has been very unstable. I’ll pick a lower level of 5 to remain (very) conservative.

With extra production and higher ore prices, free cash flow could continue to grow. Conversely, a slowing Chinese economy could kill growth. First, I wanted to run the valuation with 0 growth and see what the results would be.

With these conservative assumptions, Fortescue Metals would be valued at $32, slightly above its current stociank price of $28.91.

A return of 15% seems quite safe, even if multiples never climb back up (unlikely, considering the historical volatility) and cash flow does not increase in the next decade.

Had I wanted to give a more optimistic outlook, it would not have been difficult. With just 3% growth and a slightly higher multiple, the company would be 1/3 under its intrinsic value.

In the end, I decided to opt for the worst-case scenario. Despite growth in production, cash flow has been permanently reduced (despite multiple contractions). Returns at the current price would still be around 10%.

DCF calculation illustrates perfectly the importance of margin of safety. In the absence of a major recession or depression, it is difficult to lose money on undervalued assets that are generating cash flow.

Last but not least, these numbers do not include any potential success in the green hydrogen and green iron ore/steel sectors. Thus, the potential for upside is even more significant.

Rio Tinto

Price to free cash flow ratios have historically been very unstable here as well. In general, it appears that markets have rewarded Rio Tinto’s more diversified assets and its sheer size over Fortescue’s. I will choose the lower level of 9.

If the Chinese or global economy slows down, then free cash flow may also stagnate. However, with so many mega projects already in the pipeline, some growth still seems reasonable.

Despite these conservative assumptions, I have a value for Rio Tinto Group of $74, slightly above the current $67.52

Rio Tinto’s 15% return also seems safe, even with multiples never returning (unlikely considering the historical instability) and cash flow barely increasing in the next 10 years.

Likewise, I will run optimistic and pessimistic scenarios for Rio Tinto. In the optimistic case, I get a company 1/3 below its intrinsic value, and in the pessimistic case, I get 11% returns.

I was surprised to see that both companies had such similar profiles, since I assumed Rio Tinto would offer better returns. I might be underestimating Rio Tinto’s growth, but anything higher than 5% a year seems unrealistic in a capital-intensive industry.

In this calculation, I only considered the current business conditions. The cash flow for Rio Tinto would completely explode beyond 2026 if a chronic shortage of lithium and/or copper occurs due to green policies. In this case as well, the upside potential is greater than the downside potential.

Conclusion

With the current cash flow and depressed valuation, both companies would be smart picks with a large margin of safety. As commodity traders, they will be sensitive to macroeconomic conditions:

• If inflation remains high, they will outperform and may become the next market darlings instead of tech. Mining companies are in an ideal situation under this scenario.
• If the global economy suffers a recession, and especially if the said recession is severe in China, the two companies would suffer. Their current large cash flow would shrink dramatically to 2015-2016 levels at least. Although the current multiple is low and the balance sheet is solid, the losses should be contained at an acceptable level. The miners of 2022 are not the debt-ridden miners of 2015.

Now, how should they be incorporated into a portfolio?

It depends on what your investment goal is. Is your goal to reduce volatility and be protected from inflation risks, or are you looking to maximize returns? Maybe you want exposure to the green transition without having to guess what technology will win?

A small allocation of 5-10% of the portfolio for inflation risk seems reasonable. Additionally, a 50-50 split between the two miners would provide some diversification.

To maximize returns, a higher allocation of 10-20% would be ideal. Fortescue offers a higher dividend yield and generally lower risk. However, in the case of persistently high prices, it will not be able to reap the benefits for at least 6-10 years (the time it takes to launch new mega mines).

If metal prices continue to rise, Rio Tinto will generate better returns due to its aggressive profile. It is also more vulnerable to recessions due to its more ambitious expansion and greater debt.

I expect both companies to provide similar returns in the long run, though Rio Tinto may perform slightly better. Compared to Rio Tinto, Fortescue will be less volatile and less prone to price fluctuations, scandals, and protests.

In order to gain exposure to the electrification trend, Rio Tinto is a smart choice. In addition to aggressive expansion of its lithium business, it will continue to grow its copper production. The hydrogen bet could also pay off for Fortescue, but it is unlikely to provide the same level of benefits as Rio Tinto’s multi-country mega-projects.

Some investors have multiple goals at once and prefer a different mix for their portfolio. Therefore, it depends on your tolerance for volatility, your time horizon, and the composition of your portfolio.

The tech-driven rally is showing increasing signs of speculation and instability, so I think it is time to bet again on “real atoms” versus “virtual bits.”

Personally, I would like to keep a part of my portfolio in a safe harbor with these two undervalued miners, along with some energy and gold as well.

The post Fortescue (FSUGY) and Rio Tinto (RIO) Stock Research Report appeared first on FinMasters.

Quick Stock Overview

Ticker: REGN

Source: www.stockrover.com

Key Data

Investment Thesis

A Great Complicated Company

I have only covered one biotech company (Vertex) simply because they are simply tough nuts to crack. A gaming company or a gold mine can be roughly understood with little research. Biotech products, however, are incredibly complex and technical. Regulatory conditions and sale processes are also complicating factors that usually cause me to look elsewhere.

This is even more true for actual “biotech” companies. It’s true, there are still a lot of old-school pharmaceutical companies in the pharmaceutical industry. Many of them were born out of the chemical industry. A chemical compound would be created to see if it could be used as a medicine. Chemical molecules came first, and finding a purpose for them was the general strategy. It is only a few hundred atoms in size, so a relatively simple product.

During the late 1970s, a new type of pharmaceutical company appeared, which I will call “true” biotech. Rarely do their treatments involve a chemical compound, but rather something of a biological nature. There is a specific protein, hormone, cell, etc… that can help cure or alleviate a disease.

Typically, such products are made of hundreds of thousands, if not tens of millions, of atoms. Due to its complexity and size, it requires a deeper understanding of the underlying biological mechanisms. Simply modifying a known theme will no longer suffice. Because of this, it is difficult to judge their treatment except by the most qualified specialists.

In spite of the complexity of “true” biotech, I cannot ignore it when the financials of a company shout “cheap!”. And sometimes the universe is guiding you.

When I decided to write about today’s company, Regeneron, news about the Omicron Covid variant came out and made the company even cheaper. I now had a double task on my hands. First, I had to determine the value of the business. Second, determine if the market panic about Omicron has affected the future value of Regeneron.

In an ideal world, the panic would provide us with a remarkably cheap entry point. I believe it does. But before that, let’s see what Regeneron has to offer.

This report first appeared on Stock Spotlight, our investing newsletter. Subscribe now to get research, insight, and valuation of some of the most interesting and least-known companies on the market.

Subscribe today to join over 9,000 rational investors!

Subscribe Now →

Learn More

Chapter 1: A New Field of Medicine

A Science-Driven Company

The tech industry gloats about its innovative profile quite often. For Regeneron, however, it rings true. The company’s mission has always been to create scientific breakthroughs. The company achieved its first milestone in 1990 by being the most cited paper on neurobiology. Scientists have a way of thinking that is seldom emphasized by “normal” companies but makes perfect sense to them.

Both of its founders, Mr. Schleifer and Mr. Yancopoulos, are neurologists and molecular immunologists, respectively. The first FDA approval happened only in 2008, which demonstrates how tedious medical research can be.

Source: www.regeneron.com

Until the 2008 approval, the company had managed to stay afloat by contracting with large legacy pharmaceutical companies such as Sanofi and Bayer.

Since then, the FDA approval has kept coming:

• In 2011, EYLEA, an eye injection for age-related diseases.
• In 2015, PRALUENT, reducing the risk of heart attacks.
• In 2017, DUPIXENT (eczema) and KEVZARA (rheumatoid arthritis).
• In 2018, Libtayo, a drug to treat specific types of skin and lung cancers.
• In 2020, Inmazeb, an Ebola treatment.
• Multiple new indications have also been approved for most of these medicines since their initial approval.

Source: www.regeneron.com

A Unique Type of Treatment

Antibodies Treatments

Regneron progressed from very slow (and at times unsuccessful) drug development to a volley of successes and approvals. A huge part of the focus has been on immunobiology and antibodies, the field of expertise of the Co-Founder and now Chief Science Officer, Mr. Yancopoulos.

I won’t go into too much detail about the field in this report. I recommend a four-page document provided by Regeneron if you would like a primer. The final product is an antibody-based treatment.

The body uses these mechanisms to fight most illnesses (especially viruses). Vaccines work the same way. A vaccine is an antibody-based medicine, since it trains your body to make antibodies against a specific disease.

Regeneron has learned the art of manufacturing and converting antibodies into injectable forms to treat specific diseases that the body is unable to control on its own. This opens up the possibility of using antibodies to not only prevent, but also cure diseases.

Source: www.regeneron.com

The Potential

The targeting mechanisms of antibodies are similar to those of guided missiles. Either the antibody neutralizes its target directly, or it “tags” the target to be destroyed by the body’s immune system.

This ability to target is why it is considered one of the most promising fields for cancer treatment in the future. Cancer cells can be tagged with antibodies to be eliminated by the body’s immune system using custom-designed antibodies.

Since antibodies are naturally occurring molecules, the body tends to accept them more readily than exotic chemicals. They also last weeks or months, instead of hours or days.

We have mechanisms in our bodies that allow us to build distinct types of antibodies in response to new diseases. Therefore, you can replicate the process in the lab. This is how Regeneron developed its Ebola treatment and REGEN-COV for COVID-19.

In the present, Regeneron has focused on the most promising or most needed antibody treatments. As a result, the company is now active in three fields: ophthalmology (eye medicine), oncology (for cancers of a very specific type), and inflammatory disease (like asthma).

The technology has a much broader range of potential applications. It has already commercialized solutions against infectious diseases (Ebola and Covid), and many more are on the way, which will be discussed in the R&D chapter.

Chapter 2: The Drugs Lineup

As all Regeneron’s value is derived from its treatments and patents, this report will focus heavily on its approved and in-development treatments.

The Existing Treatments

Covid

How could a biotech company report these days not mention Covid? Since I mentioned earlier, the company has a Covid treatment, which may or may not still be effective against the newly discovered Omicron variant. In response to a possible resistance to the new variant, the stock of the company dropped 5% in one day.

First, let’s discuss something. Covid is probably here to stay. Vaccination does not seem to fully prevent its spread. Moreover, anti-vax sentiment will prevent vaccination campaigns from reaching their full potential.

In order to reduce death and hospitalization, we need actual treatment. With REGEN-COV, Regeneron reduces deaths and hospitalizations by 70%. We will need this kind of treatment to turn Covid into a manageable problem, one that can be solved without lockdown and further restrictions.

Governments around the world seem to agree, with 4-5 million doses expected in 2022. The distribution will be handled by Roche. If 2022 is anything like 2021 (I hope not), I would expect 2023 to be a banner year for COVID-treatment.

What about the resistance to Omicron? The recent mini-panic is unwarranted, in my opinion. First, Regeneron developed this treatment from scratch within a year. Since then, it has been successfully tested for safety. Only additional tests will be needed to determine the effectiveness of the tweak against Omicron, so the process will be sped up.

In addition, if there are new resistances (something we are not yet sure of), a redesign will be quicker than figuring out how to make an antibody cure from scratch for a disease we don’t yet know. In other words, I fully expect Regeneron’s headstart in curative Covid treatments will allow it to keep up with new variants as they emerge.

In fact, new variants and constant updates and new orders for the last version of the treatment will boost sales. Once again, I think Covid will stick around, so Regeneron’s income from it will be more durable than what markets are pricing in.

Other Infectious Diseases

Regeneron also developed a drug to fight Ebola, a disease that can kill up to 50% of its victims. The Covid treatment was developed so rapidly thanks to this research.

With Covid, what at the time looked like an unprofitable area of research has become a cash machine and reputation booster. An example like this exemplifies brilliantly how science-driven companies use technology platforms and data as their most valuable assets. I will elaborate on the value of the research tools and data in chapter 3.

Currently, Regeneron does not appear to be pursuing any other diseases in its research pipeline. Nevertheless, I like the ability to produce quick treatments in case of new and unexpected situations. Covid taught us that modern biotechnology can turn out innovative treatments at an unprecedented rate.

Eyes Treatments

A treatment that prevents people from becoming blind is of priceless value to those affected.

Product sales have grown steadily by 5-7% every year through the Bayer distribution network. For some patient categories, Regeneron treatment has demonstrated that it can prevent vision loss in 75% of cases. These drugs should have a steady market for the next decade.

Inflammatory Diseases

Many diseases are caused by abnormal inflammation, from allergies to skin rashes and chronic respiratory and digestive issues. Antibodies play a part in regulating inflammation, which is a central aspect of immunity. Duxipent has been approved for three applications so far, including regulating inflammation of the skin and respiratory system.

The effectiveness of the drug is now being tested for 14 other diseases, including asthma, food allergies, and pollen allergies.

In just one year, Dupixent sales have grown by 55%. The drug is going to grow very quickly, both from new approvals and wider use of already approved treatments.

A 50-100% increase in Dupixent’s revenue is expected by 2024. This is BEFORE we get news about the effectiveness in selling serious, but very common allergies such as peanut, cat, and pollen.

Oncology

Regeneron’s main cancer treatment revenue grew by 80% in one year, and it is only now expanding outside the U.S. We can expect explosive growth here as well. The treatment has been validated for some skin and lung cancers, and there are more trials to test it for other types of cancer, like cervical cancer. In the research portfolio section, I will discuss Regeneron’s full potential in cancer treatment.

Overview

As of now, the main revenue driver is EYLEA, the ophthalmology treatment. Given that it is the oldest drug in the company, it makes sense. Until recently, Dupixent had the second-highest revenue.

Both drugs are still growing quickly, especially Dupixent with a 54% year-to-year jump. And that’s before it’s used for other diseases like asthma and cat allergies.

In the last 9 months, the Covid treatment (REGEN-COV) has significantly boosted the bottom line, accounting for a quarter of total revenues. The majority of revenue comes from the United States, with the rest of the world (notably the EU) only recently approving the treatment. A wider geographical reach and a move away from a vaccine-only approach should provide very strong support for REGEN-COV sales.

The Research Pipeline

First, A Small Recap

Let me sum up a little before I delve into the most complicated part of the company. Regeneron’s current product lineup focuses on eye treatment, inflammatory diseases, and oncology. Covid recently introduced a 4th “infectious disease” segment to its business.

Each of the existing drugs is showing aggressive annual growth, with a lot more applications and diseases to follow in the next 1-3 years. On its own, this is the simplest part of the company to understand.

There are multiple diseases for which these products are already approved. In light of their proven safety, the only problem connected with clinical trials could be low efficacy. As a result, a lot of the research effort is de-risked, so it is likely that clinical trials will be successful. Expect an approval rate of 50% or more.

In this section, we get a pretty solid picture of how well the company is doing, with growth coming from approved and well-understood molecules. Let’s talk about the newer drugs in the portfolio.

The R&D Pipeline

Regeneron is working on a bunch of upcoming drugs, and also on various applications and modifications for its approved drugs. In the diagram below, I highlighted the existing drugs in red. All the others are potential breakthrough treatments.

You can tell at a glance what company’s future focus is by the color-coding. Phase 3 trials are the most advanced and most likely to be approved. I believe this will strengthen the business, especially in the inflammation segment. This covers Cat and Birch allergies, 2 not-life-threatening but also very common and potentially very lucrative conditions.

Phase 2 trials are using molecules that have proven safe, but we aren’t sure if they work on real patients. Regeneron is trying to break into a brand-new line of business, hematology. There’s a whole business section for it.

Guessing the future success of clinical trials is a fool’s errand, especially in the first and second phases. Not even the scientist working on it every day can guarantee success. Therefore, investors shouldn’t bank on these outcomes. It’s better to rely on general probabilities. Nevertheless, with 8 different molecules being tested, at least 1 or 2 should work well.

Also, Regeneron is testing a whole bunch of new molecules for treating cancer thanks to its growing success in oncology. Oncology has the highest failure rate when it comes to developing novel treatments, so I expect maybe one of these will make it to market. Using Libtayo as a template, this could generate at least a few hundred million dollars in extra income.

Here’s Regeneron’s slide about when to expect news about its multiple clinical trials. I highlighted the most interesting ones in red.

Cancer treatments are critical because they’re likely to be very profitable. In the future, these studies could also help develop better cancer drugs.

I also highlighted the other three because of how big their addressable market is. Osteoarthritis pain is going to keep growing thanks to the aging population. Cat and birch allergies are so common that Regeneron’s revenues would surge up if they found a treatment.

The rest of the research pipeline isn’t bad either, but shareholders should probably pay attention to the news on either the most lucrative or the most addressable markets.

Chapter 3: The Hidden Asset: The Research Platform

How Did They Do It?

In my introduction, I talked about how Regeneron had contracted its research platform out to big pharma companies to survive its early struggles with drug approval. That platform formed the foundation of its later successes.

Earlier, I gave you an overview of Regeneron’s existing treatment and research portfolio. We can then guesstimate the growth in the next 2-5 years. In addition to that, it’s the ability to keep innovating that will drive future revenue.

Regeneron has built an entire treatment discovery process over 30 years. This is the company’s most valuable asset, as its competitors could not replicate it in less than 10-20 years. In order to do this, you would have to recruit the right scientists, select the right cell lines, identify the right targets to develop antibodies for, and develop the tools and software to analyze them.

The Process

The whole process is explained in multiple videos here, so if you want to find out more, check them out. Here’s a simplified version:

1) Animal testing

With Velocigene and Velocimouse, Regeeron scientists can discover the function of thousands of genes previously unknown, as well as create genetically modified mice to find new treatments. This gives the research team original ideas and speeds up the discovery process.

2) Human antibodies

When a mouse target is found, a human antibody needs to be developed. Velocimab and Velocimmune provide a platform to make large quantities of human antibodies by modifying lab-grown cells and mice.

3) Clinical trial

Once enough of the product has been made, clinical trials can begin. Phase 1 tests safety only, phase 2 the medical potential, and phase 3 the efficacy in real patients.

4) Mass production

Whenever a drug is approved, Regeneron sets up a factory to mass-produce antibodies. As antibodies are very complex products, they’re made from genetically modified cells or mice, so the process isn’t easy. Experience is another key asset that’s nearly impossible to replicate.

The Genetic Database

To expand beyond animal genetics, Regeneron will use an extensive human genomic database, the Regeneron Genetic Center, to find breakthrough ideas. The center has now gathered its 1,000,000th exome (the part of the genome that turns into protein in the body).

Genetic data combined with de-identified medical records is the world’s biggest data set of its kind. The idea behind gathering so much genetic data is to find the common denominator between people with the same disease. This should lead to more effective treatments.

During the past decade, genomic technology has exploded, supporting Regeneron’s efforts in the domain. The project’s first target was just 20,000 exomes. That’s now the weekly target. Going forward, Regeneron can add another million exomes every year.

Earlier, I said the Velomab, Velocimmune, etc… were Regeneron’s best kept secret. As these are already used at full speed to develop and test new drugs, it’s mostly true. I think in 5-10 years, the visionary decision to collect a huge dataset of exomes started in 2014 will prove to be the driver for new discoveries. Regeron is very data and science-driven, and it shows.

Chapter 4: Financials & Valuation

Financials

Of course, none of these qualities would matter if Regeneron’s price was too high. Quality is critical, but so is price.

Regeneron is known for its aggressive growth. The company has almost tripled its revenue in five years. In the same timeframe, the company has also invested in extra capacity, nearly doubling its employee count.

Often, biotech companies have to enter into heavy debt to fund their growth. This is This is because R&D for products that will be profitable after three or five or seven years is tricky to finance. Here, it doesn’t matter because of exploding revenues. We have twice as much cash as we do in liabilities. Furthermore, it provides a healthy cash cushion to cover the cost of all trials.

I also appreciate the conservative approach taken to the balance sheet, with no significant intangible assets that can be challenging to understand. I think it might even be a touch conservative since it ignores the patents, the immunology platform, and the exome database, which are obviously very valuable.

Most of the revenue gets reinvested back into the business, especially in R&D. That’s $2.7B of R&D investment, or 32% of total revenues.

Sales and cash flow are up compared to 2020, partly because of new treatments and partly because of the emergency approval for Covid.

The company doesn’t pay dividends, but buys back shares, and has stepped up re-purchases in 2021. Stock repurchases have broken a long-term trend of increasing share count.

Valuation

Discounted Cash Flow (DCF)

In the past, the company price to free cash flow ratio has been on the decline, but this partly reflects the lack of free cash flow until 2017-2018. Given the company’s growth profile, 13 is too low and I’d prefer 16 which is still conservative.

Most of the multiple depression has to do with a quick increase in cash flow related to the commercialization of Covid treatments (from 2,004 to 5,381). This is the good kind of multiple compression!

Due to so much cash flow coming from Covid-treatment, I’m running two DCF calculations, one with 2020 numbers and one with 2021 numbers. This way we know how valuable the core business is outside of the pandemic effect, which may or may not be a sustainable business line.

DCF with 2020 numbers

DCF with 2020 numbers

I was a bit shocked when I got the results. Even if you ignore Covid’s income, which is very conservative, it seems undervalued. It seems like a bargain at the current price of $625 per share.

What’s even more shocking is that I used a 20% growth rate of free cash flow. The actual historical growth rate was 37%. The company probably can’t keep up with this, but if you want to see a wild bull case, here is what it would look like:

What kind of return would that be? A whopping 47%! This is really reaching the limit of valuation methods and I totally don’t expect this to be Regeneron’s future. On the other hand, that’s a pretty reasonable expectation of 15-20% yearly return.

Earnings Growth

Here too, I’ll calculate with the pre-Covid treatment and post-Covid numbers. Over the last 10 years, earnings have grown 28% a year. Let’s take a more “conservative” 15% – 20%.

Earnings Growth with 2020 numbers

Earnings Growth with 2021 numbers

As you can see, using 2020 or 2021 changes everything.

From both DCF and earnings calculations, I’m estimating 11%-15% return for 2020, and 25-27% with 2021’s earnings and the Covid treatment.

The reality will probably be somewhere in between. 2021 wasn’t all about Covid treatments, and the main products are still doing well. In a few years, Covid will probably fade away (I hope so). By introducing new drugs, growth should remain strong regardless of any Covid-related events.

Conclusion

I’m still a bit confused by Regeneron’s current valuation as I finish writing this report. As far as I can tell, the company just seems to have grown its revenue and earnings faster than its valuation. Considering that the valuation is close to the all-time high, it can be said that the market hasn’t re-rated the company yet.

With so much attention on Covid, it’s easy to forget about the rest of the company. There’s skepticism about Covid income’s sturdiness. That 5% drop in a day shows that REGEN-COV might not be that effective against Omicron.

Obviously, that’ll hurt short-term results. However, with the company’s demonstrated ability to quickly develop antibodies for Covid, it might actually be able to compete on equal terms with vaccines that had the first-mover advantage. So, overall, not much of a concern.

The company’s research portfolio is another strength. As I said before, guessing clinical trial results is a fool’s errand. What’s more significant is the process the company developed to build this portfolio in the first place.

By focusing on one kind of innovative medicine (antibodies), Regeneron has become a leader in its field. The company can leverage its patents with big pharma’s distribution network.

They have world-class immunology knowledge, and it’s just starting to come to fruition. The upcoming entry in hematology, an entirely new field of application for Regeneron, is a great example. I’m sure there’s other applications in neurology, pneumology, etc… that are still unexplored. Some are just getting started, like oncology.

Last but not least, platforms like Veloci-X and initiatives like collecting 1 million exomes will allow Regeneron to stay ahead of its competition.

Current valuation largely ignores the company’s long-term growth potential and discounts quite a bit of its Covid drug’s potential. I think both of those are wrong.

First of all, the number of Covid cases is trending up in heavily vaccinated areas like Gilbraltar and Portugal, which means symptomatic treatments need to be increased too. This should be a boon for REGEN-COV in the US and worldwide.

Additionally, Duplient’s applications for common allergies should boost the company’s income regardless of the pandemic.

Investors should keep an eye on the following:

• REGEN-COV ability to keep up with variants
• Extension of Duplient to new applications, especially the one with a large addressable market like common allergies.
• When will EYLEA’s revenue plateau?
• Results from the new drugs clinical trials, especially success or failure of extra cancer drugs and new hematology drugs.

Regeneron growth is cheap right now, and for long-term investors, this could be a compelling entry point.

The post Regeneron (REGN) Stock Research Report appeared first on FinMasters.

Quick Stock Overview

Ticker: ATVI

Source: www.stockrover.com

Key Data

Investment Thesis

Great Company, Even Greater Scandal

A video game company’s most valuable assets are its brands, recognizable IP, and devoted fan bases. In this report, I cover a company that has all three. The gaming franchises from Activision Blizzard are legendary, with names like Warcraft, Diablo, or Call of Duty.

Since it continually develops and expands its beloved games, this should be a surefire way for the company to grow steadily and sustainably. Or it can create a new, extremely successful game, like Overwatch (my personal favorite). This kind of quality should translate into a steadily increasing stock price.

Or not.

In fact, there is something rotten at the heart of the enterprise and this is the company’s work culture. It is no secret that much of the video game industry has a bad reputation for mistreating its employees and for having an overall sexist culture. But Activision Blizzard has pushed it one step too far.

The details of what happened will be explained later. However, this is not the first time a scandal about sexual misconduct has damaged company stock prices. The same thing happened in 2019. Once again, investors have suffered serious losses.

Why am I even reporting on the company? Firstly, the core business is still solid, as are the financials. I also anticipate that most of the current price collapse will slow down soon. And finally, now that the company has made its behaviors publicly known, I fully expect it to change.

According to this theory, we could see a repeat of the price action of 2019. In 2021, the stock rebounded to $103 from its lows of $43/share. As a result, Activision Blizzard could serve as a model for crisis investing. Or, as Baron Rothschild said, “Buy when there is blood in the streets”.

This report first appeared on Stock Spotlight, our investing newsletter. Subscribe now to get research, insight, and valuation of some of the most interesting and least-known companies on the market.

Subscribe today to join over 9,000 rational investors!

Subscribe Now →

Learn More

Chapter 1: Great IP, Terrible Work Culture

Some Of the Strongest Video Game IP On Earth

Last time I covered a video game company, Nintendo, I argued that their IP was extremely valuable and undervalued. The same is true for Activision Blizzard.

Activision is the result of the merger between two video game giants, Blizzard and Activision (no surprise). In the past, Activision has been more of a producer than a developer, contracting studios to create games it could then sell. In a way, it’s similar to how Hollywood studios work. The company has focused on games it can serialize and release often, like Tony Hawk’s skating and Call of Duty.

On the other hand, Blizzard was a true grassroots, developer-led company that created entire categories in video gaming. Its StarCraft and Warcraft games remain reference points for the genre more than a decade after they were released. In the MMORPG (Massively Multiplayer Online Role-Playing Game) genre, World of Warcraft (or WoW) dominated for more than a decade. More recently, Hearthstone has dominated the collecting card game sector.

In contrast to Blizzard, Activision was perceived as more corporate and money-driven, which is a concept that is generally negatively perceived by gamers because they have a very emotional and anti-corporate outlook.

It was challenging for Blizzard to merge with Activision, with many key founding members leaving. Even today, the majority of the Internet seems to agree that Blizzard sold its soul in the deal.

Despite this, the company’s growth has not slowed one bit. The group also acquired King, a mobile gaming giant. A few notable series include Candy Crush, Farm Heroes, and Bubble Witch.

With its three divisions, the group makes up a three-headed hydra capable of encompassing the entire video game market:

Games by Activision, such as Call of Duty, are mainstream games that are updated every year.

Games that have a dedicated fan base, such as MMORPGs, strategy games, and competitive shooters, are Blizzard’s forte.

And King rounds out the trio with casual mobile gaming and puzzle games.

Even with the criticisms, Blizzard’s games have maintained healthy sales, and Diablo 3 and Overwatch are even more popular than the older games in the Blizzard catalogue.

In addition, Call of Duty and King’s game players don’t give a damn about the corporate entity behind their mindless hours of fun.

IP and business foundations are rock solid, as evidenced by revenue and operating cash flow.

The story doesn’t end here, of course. The share price of Activision Blizzard would be difficult to justify for any value investor if everything were so flawless. But why is the company embroiled in such a scandal?

How Bad Is It?

Bad, Really Bad

As I began my research for this report, I was vaguely aware that sexual harassment was a problem at the company. Even though this behavior cannot be tolerated in any way, I thought that this can be resolved with stronger HR policies, firing the few employees guilty of misconduct, and better support for women employees.

However, it’s a lot more serious than a couple of rotten apples. Sadly, this is one case in which the idea of entrenched gender bias and discrimination is not an exaggeration.

In addition, the company’s employees have had enough of staying silent and tolerating it for too long. More than 1000 employees have already signed a petition calling for the resignation of CEO Bobby Kotick. That represents more than 10% of the company’s employees in open rebellion.

Quite rightly so, as a Wall Street Journal investigation showed he knew what was going on and buried it. Investors should also be concerned that he failed to inform the board and actively concealed the information from the board members and shareholders.

A Toxic Work Culture

In reality, the accusations are grave. It began with a “frat boy” culture, including company parties with strippers and DJs encouraging female employees to get drunk. Defamation of women, comments about female bodies, and jokes about rape were also included. As I said, this is going to be an ugly chapter.

By discussing investing in the company, I am in no way trying to minimize the severity of the situation. Later on in this report, I will discuss the ethics of this possible investment.

Following a two-year investigation, the State of California has filed a lawsuit regarding groping, unwanted advances, and unfair pay discrimination against women.

One of the more damning allegations (yes, it gets worse) includes allegations that an employee took her own life over sex toys brought along with her supervisor on a business trip in 2016 and 2017.

Bloomberg reports that employee was severely harassed prior to her death, with her nude photos being circulated during a holiday party at her company.

The link above also includes a denial from the company official regarding the accuracy of the lawsuit claims. Honestly, I am not convinced. Of course, you are free to make up your own mind.

Hierarchical Cover-Up

In addition to all that, it is now apparent that the CEO decided to keep the whole thing under wraps. He did not inform the board, the shareholders, nor did he appear to have done much to protect women at the company. We are talking about this man, Bobby Kotick:

Source: www.nbcnews.com

Apparently, some of the most serious issues occur within some of the Blizzard-owned studios. Despite the problem appearing to be widespread, it may not be company-wide since the King division of the company was relatively different.

Chapter 2: What Now?

The Response So Far

Due to Mr. Kotick’s abysmal lack of leadership, the company is now in full damage control. The company will pay $18M in settlement to the California lawsuit. Furthermore, the company terminated 20 employees and got the heads of Blizzard and HR to leave in June.

By 2025, it aims to have 50% female employees (up from 20% today). I have no idea how this will work because I imagine it will be difficult to convince any woman to join the company. It is still a positive thing, as these new hires will likely replace some of the guilty staff. By doing so, the rest of the staff will see that the “party” is over.

Even so, this is not enough when entire offices are sharing nude pictures of their colleagues. Or when the CEO hides it all. Bobby Kotick is now “considering stepping down”, but I don’t believe his sincerity.

The following are more likely to motivate him to finally care for himself:

“Reduced CEO salary and bonus for 2021 by 50% to below 25th percentile of peers;†95%+ of CEO pay remains at risk; future LTI grants no greater than peer median”

and

“Increased the ownership requirement for our CEO from 10x base salary to 50x, which we believe is the largest ownership requirement of any Fortune 500 CEO”

It is still my opinion that he should be fired and lose as much money as possible for his awful behavior. However, this is a step in the right direction.

The Consequences

Having simmered for so long, the toxic work culture is now inevitable.

Activision Blizzard’s key partners, including Nintendo, PlayStation, and Xbox, are threatening to end their relationship with the company.

The brand of the company has also been severely damaged, and people will have to stop associating it with harassment and rape for many years. The company may have some sales and revenue problems as a result.

Because of this, I think the company will still be in trouble for a few weeks or months to come. This is also true for its stock price. In this report, I am not laying out an idea for an immediate buy. Instead, I am describing the condition of a company with solid financial foundations that got cheap and might still do so.

On the other hand, it is unlikely that it will get much uglier than this. Therefore, I anticipate a favorable entry point by the end of 2021 or early 2022. My yardstick will be when the company’s management has shown real change, either in composition or behavior.

Considering the scale of the scandal, I’m fairly certain this will happen very soon. We will no longer tolerate such behavior as a society, and the board should realize this soon enough.

Threats from all console manufacturers to cut ties with Activision (made only on the 23rd of November) should prompt the board to act, and hopefully result in the removal of the CEO.

I personally don’t feel comfortable investing in this company while the CEO remains at the helm.

How Can Investing in This Be Ethical?

The situation reminds me a lot of BP’s right after the explosion at DeepWater Horizon. In order to increase margins, the company had gotten sloppy with its security protocols. The result was the largest oil spill ever in the Gulf of Mexico, and an absolute disaster for both the company and its shareholders.

This also made entry level investments incredibly cheap for bold investors.

This radically changed BP’s nature as a company. Historically, British Petroleum has been a profit-oriented company that doesn’t care about the environment. Now it is a leading force in the growth of renewable energies, seeking to rebrand itself as “Beyond Petroleum”. The results of a massive stock crash and managerial turnover are astounding.

Activision Blizzard is poised to become the BP of the video game industry. As a result of the current image, the company must completely revamp its corporate culture. As a result, the company will be scrutinized more than ever before.

Sexual discrimination cases could be passed over by companies with a better reputation as “an isolated incident.”. Activision Blizzard lost that chance long ago.

Once they realize this, shareholders and board members will be careful not to repeat the same mistake. Large institutional shareholders are also likely to become more active and exert more pressure on the board members, lest they too get caught up in the scandal firestorm.

I hope so, at least.

Chapter 3: The Company’s Future

The Financials Ignored the Storm

It does not reflect well on my fellow gamers, but Activision Blizzard sales have not been affected at all by the scandals.

As a result of the pandemic, more people have more free time, and many have upgraded their gaming gear (both PCs and consoles) in 2020.

Source: investor.activision.com

Over the next several years, I expect the 2020 growth to slow down a bit, but still maintain a healthy long-term trend.

Several game releases have been postponed. Partly, this is to avoid negative press coverage about sexual discrimination drowning out the release. Additionally, I think the team will need new members before the release, since more people will be fired before the launch.

This might impact quarterly results, but it will give developers extra time to polish their games, which should help rebuild the company’s reputation among gamers in the long run.

New Commercial Model

With the yearly release of Call of Duty games, Activision has developed a very strong formula for monetization. As a result, the company’s portfolio is now being expanded to include:

“We had roughly 400 million players in 2020, and we’re accelerating our path to reach 1 billion players per month as we deploy our Call of Duty model to other franchises and pursue a clear path to drive expanded reach, engagement, and player investment across our largest franchises”

In order to reach this +150% increase in players, the company is not only releasing updates to licenses more frequently. It is also focusing heavily on mobile gaming, as evidenced by the success of Call of Duty Mobile (450 million downloads) and Warzone, a free-to-play game.

The free-to-play model with microtransactions allows for a “free” entry point for new players, while at the same time allowing for substantial income down the road once the user base is established. Today, almost anyone has a powerful enough mobile phone to run these games.

There will likely be two effects from this.

It will alienate the old guard of the Blizzard fanbase a little more. The video game industry is increasingly moving into a mainstream market rather than a niche, geeky market, so this is unavoidable. Microtransactions are becoming more common in games like Diablo, MMORPGs, and shooters. There has been a lot of development in the market in recent years, leaving some fanbase tastes of the past 10-20 years behind.

Thus, we have the second effect. Hardcore gamers will undoubtedly hate such changes. The “mainstream” players will also generate plenty of revenue when they fork over extra cash for upcoming playable characters or “cosmetic” upgrades to their avatars.

Blizzard will become more money-focused, bringing its licenses in line with Activision’s and King’s, as this finalizes its “mainstreamization.”

No matter what, despite having the most recognizable franchises, Blizzard is no longer the heart of Activision Blizzard and is actually the smallest of the three departments by revenue. Unlike its iconic strategy games, most of its income comes from WoW. Therefore, it is probably time for this division to catch up with the rest of the company in terms of revenue.

Some may lament the passing of the “old Blizzard”, but this happened easily 5-10 years ago. As shareholders, we should instead celebrate the success of pivoting to the new dominant business model in the video game industry.

Future Products

Follow Up and New IP

The company’s main line of business is to continue what has worked in the past. The next-generation Call of Duty games, Diablo IV, etc… should keep the bottom line pretty healthy. The user base is there and will easily upgrade to the upcoming opus.

New licenses are another area of expansion. Despite its terrible leadership and work culture, Blizzard has managed to launch new IP like Overwatch. Overwatch 2 will premiere soon. The same can be said for the Activision branch of the company and the creation of the Sekiro franchise. An improved management team should help to maintain this momentum.

Over time, I expect the company to continue developing new licenses and to use them as a key engine of growth. Every now and then, brand-new video game trends emerge, such as MOBAs and Soul-like games.

Despite the scandals, Activision Blizzard has the marketing skills, financial firepower, and technical ability to take these upcoming trends and build entire franchises. It could also adapt existing licenses to fit these evolving trends. In any case, creating a new growth engine would mean creating an entirely new opportunity for the company.

The Power of Nostalgia And Evolving Mediums

Even if fans are dissatisfied with changes, nostalgia remains a strong buy factor for older gamers. Activision Blizzard understands this well.

The company recently released a volley of nostalgia-themed games. Among these are remasters of old games with updated graphics and improvements, such as the legendary Warcraft III, Diablo II, or a return of WoW in its original form.

In addition, it means the resurrection of long-abandoned, but still dearly remembered IP, such as Crash Bandicoot and Spyro the Dragon, both classics of the Playstation 1 in the early 2000s. Gamer’s feelings about such a long-awaited new opus are captured best by the new Crash Bandicoot game’s subtitle:

The interesting part, however, is that these licenses are also being made available on mobile devices through the King division. Mobile gamers (mostly women) who did not experience the old Crash Bandicoot games will now become familiar with the previously dormant IP.

Still Dormant IPs

Activision Blizzard still has a lot of under-exploited IPs at the moment. There have been NO MMOs or shooters in the Starcraft franchise, for example. There is no reason why they couldn’t or shouldn’t exist. Starcraft Nova, a shooter set in the Starcraft universe, was planned, half-developed, then abandoned. As a successor to the aging World of Warcraft, World of Starcraft might do very well as a best seller.

There are still plenty of IPs Activision Blizzard owns or has worked with in the past. These IPs could make a successful return, get adapted to updated gameplay, or get a modernized release. Examples include:

• Prototype, an acclaimed open-world action-adventure game.
• Vampire the Masquerade, a grim RPG perfect for an adult audience.
• Destiny, an action-oriented shooter.
• Guitar Hero, a party game that used to be a massive seller on consoles.

Financials

I had a quick look at the company’s financial performance. Taking a closer look allows us to see the company’s operations more clearly. The PC segment is now the smallest of the three, with consoles and mobile ahead.

Source: investor.activision.com

With a total debt of $3.6B, the company pays very low interest rates (2.87%) on that debt. Regardless, the debt load is small compared to the assets, with total liabilities below the current asset value.

It would be prudent to use cash and/or these low interest rates to acquire competitors or existing game licenses and maintain the share count.

The $8B treasure chest seems like a poor allocation of capital to me, so I would support such a strategy. I would prefer to see the money used to develop original games or to acquire competitors and valuable intellectual property.

Since a large drop in share count in 2013, the company has not done any buybacks. Additionally, its dividend yield is very low, even though the dividends have grown regularly over time. Due to the fact that share price appreciation is a major factor in shareholder returns, I imagine existing shareholders have been upset by the current crash.

The company uses a special accounting method for measuring cash flows. In this method, most of the actual costs, such as software development, are accounted for under operating activities rather than investing activities. The example above illustrates how traditional accounting struggles to measure well intellectual property-centric companies.

Most of these expenditures are actually capital expenditures, so operating cash flow is actually higher.

Chapter 4: Valuation

Given Activision Blizzard’s strong video game license base and its ability to keep growing revenues over time, I think two valuation methods make sense. Either Discounted Free Cashflow or Earnings Growth, both measure the value of future profits.

Discounted Cash Flow

The company trades at a price to free cash flow ratio of 15-25, with periods of much higher ratios. The current ratio of 17.2 is rather low.

The company’s free cash flow has grown at a very impressive rate of 17% over the last 10 years. Should the damage to the brand impact growth or if some of the plans for mobile expansion fail, I will use a more conservative estimate.

With these conservative assumptions, Activision Blizzard is worth $65, slightly higher than its current $61.77.

Earnings Growth

EPS has grown at 14% over the last 10 years, but I assume a lower number to be safe. For the 2014-2020 period, P/E was between 24-62, so a very conservative estimate here as well. The P/E ratio is currently at 18.

Even with these conservative assumptions, I am still expecting returns of 12.3%, which is pretty high considering the company quality and how conservative the assumptions were.

I expect Activision Blizzard to deliver a 12-15% return over the long run based on these valuation calculations. Even though the stock price is still falling, there will be better returns soon, since the ongoing price drop does not reflect the degradation of fundamentals.

Conclusion

There is no doubt that the current situation of Activision Blizzard does not make the company appear particularly attractive. The treatment of female employees is truly abhorrent, and I expect it will take some time to remove the stain from the brand.

I am, however, doubtful that it will have any effect on game sales. Games are bought for their entertainment value, and gamers know little or nothing about the companies that make them. Even though the scandals will force changes in the company, they are unlikely to have a lasting impact on sales and profits.

As all the main console companies press Activision Blizzard, some real change should finally occur. The lawsuit filed by the state of California and activists’ pressure should be finished by threats from irreplaceable clients and partners. It is no longer possible for the board to ignore the problem or hope to silence it.

In a decade, BP transformed from being the world’s biggest polluter to being a poster-child of an ESG-friendly, green energy company. I expect Activision Blizzard to undergo the same transformation when it comes to social responsibility and gender equity.

The company may still face weeks, if not months of troubles in the future. If the CEO is ousted, I believe we’ll have reached the bottom of it as far as the stock price is concerned.

As far as trading strategy for Activision Blizzard is concerned, I can see two possible outcomes:

If ATVI continues to weaken, you can add to it slowly as it weakens, averaging down your cost basis as it does so. Taking this approach ensures that you don’t miss the cheap price. Nevertheless, keep some dry powder on hand in case prices crash further.

Another option is to wait until management changes have been made. The “wait until it gets a tad better” strategy. So far, it is nearly impossible to say if this will happen next week or next year. It should happen by spring 2022 at the latest, but who knows?

If Activision Blizzard can clear the skies of scandals and additional lawsuits, as well as shareholder punitive actions, it can become a leader in the main gaming categories of shooters, mobile games, strategy games, and MMOs.

License revenue is still strong, and mobile revenue is just beginning to show. Additionally, Nintendo-style expansions of the IP are also possible in the future. We’ve already had a semi-successful Warcraft movie; we might see more of this in games like Call of Duty, Starcraft, etc… I also hope that more creative work environments and new teams will help foster more innovation.

Overall, the marketing acumen, growing experience, and wealth of IP of the company give it a high chance to succeed and prosper again. It would be wise for investors to ignore most of the fluctuations in the stock and concentrate on the company’s fundamentals. As long as sales remain strong, Activision Blizzard’s future will be much safer (and more profitable) than the headlines suggest.

The post Activision Blizzard (ATVI) Stock Research Report appeared first on FinMasters.

Quick Stock Overview

Ticker: GILT

Source: www.stockrover.com

Key Data

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

Investment Thesis

The Space Tech Comeback

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

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

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

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

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

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

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

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

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

Imagine the cost!

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

Source: ttu-ir.tdl.org

This report first appeared on Stock Spotlight, our investing newsletter. Subscribe now to get research, insight, and valuation of some of the most interesting and least-known companies on the market.

Subscribe today to join over 9,000 rational investors!

Subscribe Now →

Learn More

The Satellite Boom

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

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

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

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

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

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

So, let’s jump into orbit …

Chapter 1: Making Sense Of Satellite Telecommunications

A Key Component of Telecommunication

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

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

Some of Gilat antennas

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

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

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

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

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

Access to data and connection everywhere, at all times.

Gilat charges a fee for providing it.

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

The Roaring LEO

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

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

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

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

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

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

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

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

Source: Gilat Investor Presentation

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

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

A Whole New Gigantic Market

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

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

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

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

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

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

Source: www.gilat.com

Chapter 2: Gilat’s operations

The Main Segments

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

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

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

Cellular

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

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

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

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

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

Mobility

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

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

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

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

Internet of Things (IoT)

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

I am not the most enthusiastic about the Internet of Things. As a rule, I prefer my personal items to be “dumb” and functional, as opposed to smart and connected. I don’t need my fridge to run on Windows and be connected to the Internet.

But there is one field where IoT makes perfect sense, and that is in industrial settings (IIoT). Gilat uses pipeline monitoring on its website as the perfect example. Gilat systems monitor 700 locations for leaks or potential issues so that Philips 66 can respond quickly.

An always-on monitoring system based in the sky is the best option for sensitive or dangerous activities.

Gilat provides a useful infographic depicting all the possible applications. My two favorites are:

• The industrial/energy/agriculture segment
• The logistics and autonomous vehicles segment

Source: www.gilat.com

Industry and energy applications make the most sense to me as they need powerful remote connections and top-notch reliability.

In the future, Gilat will see a lot of growth from the logistics and autonomous vehicle sectors. The over-the-air update and constant connectivity of Tesla cars will become industry norms. Even more so with self-driving vehicles and delivery robots (as I detailed in my previous report on Deutsche Post).

In addition to spotless connections, same-day delivery logistics will also become increasingly complex. Gilat is prepared to assist. Click here for more information about each application.

Industry & Broadband

Flexibility is an essential part of Gilat’s offer. There are benefits on both sides.

To start their connection process, the client requires a low initial capital expenditure, but can scale up as they grow.

By spreading the costs between many, many clients, Gilat is able to amortize the massive operational costs and technological complexity.

Therefore, Gilat has multiple business moats, such as economies of scale, lower costs, and the ability to develop more patented technologies at a lower cost per user.

Source: www.gilat.com

As a leader in the field, it has the capacity to provide extra capacity when needed by its clients.

Source: www.gilat.com

The segment includes multiple sub-segments:

l  Remote education and E-Learning

l  Bank’s private network

l  Oil & Gas and Mining

l  24-hour news channels (and live broadcast from anywhere)

l  Residential broadband (home Internet for isolated places).

I find the last segment to be the most interesting. There are many regions that are too remote for 4G networks to be properly deployed. In these regions, getting a stable home Internet connection is either difficult, expensive, or downright impossible.

Up until recently, satellite broadband was too slow to be anything other than a last resort. Once LEO constellations are in place, this will not be an issue.

New Yorkers will still get their Internet through ground-based solutions. However, people living in low-density areas, such as the Rocky Mountains, the Alps, Northern, Central Canada, Scandinavia and most of Russia, are likely to switch to satellite Internet.

By establishing advanced remote work in scenic and cheaper villages, these areas will become more livable and modern.

Military

https://www.gilat.com/solutions/defense-and-government/

Last but not least, satellite communication is obviously used by military and government agencies. Historically, this is the first sector to extensively use satellites.

Almost all military operations today rely on satellites, including imagery, telecommunications, and GPS-guided missiles. It surprised me to learn that this is a relatively small market, with less than $1B expected by 2025, compared to $10B in the mobility sector.

Gilat seems to have the advantage here due to its product design, with an advantageous SWaP profile (Size, Weight, and Power). Gilat’s antennas and systems are light, small, and nimble enough to operate in front-line conditions, as well as on UAVs and vehicles.

In addition, the antenna and other electronics are described as “robust, ruggedized, and designed to operate in harsh environments“.

As an Israeli company, I also expect Gilat to have plenty of opportunities to test and demonstrate its products. Furthermore, I imagine it will also benefit from connections with foreign American and European allies.

Government

https://www.gilat.com/solution/public-safety/

Among Gilat’s services is the provision of emergency and disaster response systems for the government. Satellites are ideal for restoring communication lines after earthquakes, hurricanes, floods, and other disasters that destroy land-based systems. In addition to working well for the military, they are also effective for first responders.

Also, the company signed a deal directly with the government to provide Internet access to the population. An example of this is the agreement with Peru. As a result of this deal, Gilat will be able to generate initial revenue for building the network, as well as recurring and steady revenue for operating it.

This business model intrigues me. Per’s government pays upfront the capital expenditures for the system, and Gilat charges $50M/year for its operation. While most subscription-based business models require large initial capital expenditures, Gilat’s government contracts appear to have the capital expense covered by the local authorities.

Management

https://www.gilat.com/about-gilat/management/

As a company like Gilat is so dependent on proper execution and technical ability, I wanted to briefly review the management team.

Adi Sfadia, CEO

Since 2004, he has been involved with telecom and VoIP, mostly as a CFO. Sfadia’s financial background is not a technical profile but should ensure that Gilat’s capital is allocated effectively during its growth.

Ron Levi, COO

It appears that Mr. Levi, who holds diplomas in both computer engineering and management, is the ideal candidate to lead Gilat’s daily operations. His entire career was spent in telecom, including companies acquired by Cisco.

Noam Rosenfield, Senior Vice-President R&D

An Israeli Defense Forces former commander of cyber defense. Additionally, he headed the R&D efforts of Verint, a leading cyber intelligence solutions provider. In addition to handling the very sensitive infrastructure managed by Gilat, he also brings a software angle to the more telecom hardware profile of the rest of the board.

Chapter 3: The Company’s Future

The Key Growth Advantages

Gilat is in a perfect position to participate in the growth of satellite communication. Because LEO constellations are multiplying rapidly, the addressable market will expand much faster than most analysts think.

What was once a growing but also stable industry is now going to be the next big investment topic. In these volatile and profitable times, space is trendy again.

Consider Virgin Galactic, one of the three top private space companies (along with SpaceX and Blue Origin) that recently went public. A company with only a prototype and no income has been on a wild ride, from $7.20 at IPO to a high of $59 today.

With space investing becoming a popular investing trend again, I fully expect the whole sector to gain more attention. After the LEO constellations of Internet satellites are launched, Space Internet will be the next big thing. And Gilat is leading the way in building land-based receivers.

The Moats

In terms of investments, the telecommunications industry is known for being technology-driven and conservative. National telecom companies prefer working with other well-established firms.

Gilat is responsible for 80% of 4G satellite-mobile network connectivity. A company with this pedigree and all the right connections can grab a piece of the space-based 5G pie.

It will also have the ability to spread its R&D and capex costs, giving it a durable price advantage. The company sold 1.6 million satellite terminals in 100 countries.

The combination of a strong reputation, established relationships, economies of scale, and better technologies gives Gilat a powerful moat to remain competitive.

The Techs

As I mentioned previously, I believe it is beyond my capabilities and the scope of this report to dwell on the engineering itself. Gilat, however, has a few unique technologies that set it apart from its competitors:

l  The “Elastic Era” connection system; a specialized infrastructure able to handle LEO satellite high-speed orbits in the sky.

l  Layer-2 accelerated data. This simplifies the process of integrating satellite connections into mobile networks.

l  Fastest airborne modems available on the market

l  5G-ready CBH (Cellular) devices and infrastructure

I won’t pretend to understand it all. There’s no need for me to.

When it comes to overly technical industries, I refrain from second guessing the technology. As an alternative, I can rely on the purchases decisions of people who are way smarter than me, such as engineers at mobile operators or people who handle defense procurement.

I think a product is the right choice if almost all the experts who have worked in the sector for their entire lives choose it.

Financials

Gilat had a disappointing year in 2020. There was little flying, cruise ships stayed at the docks, oil & gas were in disarray, and many clients delayed investment until they could see the economic outlook more clearly. Revenue declined significantly, especially from product sales.

As a result of this very poor 2020, the stock price fell from +/- $8 to $5. A new line of 5G-ready antennas was announced in February 2021 and the stock rose like a rocket.

Due to the short attention span of today’s markets, the focus has instead been on “disappointing” quarterly results. It seemed that the new product would be sold instantly, rather than being carefully and slowly considered for the next round of investments by Gilat’s clients. Considering the bureaucracy of telecoms, that was not a possibility.

This presents us with an opportunity. The future growth of Gilat was already factored in at $20+ / share. At $8, not so much. Thankfully, the company’s revenues are improving in the first half of 2021.

Because of this, a company is selling cheaply despite excellent growth prospects. For the company as it is now, all metrics and ratios scream cheap. There is also no debt, and the dividend yield is 12%!

I expect Gilat to outperform the market in the long run due to the additional great growth prospects. It might take a little while, however, for revenues to increase as a result of the slow decision-making of its clients and the ongoing deployment of LEO constellations.

• P/E: 10.2
• Price to Sales: 2.6
• Price to Free cash flow: 8.4
• Price to Book: 2.1
• Debt: 0
• Equity per share: $4.05
• Dividend Yield: 12%
• ROIC: 19.4%

Chapter 4: Valuation

Considering Gilat’s financial ratios are more in line with a no-growth company, I expect Gilat to be undervalued. But by how much?

Discounted Cash Flow

Discounted cash flow is the most relevant valuation method for Gilat, as the majority of the company’s value will be in its future free cash flow once the satellite-based 5G Internet revolution begins.

The company has historically traded a price to free cash flow ratio of 10-20, with periodic spikes at much higher levels. The current ratio of 8.3 is very low by comparison.

There is no doubt that space enthusiasm will make a comeback in the near future. This is true each time SpaceX flies a fully civilian crew, Virgin Galactic takes a test flight, or when The Artemis mission brings us back to the Moon. At the very least, this should return the terminal value multiplier of Gilat to its historical norm.

Free cash flow grew by 8% over the last decade, so I will use that, even if that is probably too low, as I ignore the LEO-based Internet growth.

Even with these conservative assumptions, I still get a value for Gilat of almost $13, well above the current $8.23.

I was also curious to find out what could justify the current price.

We would need the value multiplier to never return to its historical level. Annual growth would need to drop from 8% to 5%. This still leaves a margin of safety of 15%.

The entire report was written under the assumption that satellite communication is about to boom. The valuation (at the moment) is so low that the business growth of Gilat has to slow down in order to justify it!

However, I see a bull case, where growth accelerates beyond the historical trend. An exploding mass consumer market can easily justify the switch from large airlines, oil & gas companies, and the military.

In the event that Gilat only experiences additional growth in five years, this still indicates a substantial undervaluation of the stock: intrinsic value would be more than twice what the stock currently trades for!

Conclusion

My interest in Gilat was sparked by the strong financials on my screener, but I had no clue what Gilat did.

I was intrigued by the satellite communication segment, but I was wary of the competition from SpaceX’s Starlink and similar companies.

I expected a business like ViaSat, which operates GEO satellites. The business model is still profitable, but also declining and in danger of extinction.

The current valuation would have justified the current valuation, making the company a typical value trap.

So I was genuinely surprised when I saw their presentation and found out that the switch to LEO satellites was actually an opportunity for Gilat.

As far as I can tell, the current valuation is more a function of short-term “disappointing” quarters. Covid’s aftermath seems to be holding back the company’s short-term results. In the long run, the company is still well positioned.

The current core business will continue to grow. Mobility continues to grow rapidly. The need for mobile connections has never been greater. Industry IoT is going to become a standard in many more industries. Sat-comm spending in the military is not going away.

Add to this very solid foundation the emerging but soon to be large and well-established residential satellite Internet.

At the current valuation, the businesses should provide a comfortable 15% annual return. However, if I am right, Gilat in the residential internet market is perfectly positioned to grab a leading position and expand its market share.

Growth in the core operation, expanding markets, a growing moat, and a sector poised to become a darling for investors, all at a discount. What’s not to like about Gilat?

The post Gilat Satellite Network (GILT) Stock Research Report appeared first on FinMasters.

Quick Stock Overview

Ticker: DPSGY

Source: www.tikr.com

Key Data

• Sector: Industrials
• Sales ($M): 85,594
• Industry: Freight and Logistics
• Net Cash per share: $4.93
• Market Capitalization ($M): 76,634
• Equity per share: $15.03
• Price to sales: 0.9
• P/E: 14.5
• Price to Free Cash Flow: 10
• ROIC: 32.7%

Investment Thesis

Boring Means Safe in Turmoil

Investors are by nature thinkers. Pessimists (bears) are thinking about what could go wrong. Optimists (bulls) what could go write. But both agree that some businesses are simply boring.

Some businesses are naturally difficult to hype up. Most firms are altogether implausible to grow 50% year to year for decades and become the next Apple. And they are equally unlikely to go bust. So, it is hard to garner much interest from the investing crowd for such uneventful stocks.

However, boring does not mean unprofitable, or a poor investment. It is just uninteresting, dull, and stable. The thing is, boring can be profitable.

Especially if it is cheap!

Today’s report is about such a company, something as mundane and ordinary as postal services. And more precisely, the German postal service: Deutsche Post Group.

The company has a long history, going back to 1876 or even 1490, depending on how you want to see it. This is rather a strong point, as a structure that lasted centuries is likely to survive a few more centuries.

I will provide greater detail later on about the different segments of the companies, but you already know the general idea well. It’s a postal service. It takes items or paper from point A to point B and charges a fee for it.

Recently, Germany has not really been at the top of its game. The Eurozone is facing very slow growth/a recession. It is also in the middle of an energy crisis to the point of risking massive blackouts this winter, with the Nord Stream 2 pipeline still in limbo.

Germany is also facing large political uncertainty with the end of the Merkel era, compounding the unknown about economic and energy policy.

So overall, investors are not favoring Germany at the moment. As you can see, while the US markets are still exuberant, the main German index, the DAX, is quite down since July.

Despite that lack of enthusiasm for Germany, Deutsche Post stock price has handsomely rewarded its shareholders in 2021. The stock was rising strongly, before stumbling at the end of summer with the rest of the DAX.

As we will see at the end of the report, I do not think that, at the current price, the company is overvalued. Rather, simply that it was ridiculously undervalued just before and after the covid crash. I am just sorry for not having thought of it then!

But ultimately, Deutsche Post is the type of company to invest in for the long run, so it is fine to pick it once the storm clouds of the pandemic are clearing.

This report first appeared on Stock Spotlight, our investing newsletter. Subscribe now to get research, insight, and valuation of some of the most interesting and least-known companies on the market.

Subscribe today to join over 9,000 rational investors!

Subscribe Now →

Learn More

Chapter 1: A Simple and Well-Run Business

From National Dinosaur to International Leader

A postal service is a remarkably simple business. It is so simple that it more or less falls into everybody’s circle of competence. Everybody in the world knows how their post-service works.

However, in many (most?) countries, this is not an endorsement of quality. I remember a comic strip describing how the author imagined Hell: a noisy, crowded, and endless waiting line in a post office.

For others, it means a company on the permanent edge of bankruptcy, always looking for more support from taxpayers, all while delivering letters and packages haphazardly. Adjectives like inefficient, unreliable, costly, archaic, lazy, abound to describe most postal services in the world.

Deutsche Post itself was suffering from this dreadful reputation of postal services. I find it very interesting and funny that the company itself acknowledges it in its “The company at a glance” communication. How often does corporate communication describe the company as formerly “government-controlled, deficit-ridden”? Germans’ reputation for brutal honesty seems at play here:

Source: https://www.dpdhl.com/content/dam/dpdhl/en/media-center/media-relations/documents/2021/fact-sheet-dpdhl-group-03-2021.pdf

Truly, the description seems adequate. The Deutsche Post had a terrible reputation and was losing tons of money. But privatization and reforms changed the company in the 2000s. And it paid off, even if slowly, as can be expected for such a large institution.

This is a company more akin to a cruise ship than a speedboat. It will take a while to change its course, but once done, it is likely to stay steady. Since 2013-2014, all measures of profitability are pointing upward for the last 10 years, with a net inflection point after 2018.

A big part of this transformation was turning the government-run Deutsche Bundespost into a modern international logistics company. The company did this by raising private capital and changing management. This led to the key moment that was the acquisition in 2002 of DHL.

While Deutsche Post was formally gaining DHL, DHL turned into the dominant actor of the fusion. What had strategy and practices made DHL a global leader in logistics ultimately took over throughout the rest of the group, bringing its competitive, private-sector way of management to the bureaucratic postal services.

Notably, DHL was bundled with the express and logistics part of Deutsche Post, now one of the most profitable parts of the group.

One other milestone was that Deutsche Post shares have been listed on the public markets since 2005. The same year, Deutsche Post was also acquiring the British Exel group (111,000 employees).

After that, the company would withdraw from banking activities, an extension that many postal companies tried at the time, generally unsuccessfully. Instead, it refocused purely on logistics. It would also expand its logistic network abroad, notably with new planes and giant distribution centers in Asia. More recently, the company has used its experience in modernizing and turning profitable postal service by acquiring UK Mail in 2015 and bringing up to speed the rest of the Deutsche Post divisions.

So, as you can see, what seemed on the surface boring, the “German Post”, is a leading and global logistical company. But you need to go beyond the first glance to realize it.

A Diversified and Global Business

The company business is divided into 5 segments.

The Post & Parcel Germany is pretty self-explanatory. This is the purely domestic part of Deutsche Post’s activity. It transfers 49 million letters and 5.9 million parcels every day. The sheer size of just this department is the kind you usually hear only from companies like Amazon. The company controls most of the German market. Especially the largest and most profitable market, advertising:

Deutsche PostCompetitionMarket volumeMail63%37%EUR 4.3BAdvertising93%7%EUR 23.8B

The competition exists, and it is good, so it keeps Deutsche Post from turning back into an inefficient bureaucracy. Still, the company is the dominant player in Germany and has a stable market share. This is akin to all the advantages of a monopoly, without the inefficiencies that come with it.

The express division is what you probably know better as DHL and never associated with the Deutsche Post (I sure did not before doing the research for this report). This is the express, worldwide delivery of parcels that absolutely need to arrive as quickly as possible, and in perfect shape, at their destination.

These are mostly just documents and small boxes. Most customers are B2B, and the service is relatively expensive compared to normal posts. The company operates a mix of its own airplane fleet and also rents empty space in regular airlines’ planes, accessing this way a “virtual fleet”.

The division recently acquired cheap planes from desperate-for-cash airlines companies and is converting them into freighters. Excellent use of a once-in-a-lifetime opportunity to save capex!

The freight division includes air, land, and sea transport. It is dedicated to the larger, bulkier cargo. I was pretty surprised to discover that DHL is not only the leader in Air Freight but also the top two for Ocean Freight. Again, not something I expected when I looked into the Deutsche Post.

Supply chain is the division sub-renting or managing warehouses for other companies. In that activity, Deutsche Post/DHL can use its scale and experience to deliver best-in-class supply chain management. Including dedicated software, warehouse designers, semi-automatic trailers, custom-made devices, etc.…

This level of quality would be very difficult and expensive to replicate for smaller companies, at worst impossible. Especially for very extensive automation and complex robotic tools.

Here too, the company is simply the world leader, with as large a market share as the next top 2, 3, and 4 combined. This is for a market worth no less than $228 BILLION. It is also a constantly growing market, with more and more companies needing top-notch logistics to keep up with Amazon and Walmart.

The market is, however, VERY fragmented, and this should leave plenty of growth and consolidation potential. It would not surprise me to see Deutsche Post controlling 10% + of this market in 10 years, through a mix of acquisitions and organic growth.

Source: www.dpdhl.com/

E-commerce and international trade drives both directly and indirectly, much of the company’s activities. Like companies operating more internationally and needing express delivery and freight, or assistance for their own warehouse and supply chain.

The dedicated e-commerce segment of Deutsche Post employs 37,000 people and delivers 1.1 billion parcels per year. Or 29,730 parcels / employee / year. Or 120+ parcels per employee / day. This is some incredible volume and efficiency, considering one parcel will be handled by many people on its journey.

They mostly focused on the so-called last-mile deliveries for 7 European countries, and international cross-border delivery in other regions.

Deutsche Post operations are focused potential needs on the heart of world economic activity: North America, Europe, Asia, and Oceania. Its e-commerce division covers almost all the potential needs for e-commerce distribution. It levels the field for every company forced to match the offer like same-day delivery from Amazon, without forcing them to build themselves hundreds of warehouses on all continents.

Overview: The several business lines allow for diversifying risk. Some activities are strongly linked to GPD fluctuations, while others are likely to be more robust. In addition, each is growing at different rates.

Freight and Express highly depend on economic conditions and have quite a good growth profile. E-commerce is growing no matter what. And traditional Post services are slow gorwing, but a solid cash cow even during recessions.

Chapter 2: Embracing the Future

The 2025 Strategy

I am generally skeptical when large corporations come with a well-crafted narrative with a catchy name for their strategy. It is often hard to find what is purely PR and what is going to impact the company’s future. Or even understand it all sometimes.

It was a bit the case with Deutsche Post’s 2025 strategy. Things like the logo below look nice, and give work to the communication department designers, but contain very little useful information.

Beyond the corporate-speak, we can find a few interesting pieces of information in that strategy declaration. First, the company will invest EUR 2B in further digitalization. The EBIT is “expected to grow to at least EUR 5.3B” and the company to “generate a total EUR 5B of free cash flow by 2025”.

The second part is to create “Centers of Excellence”. These are essentially teams that will be in charge of integrating new technologies into the company.

The first part, the investment strategy, seems solid and will allow for more efficiency and maintain growth. The second part is a little harder to judge.

Throwing around catchphrases like IoT and blockchain does not really mean anything in terms of operational results. However, I believe things like blockchain could create a more accessible and persistent tracking system for packages. And warehouses are likely to become almost fully robotic in the future, with each captor talking to a network and workers using fully wearable digital tools.

It is nice to see the company embracing change instead of resisting it. But I am not convinced it will impact the company’s results for the next 5 years. It might, however, have some on the stock price if the re-branding of Deutsche Post as a technology company catches on with investors.

A Unique Strategic Position

More importantly, I think the position of Deutsche Post in the global trade network is worth a premium in itself. We saw the last 2 years the complexity of global supply chains, and we might have again problems with empty shelves this Christmas. “Just in time” is suddenly not that great, and reliable deliveries will command a premium.

Deutsche Post has tremendous advantages to ride the ongoing storm in logistics compared to its competition:

• Dominant position in the largest European economies.
• World leader in airfreight AND ocean freight.
• World leader in contract logistics.
• Strong position on e-commerce deliveries.

Altogether, this provides the company with a wealth of data, scale, and network effects that no one except maybe Amazon and Alibaba can rival.

We are likely to keep seeing trouble in supply chains, created by energy crises, inflation, shortages, trade wars, re-shoring industries, and the China-USA tensions. This will be a major headache for most logistics companies. For the like of Deutsche Post, this will instead be the occasion to shine and steal contracts from its competitors.

If you are an industrial company or a retailer expecting troubles, you want your supply chain to work well, and you need simply the best and largest provider to help you achieve it. Each time you read about clogged ports, missing parts, and exploding shipping costs in the next months and years, you can bet Deutsche Post is going to turn it into an opportunity.

The Technologies to Come

Postal services and delivery is a very labor-intensive, low-tech process. This is why Deutsche Post employs almost 570,000 people, making it one of the largest private employers on the planet (apparently the 5th largest).

But this is about to change. There is already existing and deployed technology to automate much of the business: automated parcel machines. They are very common in the Baltic countries, and they are likely to spread in all Europe, as well as the USA/Canada soon.

How does it work?

You receive an email/SMS telling you your parcel has arrived. You go to the automat 500m-1km from your home and go pick it up by entering the unique code in the SMS. One delivery postman can handle a lot more packages than a traditional postman.

And no more packages left on the porch, undelivered. This works well in the dense urban area, but also in the rural area where post offices are far apart. Do you want your package in the nearby town manned post office 15km away (costing fuel and time), or in the unmanned automat 2km away?

The same automats can easily be used to send parcels nearby. You enter the address, pay, leave the parcel in a compartment, and viola! No more queue and fully contact-less (especially important if Covid stays with us).

You might remember from a previous report on iRobot I talked about robotic deliveries (at the time for food and local shopping). But startups are also looking at autonomous driving and realizing that delivery is a much simpler solution that can be achieved right now.

The robot can be tiny, confined to sidewalks, with no danger from a collision with cars or passersby. This is the promise of Estonia’s Starship Technology robots.

Source: www.medium.com

In the same country, another company, Cleveron, already has a driverless prototype for an autonomous parcel delivery robot. The company started doing the parcel automation I mentioned before in 2009! You can see more about the model here, where the specs are more detailed. And this promotional video, by the way.

Anyway, the point is not to praise the progress of robotics in the Baltics. But to emphasize that the “boring” business of postal services and parcel delivery is going to twist into a tech industry. This is for now limited to test markets and small countries where it is easy to deploy, but will soon expand everywhere in Europe, the Americas, and Asia.

This will be a period of explosive growth for e-commerce, as lower prices and even better convenience of delivery will overcharge the already quickly growing sector. Only logistic companies with a specific profile will manage this turn well:

• Profit-oriented instead of bureaucratic and archaic postal services.
• Existing high level of digitalization.
• Profitable with ability and plan to spend enough capex.
• International with experience of adapting to local customs and culture.
• Critical mass (at minimum dominant in 1 major country) to cover the extra overhead and R&D.
• Already using robotics in warehouses.
• Having experience in integrating new processes and recent acquisitions into the existing operations.

Or simply put, Deutsche Post / DHL is the poster child of the logistical company that will be primed to capitalize on the postal industry transformation into autonomous robotic delivery.

We hear a lot about jobs that self-driving vehicles will destroy. But really, the first industry to see job destruction will certainly be the post and food/parcel delivery. In a decade, a human delivering pizza or parcel might join phone books and dumb phones into technological obsolescence.

These technologies are already there, on actual streets with real customers and making real income. The same cannot be said of autonomous cars…yet. Besides, regulatory agencies will be a lot less picky with slow-moving, silent, small robots on sidewalks than with 2-3 ton cars or 20-30 ton semi-trucks.

So, watch out for the next big story in IA, robotic and autonomous driving, where the “boring” companies will rule the new narrative.

Chapter 3: Not Your Ordinary Postal Service

Growth Expectations

Deutsche Post’s management is expecting relatively solid growth, considering its business line. Most of the activities are expected to grow yearly by 4-5%, with e-commerce expected at 5-10%.

On top of that, margins have consistently improved over the last 10 years. This directly results from economies of scale and digitalization. The same is likely to still be true for the next 5 years. So, we can easily expect profits to grow from both revenue growth and margin growth.

Outstanding Results

Deutsche Post is this business completely misunderstood by most of the market. The name hid a much more global business, and I think almost no one has realized how different delivery services will be in 10 years. A few more self-driving robots around your street and this will change.

In that respect, I suspect the company is even conservative with its growth target for 2025, or maybe the real acceleration will only start then? It is possible that 2025-2030 will surprise us in a good way.

But how is business now? What if none of these lofty projections ever happen? Is the business as it is today solid?

To start, the company has dramatically improved its margins, no matter what metric is used. I really like that management shows multiple margin calculations. This reduces the chance it is a mere accounting trick.

This translated into slowly but steadily growing dividends. They postponed the 2020 dividends when Covid made everything uncertain. But they finally paid it, just with a delay. Conservative approach, but not overly risk-averse either.

The payout ratio is maybe a little high to my taste, but it did not hinder a parallel growth in capex. So, it does not seem the company is giving back too much to shareholders and risking future profit.

Covid was a period of a sudden drop in activity before a surge because of more online purchases and lockdowns. This means the recent revenue and profit numbers are a little chaotic. Overall, I am happy to see that even in H1 2020 free cash flow stayed positive and has since spectacularly recovered, reaching all-time highs.

The balance sheet is not pristine, but solid enough. Debt is quite stable and well covered by income and cash flows. You can see below the current net assets and the net debt.

I must also point out that the company is really rich in assets. We are talking here about real things like valuable real estate, planes, cargo ships, warehouses, trucks, forklifts, and everything in between. A grand total of EUR 57.7B in assets.

When compared to the EUR 18.7B of total liabilities, this makes the company’s total assets worth EUR 49B. With a market cap of EUR 65B, this means the market is valuing the enterprise at only EUR 16B! Hard to believe for a company with good cash flow and steady 5%+ growth for the foreseeable future.

A Note on Inflation

For assets-heavy companies, inflation can be a good or a bad thing, depending how well it’s managed. On one side, already owned planes, ships, real estate and heavy equipment gain in value during inflationary period. On the other side, costs can quickly skyrocket out of control as well.

I appreciate that the long-term part of the company presentation address the issue and breakdown the costs, between fuel, staff, and transportation.

Source: https://www.dpdhl.com/content/dam/dpdhl/en/media-center/investors/documents/presentations/2021/DPDHL-Societe-Generale-Virtual-Management-Roadshow-2021-09-29.pdf

It seems that fuel is actually a rather smaller part of the group’s costs than I expected. Even with the current rise in fuel costs, this should not have a dramatic impact on the company. On top of that, most of fuel costs rise can be passed on to the customers and arbitration for local delivery on foot/bike can help capitalize on growing fuel prices.

For the rest of the activity, a lot of the services are priced with inflation-linked contracts. The problem I can see is that GPI (an equivalent to the American CPI) might not reflect fully the real inflation. But this does provide an okay protection, nevertheless.

Overall, Deutsche Post is likely to suffer a little if our inflation problems are getting worse. The combination of low exposure to fuel costs and inflation-linked pricing should shield it from most of possible damages. And less rich competitors, leasing or renting assets instead of owning them might be a lot more hurt, which will then improve Deutsche Post’s competitive position.

Chapter 4: Valuation

Deutsche Post is such a large, international, and stable company that two valuation methods seem possible.

The first is the classical Discounted Cash Flow.

The other is the equity bond yield, treating the company stock as a perpetual bond due to its safety profile.

Discounted Cash Flow

Historically, Deutsche Post investors have been ready to pay quite a lot for cash flow, reflecting their confidence in the company’s future. I suspect it is also a good pick for many German and central Europe pension funds.

Price to free cash flow used to hover around 20, with periodic spikes at very high ratios like 60+. At the moment, the ratio is a meager 10, reflecting the markets’ disaffection for boring companies, and the preference for flashier growth stocks like the FANGs or Tesla, or even crypto.

Using a conservative ratio and growth rate, we end up with an intrinsic value of $69, below the current $62. I picked a 5% growth rate (the expected growth of revenues) which does not include any improvement in margins.

Considering the stability of the company, I could also have used less margin of safety and also the historical ratio of cash flow. This would give us a slightly better intrinsic value.

Equity bond

The equity bond yield looks at the company from a long-term perspective and works well for companies with a stable outlook, growth, and dividend growth. So Deutsche Post seems a good match, and this way, I can compare it to the DCF calculation.

DCF gave me a return rate of 15-17%, Equity bond gave me 13%. The second is a little low to my taste, but I must admit that the long-term safety and perspective of the company might be worth it.

Conclusion

I first looked at Deutsche Post because of good financial metrics and to study a blue-chip company for a change. It pleasantly surprised me by what hid in plain sight. Like the very international profile and the ownership of DHL, which I am sure experts in the sector are well aware of, but I did not know about.

The more I studied Deutsche Post, the more I liked what I saw. One way to see the company is to look at it as this large, global, well-managed, low growth company. Profitability is good, return on capital too, and some growth in the 3-5% range is likely. Downturns could temporarily damage quarterly profits but are unlikely to damage seriously the business.

So, in that respect, this would make Deutsche Post a very good buy-and-forget stock, especially for a retirement account with tax advantages.

But after studying more about the business organization, the competitive situation, and the technological potential, I realize Deutsche Post also offers something more. It is BOTH, a steady, profitable blue-chip company AND an unrecognized potential growth stock. The growth is not there yet, but the technology is right now reaching the maturity level to make it happen.

So, the plan with Deutsche Post would be to go for a buy-and-forget strategy. But also, to look out for the switch of the company to a tech profile and keep that as an added option in the future. I derided a little the IoT and blockchain “Global Center of Excellence” as corporate speech, but actually, this might be the most important part of the company.

Notably, the “Intelligent Automation of Physical Operation”. The language seems voluntarily obscure and obfuscating. Autonomous delivery is indeed one focus of the company’s R&D efforts, except that they are waiting for a little before being too loud about it. Better let the market and the competition realize too late than too soon what is going on.

With the current undervaluation compared to the current profitability and growth, the worst-case scenario is likely okay returns. But if things go well, and automation becomes a big theme, this might put Deutsche Post / DHL in a whole new category.

In that case, repricing the stock at a higher ratio TOGETHER with increased profit could send the stock to new highs.

And if nothing of the kind happens, boring but profitable is still pretty nice after all.

Limited downside but large upside, with lower than usual volatility, seems a pretty delightful combination.

The post Deutsche Post (DPSGY) Stock Research Report appeared first on FinMasters.

Quick Stock Overview

Ticker: PAYS

Source: www.tikr.com

Key Data

• Sector: Industrials
• Sales ($M): 20
• Industry: Specialty business services
• Net Cash per share: $0.05
• Market Capitalization ($M): 129
• Equity per share: $0.23
• Price to sales: 6.4
• P/E: -0.2

Investment Thesis

Back To Capital-Efficient Companies

Having covered a string of large and complex companies, I wanted to focus on smaller, easier-to-understand companies. The recent turmoil in the energy sector has given us a great opportunity, which I have explored quite extensively for a few reports, including gas midstream, renewables, and two utilities.

But ultimately, I intend for my portfolio to include some longer-term compounders that can generate more profits by reinvesting their profits.

A business with low capital requirements is even better. Investors can protect themselves from inflation so long as the business benefits from it. The alternative is to follow Buffett’s example of buying businesses with a very low capital requirement

“The best businesses during inflation are the businesses that you buy once and then you don’t have to keep making capital investments subsequently,”

Following a lengthy screening process, I think I have found a financial service provider I am interested in. It’s Paysign, a company that sells prepaid cards primarily to the healthcare industry. Despite the fact that the company has a small headcount (70 employees), it has experienced rapid growth in recent years.

Hard Hit by Covid

It appeared as if 2019 would be a record year for Paysign, with the company’s revenues soaring, free cash flow expanding rapidly, and profitability increasing significantly. Exactly when every startup dreams of reaching the exponential phase, the entire system crashed down in 2020 due to…well you know what.

From the company’s market cap and share price, you can see that it enjoyed a beautiful upward trend. A few months later, Covid disrupted the growth pattern of the company, shattering its valuation in the process.

But not so fast. I was initially attracted to Paysign due to its good free cash flow (and price to free cash flow) even though it had negative earnings. Only one of two scenarios was likely to be true, so I dug deeper:

1. The free cash flow was temporary or an accounting fluke, and the company was deeply in trouble, or…
2. There were likely temporary negative earnings, and the market price had yet to realize it, so we are able to buy it at a discount

As a result, I went on to learn more about Paysign’s business in an attempt to improve my understanding of it.

This report first appeared on Stock Spotlight, our investing newsletter. Subscribe now to get research, insight, and valuation of some of the most interesting and least-known companies on the market.

Subscribe today to join over 9,000 rational investors!

Subscribe Now →

Learn More

Chapter 1: A Lifesaving Niche

Focus On Healthcare

On the surface, Paysign is a provider of prepaid debit and credit cards. While not particularly bad business, it is a rather competitive sector like most Fintechs.

So, what are Paysign’s competitive advantages?

Paysign generates most of its revenue from the healthcare industry, especially from plasma. As for the pharmaceutical industry, it had good results, too, but with Covid, this revenue stream has virtually disappeared.

The main product of Paysign is its prepaid cards that can be used at various retail outlets. Its technology allows it to tailor to any client’s specifications, from buying only from a specific location, or from a limited list of sellers.

The Plasma Business

A US plasma donation center compensates its donors with money, historically in the form of cash or checks. Many plasma donation centers looked for other solutions due to the logistical difficulty of managing the check and keeping the cash safe.

Paysign identified this unique market need in 2011, and it is still its primary source of revenue.

Currently, the company is used by 356 plasma donation centers in the USA or 36% of the industry. Management expects this number to jump to 400 by the end of the year (as opposed to 290 a year ago), or approximately 15% yearly growth.

By being the predominant solution in the sector, and customizing its solution to the specific needs of plasma centers, Paysign is likely to be able to keep growing for some time, at least until it reaches 60-80% of the market.

It is estimated that plasma centers generate $5,500 to $6,500 per month on average. Although more plasma centers are using the Paysign solutions, this number has been slightly reduced by Covid (-$3M of revenues in total). This can be partly attributed to the U.S. southern border closing.

However, considering how vital plasma donations are for a large number of lifesaving treatments, this is an impressive revenue line.

The Pharmaceutical / Co-Pay Business

Let’s talk about co-pays.

For those who are unfamiliar with the concept of co-pay, I recommend reading this article. Usually, this refers to the amount a patient has to pay on top of his health insurance coverage. Premiums can quickly reach levels that seriously affect patients’ finances or even prevent them from buying life-saving medicine.

Pharma companies are aware of the problem and have set up co-pay assistance programs to help patients. The patient signs up with the manufacturer and receives a co-pay card.

Essentially, pharmaceutical companies provide payment assistance to make expensive medications more affordable for people who need them. The method is somewhat controversial, as copay is used by insurance companies to encourage patients to use cheaper medicines instead of expensive ones.

In short, pharmaceutical companies are attempting to reduce the use of specific drugs by expressing their concerns to insurance companies.

I am not willing to debate whether this is or is not a proper response to the medical affordability issues in the American healthcare system, since that would take us far away from the purpose of this report. I have no ethical problems with companies helping patients access these vital drugs, but at the same time, the solution seems rather complicated at first glance.

Pharmaceutical companies prefer to find a service provider that can send and manage co-pay cards for them instead of doing it themselves. This is what Paysign does in its “pharma” segment.

Many insurers waived co-pays during the pandemic, resulting in the quasi-disappearance of the business in 2020.

People also avoided pharmacies and medical consultations, resulting in very low turnover for co-pay card systems. During this period, Paysign revenues decreased from $7.3M to $0.3M.

Co-pays and their associated problems for patients are unlikely to disappear anytime soon, however. Insurance companies are slowly reintroducing copays.

Pharma companies seem to agree. Paysign onboarded six new copay programs just last quarter and renewed its contract with a major pharmaceutical hub.

Paysign’s losses in 2020 are largely attributed to the sudden disappearance of co-pay revenues. The market is slowly returning to normal, so the sector should become a growth engine for the company by 2022.

Other Segments

In truth, the rest of Paysign’s operations are quite small and I don’t believe they are worth much attention at the moment. While they have generated a few hundreds of thousands of dollars in revenue from the hospitality and retail sectors, these seem to mostly be an afterthought and not the priority of the management team.

Chapter 2: The Path to Recovery

The Ongoing Growth

To be honest, the revenues and profits that Paysign has generated since 2020 do not reflect fully improving business, contrary to the free cash flow

But there is some good news!

Firstly, Paysign’s grip over plasma donation centers is gaining speed rapidly. The company could easily double its revenue in this sector if it had roughly a thousand centers in the USA. As a result, both a 15% market share growth rate can be maintained up until 70 – 80% market control, and profitability can be increased once Covid effects subside.

Secondly, with vaccination coverage among US citizens increasing, and insurers bringing back co-pays, the co-pay sector may return to normal. Co-pay assistance programs will therefore be available to pharmaceutical companies again.

What interests me most about this company, however, is its competitive situation regarding copay services. Management isn’t very candid about it and has failed to mention any direct competitors. I couldn’t tell what portion of the segment co-pay and what portion plasma center was before 2019, so I cannot compare the two segments historically.

It appears the copay segment entered the market in 2015, indicating that this business line grew to $7M within 4 years. Paysign’s co-pay support program is already scheduled to launch in 2021, so I expect revenue growth to continue (at least 5-10%), though I am not sure how unique or good the company’s offering is.

The Clinical Trials Opportunities

However, management at Paysign occasionally mentions one area of the company’s business that, in my opinion, could grow into the company’s third segment.

Prepaid cards are already used by the plasma donation centers as a practical and efficient way to thank the individuals participating in life-saving medicine production for their contributions.

Similarly, in clinical trials, patients are routinely compensated for their participation in trials. Cash or checks have been used historically for these payments, similar to the way plasma centers manage their reward programs.

There is already a growing network of pharmaceutical companies using Paysign’s card for co-pay support programs. Especially for new and complex medicines, these co-pay programs work great. Paysign should leverage their relationship with these innovative pharmaceutical companies to offer pre-paid cards for their clinical trials.

As I said, management mentions clinical trial opportunities, but for now they’ve bundled them with “other business.” As it stands, most of the copay contracts with pharmaceutical companies are at best 3-4 years old.

Because it takes so long for a clinical trial to be planned, launched, and executed, Paysign has only now begun offering its services for newly designed clinical trials.

The existing base of clients acquired with co-pay offers has a lot of potential to expand Paysign’s business.

The Other Markets

Another segment of growth is biological donation centers. So far, Paysign has focused on becoming the biggest plasma donation center. However, there are lots of other industries that might also need to modernize their reward system away from cash and checks and into digital systems.

Blood, platelets, eggs, sperms, breast milk, and hair can all be donated. I know it’s not everyone’s cup of tea, but it’s a massive market, providing patients with much-needed supplies.

Paysign offers a strong plasma-related product offering. This technology can quickly be transferred to other markets for biological donations.

Paysign could use this to get its foot in the door for providing prepaid cards as a reward for clinical trials not just by pharmaceutical companies, but also medical institutions.

It’s hard to say how fast Paysign could grow in each of those segments. However, each would be pretty capital-efficient since most of the technology R&D and support is already in place and the plasma and co-pay businesses are paying for it.

Any incremental growth would help to boost margins.

For reference in 2019, gross margins were at 55% and net margins were at 21%. Margins are pretty good but could be better considering the potential to leverage the technology to reach more clients.

The People Behind Paysign

I talked a lot about the company’s activities and possible new markets. Now let’s talk about management. Ultimately, they will make or break any change in the company.

Mark Newcomer, Co-Founder / CEO

Mark’s been working at Paysign since the company merged with 3PEA Technology 20 years ago. Interestingly, despite his background in payment solutions, he graduated with a degree in Bioscience (the field that deals with diagnostics and medicine techniques, like… plasma collection).

It’s great to see a technically oriented CEO running a company that will constantly deal with clients who are themselves doctors, pharmacists, and biologists. It might not seem like a big deal, but technical-minded pros will always prefer to speak to one of their own than a financial or corporate profile.

Matt Lanford, President / COO

Before joining Paysign in 2019, Mr. Lanford held numerous positions in payments processing, including at Citigroup and Mastercard. Mr. Lanford has a bachelor’s degree in computer science, which makes him a good fit to handle future expansion of the product line, given his IT background and experience in payment processing.

Matthew Turner, Vice President, Patient Affordability Services

Initially, I was confused about his role, but I discovered he was previously employed by TrialCard before 2019, a company that offers co-pays and clinical trial support, as well as being a competitor of Paysign. Clearly, this is what we want to poach from our competition to expand co-pays and enter the clinical trial market.

It’s great to see that the management team of the company is already in place.

Jeffery Barker, CFO

Mr. Barker joined the Paysign team in February 2021. Previously, he was a leader in the payment processing industry at Global Payment, worth $45 billion. The CFO position was also filled by top talent in the industry, which is great to see.

Chapter 3: Crushing Paysign Numbers

A Solid Base for Future Growth

Paysign’s robustness and profitability shone through during Covid, which was a challenging test for them. While co-pay revenues were interrupted overnight and plasma business declined, the company managed to keep its balance sheet very solid.

The company’s net assets dropped from $20M to $15M in 2019, primarily due to moving to a new headquarters and adding a $4M lease liability. Cash on hand stands at $7.8M in 2020 (and $6.6M last quarter) and there is no long-term debt.

It’s definitely enough cash to weather the pandemic storm and even take on any opportunities that come up in the next 2-3 years.

Judging Growth Potential and Risks

I think Paysign needs to be divided into three distinct parts. As each part has its own risk profile and expected growth profile, I will value each separately.

Plasma is by far the strongest segment and it’s growing 15% year over year. Profitability is already on its way back to pre-covid levels. Paysign is the biggest player in the industry, and it’s likely that they will control most of it in just a few years.

Next is the co-pay segment. Because insurers stopped offering co-pay waivers during the pandemic, we can reasonably expect this segment to come back to its 2019 levels by next year or the one after. With new co-pay programs coming in 2021 and the future renewal of existing relationships, it looks like the business will keep growing.

What size the addressable market is and how strong the competition is are still up in the air. Furthermore, co-pays by insurers are a very American thing, and any reform could change it overnight.

But government rarely works fast.

As long as healthcare reforms take a while, this isn’t a big deal. But if everyone hates the current system, Paysign may have a serious problem in 5-10 years.

Then there’s the new segments, from other donations to clinical trials to non-healthcare growth. I’d say this part of the company is just getting started. Keeping that in mind, Paysign’s net income in 2019 was $7M.

This is a lot of cash the company can use to market itself. Paysign could use its profit to quickly acquire new clients and replicate its plasma success in new markets if it would increase its headcount from 70 to 80-90 people.

Valuation

Earnings Growth- Plasma Segment

I want to start by valuing Paysign’s plasma business separately, because it has the most visibility into current revenues and potential growth. The company should keep growing fast for a while until it reaches saturation.

I’m using the earning growth method and the 2019 numbers (since they’re more representative of 2021 and 2022 activity, and if anything, understate the number of plasma centers Paysigns’ clients are).

Plasma revenue accounted for 77% of total revenue, and I’ll devote the same amount of operating expenses and cost of revenue to plasma. The stand-alone plasma business would earn $27M revenue – $11.8M cost of revenue – $10.1M operating expense = $5.1M earnings or $0.1 per share.

From just the plasma business, we can calculate a 6.3% return rate. Paysign returns can be anchored on the plasma operation, which seems like a pretty solid minimum.

Remember, I used the 2019 number, while there are quite a few more plasma centers now than there were in 2019, so I am probably underestimating the base case here.

Earnings Growth – Co-Pay Segment

Despite the fact that the co-pay segment is much smaller, if we calculate the company return including it, we add:

Revenue of $7.3M – cost of revenue of $3.5M – operating expense of $3M = $0.8M. Or + $0.015 EPS.

In the long run, this increases the growth prospects, since the co-pay segment won’t reach saturation, unlike the plasma market. We’re getting better returns at 10% with those extra earnings and long-term growth.

Earning Growth – Other Markets

Like I said, it’s hard to put a number on very prospective markets.

Still, I think the real value of Paysign is hidden here. 

This is simply due to the fact that the biological donation market is several times larger than the plasma market alone.

Currently, clinical trials aren’t even a serious source of revenue for Paysign (a typical study costs $12M, and the industry spends $95B/year, so even a small percentage of patient remuneration can move the needle).

In addition, Paysign’s technology could be used by other venues. Paysign could control the technology directly or license it to others.

Combined, I think this should boost the company’s growth prospects, a little bit in the short-term, and a lot more in the long run. With this extra growth potential, the expected return rate goes way up.

Discounted Cash Flow

In the case of Paysign, I’d rely mostly on the earning growth method. Mostly because cash flow is a little too irregular for a precise number to be given.

Nevertheless, I was curious how the company looked using the depressed cash flow of 2020. I think a 15x value multiplier is conservative for a fintech with a ton of potential.

The intrinsic value is above the current price, so the return should be 15%. The earnings growth valuation method would confirm the valuation in this case even if it’s a tad less robust.

Conclusion

Tech and fintech companies have benefited greatly from the pandemic, boosting their valuations to sky-high levels. It also means that some of these companies, from Wise to Robinhood, might be a little overpriced right now, and carry a lot of risk.

The financial industry is going to be massively disrupted by new technologies that make payments faster and more efficient. But I don’t want to overpay for it.

Also, I prefer companies which operate in profitable niches, rather than ones that grab headlines but don’t have a solid moat and don’t make any money.

Right now, the only way a value investor can catch a good fintech company is to find one where the market doesn’t already price in the growth. Qiwi, the Russian company I covered already, was dismissed by investors because of its potential.

Paysign is a different story. As a result of Covid, the growth pattern was broken, and Paysign was priced like a “normal” company instead of an exponentially growing Fintech. I believe this is misguided.

Plasma industry dominance is increasing every day for Paysign. Co-pay business should soon return and some more. From clinical trials to biological donations, it has a large addressable market in pharmaceutical payments waiting to be explored.

Paysign’s price isn’t reflecting its growth for what I think might be a short period. It won’t take long for revenue to stabilize and free cash flow to increase. Here are the numbers again:

In the end, the value of a company is determined by how much cash it generates minus how much it needs to spend to maintain or grow its operations. Paysign is growing and it’s cheap. It will pay off at some point because its free cash flow is growing.

It is therefore different from those expensive, but growing fintech companies. It’s anyone’s guess when the market will notice Paysign’s recovery, but I think relying on strong fundamentals would be a better strategy than hoping markets get even more irrational.

The post Paysign (PAYS) Stock Research Report appeared first on FinMasters.

Quick Stock Overview

Ticker: BEP

Source: www.tikr.com

Key Data

• Sector: Utility
• Sales ($M): 3,888
• Industry: Independent power producer
• Net Cash per share: $-66.86
• Market Capitalization ($M): 11,138
• Equity per share: $16.28
• Price to sales: 2.9
• P/E: –44.6

Investment Thesis

Long Term Energy Future

In my previous report, I explained how I think that fossil fuels, especially gas, will still play a large role in the energy mix for the 1-2 decades to come. But this does not mean I am opposed to renewable energies, quite to the contrary.

I think that a realistic scenario for the energy transition is something like this:

1. Removal of coal power plants in the next 5-10 years, replaced by a mix of gas and renewables.
2. In the years that follow, an increase in renewable and gas power generation, to handle the increased consumption for electric transportation.
3. Phasing out of fossil fuels in the 2040s and 2050s.

I would love for it to happen quicker. I really do. But considering how long-lasting are assets like power plants, cargo boats, trucks, and so on, I doubt we will see the electrification of everything before the late 2030s, or even later.

For more insights on the topic, I will refer you again to Lyn Alden’s great report.

You will notice that in the forecast above, all time periods imply growth in renewable production. First to replace part of the coal power, and then to help with the electrification process, and finally to remove fossil fuels from the mix. So, while there will be space for gas and petrochemical focus companies like Enterprise Product Partners, there will also be plenty of opportunities for renewable energy companies.

The topic has become so political that it has become hard to discuss it rationally. But ultimately, it is likely the story for investors will not be a gas versus renewables, but a gas and renewables. And I imagine also carbon capture technology like in Iceland to mitigate the slower than hoped-for pace of electrification.

The Right Kind of Renewable

Renewables is a blanket term covering a lot of different technologies and companies. So, when I started to look deeper on the topic, I realized what should be the profile of a “good” renewable company for value investors:

• A large part of the current production is from hydropower, as it is often the cheapest production with also a large moat. It is also more reliable power generation than the other renewables and can be used for energy storage.
• Demonstrated capabilities in solar and wind to be able to benefit from this technology becoming cheaper every year. And presence in both solar and wind to not be dependent on which of the two technologies dominate the field.
• A clear path for growth to respond to the need for more electricity production.
• Good access to capital and solid financial backers is possible.
• A large enough company to spread out the costs of regulatory compliance and overhead, as all renewable production needs a lot of land (or disruption of waterways for hydropower).

It took a while, but I found a company that fit the bill for all the points above, Brookfield Renewable Partners.

This report first appeared on Stock Spotlight, our investing newsletter. Subscribe now to get research, insight, and valuation of some of the most interesting and least-known companies on the market.

Subscribe today to join over 9,000 rational investors!

Subscribe Now →

Learn More

Chapter 1: A Company Hard to Analyze

Part of a Giant

At first, I almost gave up on analyzing Brookfield Renewable Partners (I will refer to it as BEP from now on). This is because the company is a part of the larger Brookfield Asset Management company.

The company is a corporate monster, a conglomerate managing no less than $625B worth of assets. Typically, the kind of company is so complex that you would need to devote a few months of work to understand it. And it would have made this report some hundreds of pages long.

You have all kinds of things into this conglomerate:

• BEP, the renewable energy segment, also listed as BEPC in Canada.
• BIP, managing infrastructure like fossil fuel midstream, water, data cables, etc.
• Wealth management in the form of Howard Marks’ enormous Oaktree company.
• But also, insurance, corporate services, public funds, private funds, real estate funds, etc.

Source: https://www.brookfield.com/

Luckily, some individual parts of Brookfield can be invested separately. This is the case for BEP, and this is what we will be dealing with in the rest of the report. So, if you are looking for information on BEP, stick to the dedicated websitehttps://bep.brookfield.com/, and do not panic or get lost in the larger Brookfield entity that owns a large part of BEP.

So why did I mention it at all? Because it shows us two things.

First, BEP’s assets are held by one of the largest and best-established wealth management firms in the USA. If they are not selling BEP, they must have their reasons. A firm like BAM does not reach $625B in assets by being bad at capital allocation.

Secondly, it means that BEP has access to a lot of capital and connections from the larger Brookfield entity. It does not matter if it is in the form of getting access to capital, human resources, or connection to the right person in government, BEP is not just an energy company. Same thing when BEP needs to market its shares or bonds to investment funds, the rest of the group already has the perfect ESG funds ready for it.

This is a moat almost impossible to replicate but by a handful of similar conglomerates.

Financials All Over the Place

The second time I almost got discouraged in digging deeper about BEP was with its financials. On one side you have a profile of a steady compounder: growing revenue, market cap, and free cash flow.

On the other side, net income is barely staying positive, and the P/E ratio is so absurdly all over the place from, -285 to 149 that it is meaningless. You might even have noticed the negative P/E in the key data at the beginning of the report, or that I only showed price to sales, not to earning or cash flow.

So, is the company growing steadily, or tethering at the edge of collapse?

I looked for a bit longer, and I found that for a company like BEP, earnings, net income, cash flow or P/E are indeed meaningless. And this for two reasons.

The first reason is that the company is spending a lot of capex for growth, but in bursts through acquisitions or the launch of large infrastructure projects, like large offshore windmill power plants, for example. This strategy creates a very irregular cash flow and earnings.

The second reason is that all BEP’s assets are very long-lasting. Hydropower dams last more than a century and renewable power plants last decades. It allows the company to essentially hand-pick the depreciation rate that will allow it to report no net income and optimize its taxes that way.

You might approve or not the practice, but this needs to be understood when looking at the financials. The almost non-existing earnings are not a measure of profitability, but clever accounting and a good CFO.

I will come back to the depreciation charges in the financial section, but this needed to be explained first.

Is It Even Worth Looking at Then?

I think it is. In the end, the only number that matters, in the long run, is free cash flow. Cash flows that need to be re-injected constantly in the business will never make it to the pocket of the shareholders. Free cash flow does.

And when it comes to free cash flow, BEP has been able to steadily grow it at the rhythm of 13% annually. A remarkable number for a utility, usually considered as boring non- or slow-growing companies.

But before I bore you with even more numbers, let’s look at BEP’s business.

Chapter 2: A Leader in The Energy Transition

The Hydropower Base

In my initial checklist, I mentioned I wanted a utility that had a large part of its business in hydropower. Why? Because hydropower dams are one of the most durable and lasting assets a company can own, with the exception maybe of the land itself. Once built, a dam will last almost forever, at least if it is properly managed.

Thanks to the energy being provided by rainfall, it is the only major electricity source this day that is truly carbon neutral. Some might argue that the building of the dam is emitting some carbon, but the quantity is negligible compared to other energy sources and on par with the carbon emissions to produce windmills and solar panels.

Therefore, I fully expect hydropower to be increasingly profitable in the future, thanks to carbon credits/carbon taxes.

Finally, the best part of hydropower for me is that it is a perfect inflation hedge. The production costs are in the past, often decades ago. Operating costs are limited, and it requires no input fuel.

Electricity prices tend to be linked in a way or another to inflation. This is not true for all utilities, but 90% of BEP power generation is contracted with an “average power purchase agreement” or PPA, that protected it against inflation risks.

This PPA is akin to a quasi-perpetual bond, and a perpetual inflation-linked bond at that.

Currently, half of BEP revenues and more than half of its capacity are provided by hydropower (energy transition is largely composed of pumped hydropower, using the dams like giant batteries).

BEP power distribution, Source: https://bep.brookfield.com/

BEP cash flows, Source: https://bep.brookfield.com/

Source: https://bep.brookfield.com/

The Growing Wind and Solar

BEP has very ambitious growth plans, planning to increase its power generation by over half by 2030.

Source: https://bep.brookfield.com/

I really appreciate how casual is the company management about the strategy, calling it simple. And it is. They use mature assets like hydropower to generate free cash flow (the dams need little capex) to invest in profitable new ventures.

This will generate new cash flow, and the new assets turn into mature assets themselves. The whole ensures a steady 12-15% ROIC that can permanently reinvest in itself.

Source: https://bep.brookfield.com/

Jeff Bezos is famous to have built Amazon’s success on what does not change. People liked, still like, and will forever prefer more choice, quicker delivery, and cheaper prices.

Similarly, as long as the world will be hungry for energy, and global warming is a concern, BEP will be able to keep this flywheel running and compound at 12-15%. This seems a pretty safe bet.

What does this growth look like?

It is things like the building of one of the world’s largest new solar fields in Brazil. Or the merging with Terraform Power to consolidate activities in Europe and North America (total of 4GW of production or 20% of BEP). Or acquire Exelon Generation company (360MW) and Shepherd wind farm (845 MW).

The total amount is 23 GW of the development pipeline, or more than double of BEP’s current production. BEP has been for now exclusively present in the Americas and Europe, but this is about to change.

Source: https://bep.brookfield.com/

In a 2019 call, BEP management explained that they had focused on US wind farms. It was simple: because they had generally better returns. But with the market quickly evolving in India, they bought 210MW of wind farms, and plan to buy more. Additionally, BEP bought 200 MW of wind farms in China.

I would not be surprised that with such acquisitions, the actual growth of BEP will be even quicker than expected, with Asia becoming quickly one of their top markets, maybe even ahead of Europe and Latin America.

Just India and China could do the trick, but also Japan, Korea, Indonesia, and the rest of South-East Asia as well, a region rich in both solar and offshore wind potential.

Chapter 3: BEP’s Future

The Coming Instability

Once again, I think the energy transition will happen. And I certainly hope it will. But I doubt it will happen in a perfectly straight line.

So, we will likely see a short period where green energy gets in trouble, either because of poorly designed unprofitable projects or because the effect of intermittent production on the electric grid has been underestimated.

The recent explosion in energy prices in Europe highlight such a moment.

This reminds me greatly of some of the few best oil majors compared to the majority of the shale oil companies. In every boom, you always have a few smart companies, generally the larger and experienced players, carefully looking at profitability, and swarms of new companies looking at growth at any cost.

Generally speaking, the experienced giants tend to buy back the assets of the failed growth-focused company when the time is right.

I fully expect BEP to come out stronger from any temporary setback for renewables. It also demonstrated a strong capital discipline, for example entering the Indian market only once the local prices, rules, and regulations allowed for renewables to be profitable. And like a fearsome ambush predator, it has plenty of cash to grab any distressed assets from overextended companies with too much debt.

So overall, I will focus this analysis on the long-term past performance and long-term opportunities, instead of trying to predict the company’s short-term perspective, which is almost always futile anyway.

BEP Financials

Revenues and Depreciation

For a utility company, BEP has the most unusual revenue profile. Revenues are growing stronger over time, even if it is more by stride than a perfectly steady pace. This is mostly since the building of large solar or wind farms, or the acquisition of a smaller company creates a sudden surge in revenues, instead of a steady growth every quarter. Anyway, from revenues alone, we can validate the profile of BEP as a steady compounder.

As said before, the picture is a lot less clear with net income, as depreciation is designed to cancel the net income. This can be shown by the rising EBITDA for the same period.

As the topic of depreciation is so important to BEP finances, I looked deeper into the annual report to find the details about it. The company uses a “straight line” depreciation method, with asset life durations varying depending on the energy source.

For dams, by far the most expensive asset to build, duration is 115 years, which is, in fact, conservative, as “the civil engineering infrastructure should last almost indefinitely provided it is maintained”.

Therefore, I would consider that the hydropower division is depreciated at a fair speed, and if anything quicker than needed, helping to reduce net income and therefore income tax.

Source: https://bep.brookfield.com/

As newer technologies, some doubts exist regarding wind and solar farms’ lifespan. Solar panels seem to lose approximately 0.5% of their output per year. Most solar panel manufacturers guarantee at least 80% of initial production after 25 years.

It also seems that proper maintenance helps increase solar panel duration. A very technically able company like BEP should easily be able to still have some production and residual value from its solar farms in 35 years (maybe even still 50-60% of initial production capacity), when they consider them fully amortized.

Again, a conservative estimate that depresses artificially earnings.

For wind farms, windmills’ lifespan is between 20 and 30 years. Windmill lifespans seems to have improved in the last decade, with 30 years lifespan becoming the norm. BEP’s estimate is not really conservative but seems fine.

Overall, this tells me that earnings are indeed artificially suppressed by the depreciation policy.

Free Cash Flow

In order to have a better view of the real profitability of BEP, we need to look at cash flows. Simply looking at cash flow will not be enough, as we need to distinguish the cash used in operation maintenance and financing from the one used for growth.

So free cash flow is a better measure, but still underestimates current profitability, as some of the current capex is going to growth projects and not just maintaining the business operations.

But anyway, a growing free cash flow gives us again a compounder profile. And the recent surge in capex should bring growing income and free cash flow in 2-3 years down the road.

Source: www.finbox.com

Debt And Balance Sheet

With utilities, considering the stability of the business, the moat, and the duration of the assets, the only thing that can bring it down is poor management of finances and the debt load. Debt has increased a lot in the last 10 years, and so have total assets.

Net debt has increased over time, but not dramatically. By following the total debt to EBITDA, it seems that while quite high (between 6x-8x), it is not out of control or out of the ordinary for a utility company. As BEP has no fuel input cost like coal or gas, its cost structure is fairly predictable, and profitability should stay strong.

The company seems at no risk of a liquidity crisis, with $3.3B of available liquidity. And as mentioned before, it can easily access some of the gigantic $625B pool of capital managed by BAM, the parent company. The debt has an average maturity of 13 years, with 97% of it at a fixed rate.

Together, this means that the company has a very stable debt outlook. And if inflation becomes a larger problem in the decade to come, BEP will be perfectly positioned to register huge profits from it (it should be able to raise the price of its products and use the extra cash to pay a debt shrinking in real terms).

Dividends and Returns to Shareholders

BEP has a strong focus on offering stable and growing returns to its shareholders, well aware that this is what investors expect from utilities. The company communication is clearly geared in that direction, with a strong insistence on BEP having consistently beaten the main indexes in the long run.

This is true both since inception and for the last 5 years, an impressive performance with the S&P 500 doing very well in that period.

Source: https://bep.brookfield.com/

Returns to shareholders are made through dividends, which have increased by 6% yearly on average.

This again seems to fit the profile of BEP as a stable growing compounder. The only weak point on this topic is the dividend yield, which has strongly declined in the last two years, reflecting the quickly growing share price compared to the slower growth of dividends.

This leads me to expect a slowdown in the share price, at least until growing free cash flows and dividends can catch up, and dividends yield get back to a more respectable 4-5%.

As such, I do not expect BEP returns in the next 3-5 years to be above 12-16%, as some of the company quality is already priced in.

Chapter 4: Valuation

When it comes to the valuation method, as earnings are artificially depressed and unstable, calculating earnings growth is obviously out of the question. The equity bond valuation method also uses earnings per share, so it is not applicable here.

So, I will first defer to my discounted cash flow method (DCF). Considering the stability of the business and its dividend growth, I will also look at another valuation method, yield on cost.

Discounted Cash Flow

BEP’s price to free cash flow multiple has historically been between 12-18x. I took a more conservative 10x to stay safe. Similarly, the historical growth rate of free cash flow has been an average of 13% the last year. I took a conservative 8% instead.

Even with such very conservative assumptions and a solid margin of safety, I end up with an intrinsic value of $43, to compare to the 38$ share price.

Curious to see what a best-case scenario would look like, I used numbers if business as usual persist, instead of conservative assumption. At the current share price, this would mean a 25% rate of return. Really impressive!

Yield On Cost

Due to the currently rather low dividend yield, the yield on cost calculation shows a less rosy picture. It would take 18 years to cover the current buy price with dividends alone.

The 6% dividend growth I used is in line with historical growth, but not with free cash flow growth. If dividend growth would follow free cash flow growth, this brings it to 14 years to cover the purchase price. Not terrible, but not great either.

It is however interesting to notice that with BEP planning to steadily grow its income and free cash flow, a 10% growth followed by quicker 20% “catch-up” growth would have a dramatic effect in the long run.

Getting back the initial investment would happen 4 years earlier, not a spectacular difference. But by year 20, the difference would be between 122% and a much juicier 310%. This is the magic of compounding at work!

Conclusion

With this report, I wanted to analyze a company that would be a true buy and hold forever. A utility company that had fully embraced the energy transition and would be able to smoothly ride with growing cash flow and dividends.

I would then say this is quite a success. The very nature of BEP business is very capital intensive and long-term focused. We have here a company with assets lifespan measured in decades or even centuries.

How many companies can you do that with? Not many.

The historical heritage of hydropower is being leveraged to finance the future wind and solar farms and guarantee strong production growth. BEP is perfectly positioned to grab the tailwinds of ESG investing, electrification, and the fight against global warming.

The company has debt, but with a very long duration and at a fixed rate, making a surprisingly strong inflation hedge, almost as much as would an energy company or a gold miner.

BEP seems to me like a slow-moving, but almost unstoppable force. Returns might be for a few years be limited to the 3-5% dividend yield when the company is focusing all the available cash on growth projects.

The share price might even fall if electricity rises too much and a backlash against renewables builds up. But in 5-10 years, I expect more of the cash flow to be distributed and go in line with the 13% free cash flow compounding.

This might not seem spectacular, but this would create exponential growth, with most of the returns happening in the years 20-30.

With that in mind, I think the position of BEP in a portfolio is pure as an investment for a retirement account (with untaxed profits). Returns can be expected to be great, but mostly far in the future. The fluctuation of the share price on the way should not impact this strategy, except maybe on when to buy some more after a temporary weakness.

Right at the time I am writing this report, financial markets are worrying about a possible Chinese crash with Evergrande, supply chain woes, and inflation getting out of control.

But here is the magic surrounding BEP: None of these concerns will matter to BEP’s long-term success!

Even if BEP is a “boring” investment, it is likely to prove to be the proverbial winning turtle over the more aggressive, but less steady hare. And provides peace of mind to its shareholders that few other companies can rival.

The post Brookfield Renewable Partners (BEP) Stock Research Report appeared first on FinMasters.

Quick Stock Overview

Ticker: EPD

Source: www.tikr.com

Key Data

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

Investment Thesis

Buy When There Is Blood in The Streets

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

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

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

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

But sometimes it is even simpler than that.

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

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

The Industry Everyone Loves to Hate

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

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

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

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

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

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

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

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

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

Source: www.yahoo.com

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

This report first appeared on Stock Spotlight, our investing newsletter. Subscribe now to get research, insight, and valuation of some of the most interesting and least-known companies on the market.

Subscribe today to join over 9,000 rational investors!

Subscribe Now →

Learn More

Chapter 1: A Postmortem

Several Storms at Once

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

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

Source: www.finbox.com

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

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

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

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

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

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

And then came Covid…

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

Source: www.macrotrends.net

A Dead Sector? Not So Fast

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

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

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

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

Source: https://www.eia.gov/

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

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

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

Chapter 2: Not All Energy Stocks Are Created Equals

The Unfairly Punished Sub-Sector

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

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

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

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

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

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

Are Midstream Right for Value Investors?

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

Cheap Despite Good Results

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

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

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

This allows us to buy them on the cheap!

The Ultimate Moat

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

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

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

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

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

An Undervalued Hedge Against Tail Risks?

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

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

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

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

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

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

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

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

Chapter 3: Why Enterprise Product Partner?

Picking The Right Target

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

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

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

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

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

EPD’s Operations

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

Source: www.enterpriseproducts.com

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

Source: www.ir-west.enterpriseproducts.com

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

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

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

Source: Finbox.com

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

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

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

Source: www.ir-west.enterpriseproducts.com

The Financials

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

Source: www.finbox.com

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

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

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

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

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

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

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

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

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

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

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

Source: www.ir-west.enterpriseproducts.com

Judging Future Risk

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

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

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

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

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

Chapter 4: Valuation

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

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

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

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

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

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

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

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

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

Conclusion

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

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

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

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

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

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

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

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

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

Quick Stock Overview

Ticker: NTDOY

Source: www.stockrover.com

Key Data

• Sector: Communication Service
• Sales ($M): 15,962
• Industry: Electronic gaming and multimedia
• Net Cash per share: 16.46
• Market Capitalization ($M): 54,557
• Equity per share: $17.84
• Employees: 6,574
• P/E: 12.5

Investment Thesis

The Hidden (Investment) Gem of The Gaming Industry

Video games have slowly evolved from kids’ entertainment to a large part of the culture. This mostly followed the first generations of gamers getting older and now having families of their own. This was especially visible after a year of lockdowns, with plenty of time to play at home. The gaming industry revenues were up to $159B in 2020, a 9.3% year-to-year growth.

Most of the industry news is dominated by blockbuster AAA games and headlines about the comparative performance of the latest consoles or PC hardware. Deeply rooted in the industry since its inception, the arms race for bigger virtual worlds, better graphics, more complex games is still ongoing.

Gaming is a highly challenging industry, where yesterday’s winners can be outpaced by their competitor’s technical innovations. The sector is littered with the leftover of former industry leaders: Atari, Commodore, Sega, Westwood studio, etc… And were bigger, quicker, and prettier = better.

It is also a field where hardware manufacturers like Sony (PlayStation) and Microsoft (Xbox) subcontract the costly and risky process of game development to third parties. These developers and publishers enjoy the ability to publish their games to all platforms technically able to support them, broadening their market.

But there is one company defying the odds and industry best-practice, betting on cheaper, lower performance hardware. It is also developing almost all its key games internally and outright refusing most third-party developers to use their consoles.

This company is, of course, Nintendo.

Nintendo is one of the most beloved companies by gamers, and also one of the most misunderstood by investors. Recurring comments about the company for almost a decade are things like “highly cyclical”, “archaic management”, “missed the opportunity”, “unable to adapt”.

Due to these widespread misconceptions, this report will be much more focused on a qualitative analysis than the financial numbers or the short-term news. These misconceptions lead investors to miss a great opportunity, as the stock went from its low of $12 in 2015 to its highest ever in February this year, at $81. An x6.75 performance in 6 years is really nothing to be ashamed of.

But is this similar to what the company did in 2008, before going through 7 rough years? I think a lot has changed within the company since 2008, as they are an entirely different company since then.

This report first appeared on Stock Spotlight, our investing newsletter. Subscribe now to get research, insight, and valuation of some of the most interesting and least-known companies on the market.

Subscribe today to join over 9,000 rational investors!

Subscribe Now →

Learn More

Chapter 1: Understanding Nintendo

Cyclical? Yes, but Not Only

The console market is notoriously cyclical, especially at the level of individual companies. A new console gets released, a lot of sales happen the first and maybe the same for second Christmas, and then a more or less slow decline happens. It is also common that “a winner” emerges for each console generation, leaving its competitors in the dust.

Nintendo is the poster child of this pattern, with an almost perfect track record of a super successful console launch followed by a relative commercial failure for the next model. The GameCube disappointed after the N64, the Wii U was a disaster after the gigantic success of the Wii.

And the successor to the Wii U, the Nintendo Switch is a large success, almost the largest in Nintendo history (for now, the Wii still holds this title, probably not for long). After releasing a Switch lite last year, a Switch OLED is planned for October 2021, with more memory and a better screen for just $50 more than the base model.

There is no hiding from it. After the successful Switch console, a shadow of historical failure looms over Nintendo near future. Here’s the good news:Nintendo is very aware of this fact.

Nintendo has been around since the late 19th century, an it has not survived that long by being careless. When it hits a home run, the company has a habit of stockpiling that cash for leaner years. It is now sitting on no less than $10.7B. While this might look like poor capital allocation to some, this might be highly reassuring for the cautious or worried investor.

Nintendo management is perfectly aware of the risk entailed by this model. If failure would succeed more than 2 or 3 times in a row, the whole company could be toast. I think that the company is now able to break away, at least partially, from this cyclicality, but I will come back to this point later on.

Until recently, the solution was a mix of radial innovation and perfectionism, and it worked. As you can see above, every single one of the new Nintendo consoles was a radical departure from the previous one. Each had a different design, control system, etc… Just compares it to the competition of PlayStation and Xboxes, can you feel the decision-making by corporate committees?

Source: www.gamespot.com/

Source: www.gamasutra.com

The Power of Corporate Culture

With no other company I reviewed, understanding corporate culture was so important. Culture is often a way to pretend things about a company, how caring it is, how sustainable, or whatnot. But with Nintendo, the culture permeates everything, and I will keep coming back to it in this report.

As I see it, it relies on a few pillars, beyond the cult of perfection I already mentioned:

A Family Company

Most other gaming companies are focused on giving their consumers an adrenaline rush. Bigger guns, more explosions, more gore, more intense experiences are always better; and then there is Nintendo.

Nintendo has built its entire branding around being child friendly. This is especially key now that parents know more about video games having been gamers themselves. It will include some games that are more “adult” focused, but mostly, its target audience is 5-14 years old.

Most gamers will have fond memories of their Nintendo games and are now transferring them to their children. Their children might want more action-oriented during their teenage years but are still likely to want to share Mario, Zelda, and Metroid with their own children down the road.

The lower pricing and less high-grade performance make a lot of sense in that light. Nintendo does not need to have the best visuals to impress teenagers and young adults, just the best games for the children. And families are usually on a much tighter video game budget than single young adults.

A Cult of Perfection

The other key element to Nintendo’s culture is a cult of perfection. A central person in Nintendo resumed it perfectly, Shigeru Miyamoto, the creator of both Mario and Legend of Zelda, two of the largest and most enduring Nintendo’s franchises:

“A delayed game is eventually good; a bad game is bad forever”

The important part is not the focus on quality. It is that a delayed game WILL be good. It is simply not an option to cancel it, for example, a very common industry practice.

The product will be perfected until it is good. Period.

Virtually no matter the costs or effort required. Shareholders and gamers waiting for sequels be damned, it will wait until it’s good. Fans of the Metroid franchise might get a new game this fall, after 19 years without any new opus.

The consequence of this obsession for quality is very tight control. Most of the games on a Nintendo console are made by Nintendo. It was not always that way, but a stream of bad games in the 1990s consoles left the company permanently convinced that having ONLY good games means doing the job by themselves.

Third-party developers are rarities and on an invite-only base. And in return, other consoles cannot access Nintendo exclusives. In addition, the latest and fanciest graphics would struggle on the weaker and cheaper Nintendo consoles.

So, Nintendo is not so much part of the industry as an isolated island with its own separate ecosystem.

A Consumer-Friendly Policy

While console and PC gaming has traditionally focused on graphics, virtual world size, and technical performance, another branch of gaming took a different direction. Mobile gaming has used the smartphone revolution, building the industry on the super-fast computers everybody already has in their pockets.

The problem of mobile gaming is attention retention. A PC or console gamer is likely to stay on his game solely focused for hours in a row. But smartphone games compete with all the other apps like news, social media, email, messages, etc.

The logical evolution was to make mobile games as addictive as possible. Most of the techniques used by the mobile gaming industry have been first discovered and used by the gambling industry: dopamine rush from regular mini rewards and “wins”, the randomness of success, unpredictable rewards, and increasing difficulty. So then, it is probably not a surprise that some of the best-selling mobile games look not-so-different from slot machines.

Source: www.theguardian.com

This led mobile gaming to be, exactly like casinos, highly dependent on “whales”, the rare players that spend more than all other players combined. Commonly, 1-5% of all players make up for 90-95% of revenues in this industry. While 0.1-0.5% players representing half of a game’s revenues. Considering very high acquisition costs for a mobile game, this makes squeezing as much money from whales an absolute necessity.

Nintendo has notoriously “failed” at mobile gaming. It is not even displaying mobile separately from its other IP-related income in its annual report.

Source: www.nintendo.co.jp

And the reason for this failure is obvious. The company literally said, “It does not want its users to spend too much on mobile games.” Can you imagine the head of gaming at Sony or Microsoft worrying about users spending too much?

But this makes perfect sense for Nintendo. Mobile gaming is using highly predatory and manipulative practices. So much that the leader, Tencent, is now getting threatened by the Chinese government to rein in such practices.

Adopting such methods would contradict everything the Nintendo brand stands for. High-quality games, affordable fun that family can trust to build a multi-generational bond. Not just a corporation, but a friend.

Just one child spending once $7,500 on a Nintendo mobile game would be a PR disaster.

For the same reason, Nintendo does not make pay-to-win games, where your credit card determines your in-game success. It also does not chop games into parts, selling the core first, and then all the rest in expensive DLCs. A practice so common and so hated by gamers that it is now integral to the brand of the largest video game companies, first of them EA (Electronic Arts).

The internet is full of memes mocking the practice.

Chapter 2: The Iceberg Company

The Richest Untapped IP Resource in The World

Nintendo’s most visible section is the console business. But a lot more of it stays immersed and invisible to the casual observer. Having been the center of so many childhoods, Nintendo is sitting on a stash of beloved IP like few other companies. In that respect, the comparison should be done more with Disney than with Sony or Microsoft.

And so far, this resource has essentially been unused. Video game IP has been used to make … more video games. And not even that many of them. One Zelda game every 3-5 years (just 18 games in 3 decades+). A Mario or Pokémon every 2-3 years. And sometimes, beloved IP either went for a 19-year hiatus, like Metroid, or simply got left behind, like Starfox, Kirby, and many more.

Switch users are the first ones to see a change in that behavior, with Nintendo now using long-time gamer’s nostalgia. Nintendo has notably successfully released a remake of Link’s Awakening, a legendary title initially released on Gameboy decades ago. A 5-game pack for Mario’s 35th-anniversary campaign, plus a few other beloved and never forgotten titles from the 1990s and early 2000s.

This is exactly the demographic matching 35-40 years old buyers, looking for a console for their kids.

So, an improvement on the games front, but still, no movie, no TV series, no cartoons, no licensed games, and not much merchandising. You need to understand that Nintendo has not always been hostile to letting other parties use its IP. But it usually went horribly wrong.

There was the disastrous 1993 Mario movie. Or the hideous Zelda cartoon, that people are still making fun of these days, together with some terrible games by third-party developers.

These failures have left a mark on the company culture, and it took a while for anyone to convince management to try it again.

And this is finally happening. A new Mario movie is planned for 2022, after the success of Detective Pikachu. Finally, the company is opening more than one retail shop for merchandise. And more importantly, a series of theme parks is being created and managed by Universal. Now people can go to a section of the Universal park that is very much like the Disney World parks, but all Nintendo themed.

Another one is planned to open in Orlando, but with Covid delaying everything, it might takes a few years to open. Other opening are also planned for Hollywood Universal park and Universal park in Singapore.

It is very hard to overstate how much potential Nintendo has unused so far. Markets have realized the potential after Disney went on a purchasing spree with Marvel and Lucasfilm (Star Wars) and turned relatively dormant IP into cash machines. The success of Detective Pikachu or the Witcher and the Castlevania Netflix series prove that video game adaption to big and small screens is not anymore “cursed”.

So I think, it is unlikely that deals as “low” as the $4B sales each for Lucasfilm and Marvel would happen today. In the long run, I would not be surprised that a large, diversified, and all-public IP like Nintendo’s could be worth anywhere between $10B-$20B alone. This would include the tens of games and evergreen success franchises of Legend of Zelda as well as Mario. Or the frequently updated and ever popular Pokémon. But also, a lot other well known by gamers, like the sci-fi action shooter Metroid, the kid-friendly Kirby, the futuristic high speed licenses of F-Zero and Star Fox.

Truly, Nintendo has nothing to envy to the endless pool of Marvel superheroes.

Licensing IP is very likely to become a steadily growing part of Nintendo in the future. It is likely to be a lot slower than investors would expect with the Disney template. But it is also certain to not risking killing the entire license like the last three Star Wars movies almost did.

If Disney is the hare, Nintendo is the turtle; and we know who wins at the end.

The Countless Growth Potentials

Beyond IP licensing, there are so many possibilities for Nintendo to grow revenues and profitability that it was rather difficult to organize. Among them are some many analysts mention, but that I personally think unlikely to the company’s culture. I will review each and give a synthesis at the end.

AR/VR gaming

This is likely the largest near-term new segment for Nintendo to expand into. One of the most successful AR games to this day is still 2016’s Pokémon Go. The game was developed by Niantic and the Pokémon company. The actual ownership of this by Nintendo is frankly a tangled mess, so let me explain as briefly as possible.

Nintendo owns fully the Pokémon trademark, giving a lot of control over it. However, from a financial point of view, the license is managed by the “Pokémon Company”, owned 33% by Nintendo. The other owners also have a third each and are “Creature” and “Game Freak”. But in practice, Nintendo is likely to own part of these companies, rising the actual ownership of the Pokémon company higher. As these two others are private companies, Nintendo does not disclose the exact numbers of its ownership, thanks to Japanese markets rules. My guesstimate places Nintendo’s real ownership of the Pokémon Company around 50-60%.

Now back to Pokémon Go. The game itself was actually developed by Niantic. Niantic is a spin-off from Google, focused on developing tools to develop Augmented Reality (AR) solutions. It is also largely owned by Nintendo, for a number anywhere between 20-40%.

Pokémon Go is owned equally by Nintendo, Niantic, and the Pokémon company. So that should make something in the range of 33%+11%+16%=60% of Pokémon Go belonging to Nintendo in total.

Where game developers for PC use massively Unity 3D, AR developers rely on Niantic’s tool, the Niantic Real World. So, Niantic and Pokémon Go are really to be compared to Epic Game and Fortnite. Epic Games is a $29B company and Niantic was valued at $4B two years ago.

Considering the extensive portability of the Switch, something that Nintendo seems to plan to keep for future consoles, a fusion of future games and Niantic technology is likely on the horizon. It might take a little bit longer but would solve the problem of poor controls on smartphones that have hindered the progress of AR so far.

So, I assume that Pokémon Go is the first in a long series of games exploiting the potential of Nintendo in AR.

New Consoles

It should be obvious, but one way for Nintendo to keep going strong is a successful new console after the Switch. It is now releasing the Switch OLED in October (an upgraded version of the Switch, following the Switch Lite some time ago).

Will the successor of the Switch be a victim of the historical hit-and-miss pattern? It is entirely possible, as Nintendo never stopped taking risks in new control and console design, with unequal results. But I believe the ability of the Switch to replace both the failed Wii U and the successful Nintendo DS shows that Nintendo got better at understanding its user’s expectations. And if the next one fails, the one after should correct the mistake (hopefully).

Retail Stores and Collectibles

Nintendo communicates remarkably poorly on its dedicated stores. After some research, I think I managed to find a grand total of four Nintendo stores, one in Japan, one in Israel, and two in the USA (In New York and Redmont).

For a license with so much potential in the sale of an infinite variety of collectibles, mugs, apparel, and other goodies, this is astonishing.

Source: www.tokyoweekender.com

Of course, Nintendo branded merchandising is available in other places. But the fact that so many avid fans cannot visit a dedicated shop without traveling thousands of kilometers show how neglected this opportunity is. I think the company could easily open 10-50 more shops, basically one per large metropolis, and still be far from saturating the market.

Relaunch & Remaster

The exceptional success of Link’s awakening remake and the Mario pack on the Switchshows the strength of nostalgia. And Nintendo is now acting upon it with notably a release in 2017 of an NES console, back from the 90s.

Not much R&D involves, just repacking old games with new cheap hardware. 4 million copies sold in a year. Not bad…

For people in my generation, a re-release of a Nintendo 64 could be worth forking $100-150, just to remember times with friends, or sharing it with their own kids.

Remasters of games is also an option. Basically, it means taking an old and now ugly game, keep the beloved level design and the gameplay, but upgrade the graphics and improve little details. On PC, the large successes of Age of Empires 2 multiple remasters, or the C&C series prove the existence of a large market. The larger the catalog of such title, the larger chance to turn nostalgic gamers into buyers of the Switch.

IP Purchases and Console Opening

As I said before, Nintendo has a long history of closing its console to outside developers, to preserve quality. But since the 90s, the industry quality standards have evolved for the best. And the tens of millions of consoles sold are a solid argument for developers to look for Nintendo’s approval to publish on the Switch.

In parallel, some PC games have become a must-have for a children-focused console and have been incorporated into the Switch catalog, like for example, Minecraft. I expect an increasing presence of selected third-party games in the Nintendo catalog, especially coming from the PC gaming world. This will increase the sales of new games, but also make more attractive the purchase of a Switch in the first place.

Could the company acquire directly more licenses or game developers? Possible, but as it has not been done in the past and considering Nintendo conservatism, I would not wait for it.

Digitalization

Almost a decade late, Nintendo has finally adopted the method to have user accounts for people to register their games and their consoles. This allows users to keep ownership of what they bought even if the initial machine or disks are lost or damaged. It also encourages people to directly purchase online, a much more seamless experience than having to physically go to the shop to buy a physical game.

Console gaming has always been a bit late at that, but the example of PC gaming,  where virtually every game is available for download on Steam or the Epic Game store show this is the way forward.

Now many investors seem to think this will open the way for Nintendo to start selling more DLCs, more unique in-game items, and so on. Personally, I think hopes of digital sales boosting revenues per user is a pipe dream. It might improve things a little at the margin, but remember, Nintendo does NOT want people to spend too much on a game. The company is focused on keeping people coming back in 5, 10, and 20 years, not squeezing money, as much as possible and right now. And it’s a good thing.

Other Ownership

Nintendo also has partial ownership in other companies. The first one is DeNa, a mobile game developer, the 10% Nintendo ownership is worth $217M.

The second is Bandai Namco, with a 1.75% ownership by Nintendo. Bandai is a private company, but it is estimated that Nintendo holdings are worth around $171M.

More surprising, Nintendo also owns 10% of the Seattle Mariners. Hard to tell again the real value, it is likely to be something around $140M-$300M.

Conclusion About Growth Venues

It is easy to lose track of all the extra things Nintendo does or could do on top of gaming consoles. As I see it, the three most important are the AR gaming potential, the theme parks, and cinematic adaptation.

The first one via Niantic gives Nintendo a lot of control over the leader of the most promising sector in video games. I can totally imagine one day seeing Nintendo smart glasses, powered by Niantic, allowing to play games in the real world seamlessly.

The theme parks have another role in Nintendo strategy, in providing a reliable steady stream of income in an otherwise very cyclical business. Reinforced fans’ loyalty and extra venues for selling merchandising will not hurt either. Letting Universal manage them is probably a good choice, or else it could become a distraction for the company’s management.

Finally, the incoming Mario movie, the potential for a Metroid sci-fi series or an action-adventure Zelda movie cinematic universe is simply unparalleled except by a handful of corporations like Amazon (now owning MGM as well as Lord of the Rings and the Wheel of Time IP) and Disney (including Star Wars and Marvel). I think this growth project could if properly managed, single-handily be worth as much as half of the current Nintendo.

Contrary to Disney’s frenetic and uncoordinated stream of releases, causing quality issues, I will be worried that Nintendo will be too cautious instead. I suspect it will take much longer for it to fully realized its full potential, but also will have a much more enduring impact, instead of risking to alienate long-time fans and damage the IP value.

There are many value creation opportunities here for Nintendo. In order to visualize this, I have created the chart below.

Overall, I like what I see here. I think that all the things that Nintendo is attempting to do with their IP can be incredibly valuable for the company, and its shareholders. The likelihoods of the outcomes are also high, in my opinion.

The biggest risk for Nintendo will be management’s mindset shift. They are very fiscally responsible, so risk of severe loss is limited.

Chapter 3: The Future

Competition

In this report, I mostly glossed over Nintendo’s quality and potential. It is however not without competition. I think that other consoles, namely PlayStation and Xbox are not actually much of direct competitors. Their price range, their offer, and their consumer target are simply too different. Similarly, Apple and Android phone gaming is a completely parallel universe, to the antipodes of Nintendo’s value and positioning.

Much has been discussed lately about the “Switch-like” console planned by Valve for this December. Will it manage to threaten Nintendo’s dominance on the low-price portable consoles?

Maybe, but I doubt it. The main advantage of Valve here is too also owns Steam, the central point for 95% of PC games publishing.

I also think this is the main disadvantage. Most PC games are not designed for a console system, either because of performance or controls issues. Shooters are better with a keyboard, and strategy games without a mouse is a stupid idea.

I struggle to understand what this console will do that a separate controller and an HDMI cable between the PC and the TV cannot do.

If anything, I see this device possibly competing with Xbox and PlayStation for its portability, but that’s all. Add to that the abysmal track record and reputation of Valve with hardware, and I would not worry too much.

In the longer run, the entry of Amazon or Google, with a full streaming offer might be a bigger threat to all the existing actors in the industry. With faster bandwidth, it might become possible to simply let these cloud servers run your game calculation and simply connect online, without buying any console or high-end PC.

Google tried it unsuccessfully with Stadia, but over time, I suspect this will be the future of gaming. Then, the extreme conservatism of Nintendo and its insistence on making its own hardware might hurt.

But by then, I think the proper usage of the IP will have completely changed the company.

The Financials

As I said, I will not look too deep into the quantitative aspect here. But is still good to have in mind the key numbers of the company.

The company made $16B in revenues in 2020, most of it overseas. This resulted in a profit after taxes of $4.3B.

Debt is at $417M, almost non-existent compared to a cash cushion of $10.7B.

The P/E ratio is at 13.3, and price to free cash flow is at 9.9. The dividend yield is at 4.5%. Overall, the market is not pricing Nintendo for future growth and cling to the idea of an outdated, cyclical, and capital inefficient company.

The last quarter has just let some believe these fears were founded, with disappointing results in Q1. I think this is a mix of several factors: a post-Covid cooldown in sales, plus some supply issues with the semi-conductor shortage, combined with no major game release in the quarter. The October release of the Switch OLED should help alleviate any short-term weakness and ensure a good Christmas season.

Nevertheless, Nintendo seems to consider its share price undervalued, with a repurchase of 1.5% of the total shares planned in September. Together with the comfortable dividend, it does not seem like a company unwilling to give cash back to shareholders once the cash cushion for lean years got big enough.

With cyclicality likely to decrease in the future, I consider that a part of the very negative net debt (-$15B on a $54B market cap) should be removed from the company market cap to get the “real price”, probably $5B to $10B.

Chapter 4: Valuation

I decided to use the Discounted Free Cash Flow method to value Nintendo. As the company is likely to keep growing for at the very least the next 10 years, I think this method is rather adequate.

Free cash flow grew explosively in 2019 and 2020, so I will be cautious in using the current numbers. We are at a high with the success of the Switch, and some short-term decline is likely. So, I will give a 0% growth for the next 5 years, and a high margin of safety. Same prudence for the value multiplier.

For the farther future, I assume something will work out to generate some growth, either a successful new console, theme parks, retail stores, movies, or augmented reality. I think any of these could produce a moderate 10% at least growth in cash flow.

This would indicate that with the recent pullback in price, Nintendo stock is quite undervalued. It was also probably a little overvalued at its peak. And this does not even include the abundant cash in the balance sheet.

Now, the worst-case scenario would be no growth in cash flow at all. What if the skeptics are right? What if free cash flow goes down for 5 years and never recovers after? Even then, the current price would almost be enough to ensure a 15% return, and certainly a 10%. Currently, a somewhat disappointing last quarter have depressed the stock price. But the long-term prospects of the company are unchanged.

And last, what if things go really well with some growth in the near term and explosive growth later? Then obviously, the current price is ridiculously low, enough to ensure a 30% rate of annualized returns.

Conclusion

Nintendo is one of these companies that fit very well the Warren Buffett style of investing. A lot of people know its products and business model. It is simple to understand, it is well established and has large moats (IP and market positioning). In addition, the experience of Disney has shown the way on how to monetize dormant IP to both management and investors.

Interestingly enough, Buffett bought 5% of Disney for $4M (yes, million!) in 1966. He then sold it again the year after for a quick 50% profit. Would he have kept it like he did with Coca-Cola, the 5% stack would now be worth $6B, or a 1500-bagger!! Selling Disney is apparently something he regrets dearly to these days.

I think the future for Nintendo is somewhat similar, even if I would be fine getting “just” a 100-bagger from it by the time I retire. A lot of patience will be required. This is the kind of stock to keep forever, and watch grow, will mostly ignoring the market fluctuations, except to buy some more in a period of weakness.

Right now, a prejudice against the Japanese market and Japanese corporate culture block most investors to realize Nintendo’s potential. The perception of Nintendo being “just” a cyclical console company contributes as well.

But really, is a super conservative, cash-savvy, and careful approach such a bad thing in a highly cyclical and unstable industry? Or is it the recipe for long-term success? I think Nintendo culture is in fact its greatest asset, despite being nowhere to be seen on the balance sheet.

It is the super-high quality of its product that keeps gamers coming back for generations. And it is its cautious, borderline obsessive management that will ensure the proper growth of its IP in new carefully crafted masterpieces.

We might never see three or four Nintendo movies hitting the box office every year as we got used to with Marvel movies. But I am confident that most if not all will be what the fans want to see. More in line with the original Star Wars trilogy or Lord of the Ring than Avengers.

And while we wait for the next one, we will be able to visit a theme park, buy some merchandising or download the latest remaster of a classic from the NES, Gameboy, or N64 consoles. On a Nintendo console of course.

The post Nintendo (NTDOY) Stock Research Report appeared first on FinMasters.

Quick Stock Overview

Ticker: IRBT

Source: www.stockrover.com

Key Data

• Sector: Technology
• Sales ($M): 1,541
• Industry: Consumer electronics
• Net Cash per share: 15.42
• Market Capitalization ($M): 2,503
• Equity per share: $29.33
• Employees: 1,267
• Debt / Equity: 0.1

Investment Thesis

The Rising Tide of Automation

One big investment theme of the 2020s will be automation. There is no shortage of sensational headlines about the marvels or devastation that robots and automation will bring to the world economy. Millions labor jobs have already been decimated by robots, and millions more will be replaced in the future.

Source: www.cnbc.com

Source: www.forbes.com

But really, any discussion about automation in any form could do. It can be autonomous cars taking jobs from tens of millions of trucks, taxi and Uber drivers. From people-less factory, (like this in this pretty amazing compilation of videos),automation of clerical tasks in offices, or cashier-less supermarkets, it seems not one job category is safe from the imminent army of robots coming to destroy jobs.

This topic will usually drift to the political, with discussions about capitalism, tech monopolies, Universal Basic Income (UBI), and so on. Everyone will have an opinion, debate heatedly and no one will agree at the end.

All in all, this is a topic where someone can choose to be enthusiastic or pessimistic, but it’s always controversial. And not very fun to think about.

Or is it?

There is one category of “work” that no one would be sad to see gone and done by a robot. One that virtually everybody experiences regularly, and no one enjoys.

Of course, I am talking about domestic tasks. Would it not be awesome to have a robotic butler to take care of everything while you watch a movie on the sofa.

Usually, in science-fiction story, domestic robots are vaguely humanoid and able to talk to us and understand complex tasks. Remember iRobot with Will Smith?

This design can raise some questions about the robots’ real abilities. It is something humans have been wondering about since at least Isaac Asimov robots. From benevolent helpers to merciless killers in Terminator and Matrix, robots are firmly part of our imagination about “the future”.

And maybe we are getting there with Atlas from Boston Dynamics as a notable example. You decide if you find it amazing or scary, I myself have mixed feelings about it.

Never mind the technological complexity or the cost associated with such an amazing machine. Do we truly really want a somewhat creepy human-size robot in our homes, after a lifetime of watching movies about robot uprising?

What people actually want is not so much a robotic butler, but to be freed of the most annoying and menial tasks. Things like cleaning the house, keeping the garden tidy, doing the laundry, etc. How many days of our lives are spent fighting dust and dog hairs, cutting grass, or painting the house?

Would it not be nice to press a button and enjoy our weekends?

This might resonate less with apartment dwellers in downtown rentals, but for hundreds of millions of homeowners in the suburbs, the hassle to keep the house clean and the grass short is a very real annoyance. Add a dog or cat, or a decent sized yard to take care of, and it turns into a never-ending problem.

There is a saying in marketing that “no one buys a drill; they buy the hole”. What matters is getting the job done, not having the most versatile and able robot possible.

The Domestic Tasks Automation

So, what does automation look like for domestic tasks?

Spoiler alert, it is really hard to imagine him as your new robotic overlords. It is even a little bit cute if anything.

Not that impressive right? I mean, I am sure you have heard of Roomba, maybe even considered buying one? Or one of the many clones’ other electronic firms released after, seeing the success of the original product.

I can think of three people close to me that personally own one. We even got my mom one for Christmas last year!

The first versions of the Roomba were frankly limited. Not that smart, not that efficient, not enough battery duration, you name it. But the thing is … it did not matter. Why?

Because the product became a sensation and captured the imagination of overworked and tired homemakers.

If you do not see the point of these devices, just look back at the pictures above. Notice anything? In half of the pictures, there are pets, kids, or both. The first ones will drop hairs … everywhere … every day… The second ones will simply make your schedule busy enough to make vacuuming a hassle. Combine the two, and you have a good description of a very large base of potential customers eager to save precious time and energy. House owner with kids and/or pets.

This report first appeared on Stock Spotlight, our investing newsletter. Subscribe now to get research, insight, and valuation of some of the most interesting and least-known companies on the market.

Subscribe today to join over 9,000 rational investors!

Subscribe Now →

Learn More

Chapter 1: A Solid Core

A Very Solid Brand Name

In technology, there is a strong advantage a being the first at something. and/or dominate the market. This is how a brand became synonymous with an entire concept.

For instance: We “Google” something. Every plastic box is a “Tupperware” container.  Robot vacuum cleaners are simply “Roomba”. A friend of mine has a “Roomba from Samsung” to handle the cleaning of hairs from his two dogs.

The best advantage (or in value investing term, moat) such position will give a company is better pricing power. If an entire class of devices is defined by a brand name, you automatically assume that said brand is the best option.

Others might have special features, or be cheaper, but the “real” one is the most recognized brand. This also gives some free marketing, as each time someone mentions some of these devices, they will mention the brand.

Roomba is a typical example of an early developer of new technology, becoming a namesake for the entire category. The company has been losing a bit of market share lately, but still controls 3-5x more of the market than its next best competitor.

In this industry, there is iRobot, and then everybody else. The only market where iRobot does not have more than 50% of the market seems to be China, which prefers cheaper, locally made models.

Source: www.investor.irobot.com

Does dominant but stable or declining market share mean the company is stagnating? Not at all. The market is growing at 25% or more almost every year, leaving plenty of room for new competitors without hurting iRobot revenues.

Source: www.investor.irobot.com

An Owner Led Company

iRobot was founded in 1990, it still have as a CEO the founder, Colin M Angle. 32 years of steady stewardship really paid off. Mr. Angle is now 53, so he is likely to stay onboard for foreseeable future.

His profile is probably one of the most technical you can find among CEOs. A MIT graduate, he previously worked at NASA’s Jet Propulsion Laboratory where he designed rovers. I can see how this level of advanced semi-autonomous vehicle ultimately translated into iRobot product line. So really, Roomba are just one more innovation that spawned from NASA research and talent pool.

The connection to USA’s public spending goes even deeper, as iRobot designed its first commercial product, the PackBot, with funding from DARPA in 1998. This was following several years of research since 1991 with the Genghis and Ariel robot, first experiment to explore robot abilities to move in the real world. iRobot would then go to develop the first Roomba in 2002.

Ariel and Genghis robots, iRobot first prototypes.

Pack bot at work in the Football World Cup

Financials As Solid as The Brand

In Q1 2021, the sales of iRobot’s vacuums generated $270M.This was  58% growth from Q1 2020! Part of it is undoubtedly  COVID-related, but still very impressive.

On top of that come the newer segment of mopping robots with $33M. And this is not the only new sector the company is expanding into, but we will see that in the next chapter.

Source: www.investor.irobot.com

There are at the moment 19 million vacuum robots in the US, a number that could easily double in the short term, and much more than that in the long run. The growth of robot vacuum is also helped by the digitalization of home, with the latest Roomba made compatible with both Alexa and Google Home.

Just the last quarter, the company generated $29M from operations, adding to its cash treasure chest for a total amount of $500M. This is quite large considering the whole market cap is only $2.5 B. The company have also no debt, so truly, the “real” market cap is more like $2 B.

IRBT’s P/E is now a modest 15, but once corrected for cash on the balance sheet, it is instead 12; something very low for a company with steady growth. Growth was not profitless like so many other tech companies, with net income increasing 15% yearly.

Source: www.finbox.com

Chapter 2: The Growth Ahead

Improvements To the Existing Business

So, we now know how solid the vacuum segment for iRobot and its Roomba is. But is it all the company has to offer? Will it slowly evolve into a slower and more steady technological company that doles out dividends to its shareholders?

I don’t think so. If this was the case, iRobot could still be a good investment, but not an outstanding one. At some point, the vacuum market will be mostly robotized, and growth would stop.

Luckily for us, iRobot management is very open about its plans for the future. One side of future growth is simply to run things more efficiently. Trade wars with China and tariffs have hurt the company’s profit margins in the last few years. This resulted in relocating some of the factories to Malaysia, a costly and slow process getting finished this year.

Higher sales volume also allowed the company to become more efficient in manufacturing and supplying parts.

New Vacuum Products and Offers

iRobot is also extending its product offer, with for example a handheld vacuum for the corners and furniture the robot cannot reach. It is also strongly investing in improving its technology, with  11% of its revenues invest in R&D.

Extended warranties have also finally been offered, something most consumer electronic sellers know to be a good source of virtually free money (they are always overcharged compared to the real cost).

And finally, RaaS, or Robot-as-a-Service, is now a real thing and not a sci-fi movie title. In practice, it is the option to rent instead of buying a Roomba. Considering the high price point can be a deterrence, especially if you are not sure it will work in your home, this should drive up both revenues and future sales.

Source: www.investor.irobot.com

On top of new products comes the progressive adoption of more expensive models. People are (understandably) somewhat reluctant to pay 3-6x more for a robot vacuum than a normal vacuum cleaner.

Here’s the thing: once consumers buy the basic model, they love it. They would never give up the effortless cleaning and all the extra time it creates. But the more basic models might be a little too weak to perfectly clean the carpets? Or, more likely, too dumb to not get stuck in the corner, or avoid the dog’s water bowl.

Once convinced about the product potential, people are much more willing to consider the middle and higher price range if it can allow the robot to do its job without any supervision.

This is exactly what iRobot observed, with premium and mid-tier price range now the large majority of sales, compared to 2016 when adoption was only starting to pick up. Not only the retention rate of previous clients is great, but they tend to buy more expansive models over time.

Source: www.investor.irobot.com

Is The Grass Greener Somewhere Else?

Extension to the house cleaning sector will only bring iRobot so far. There is only so much budget people will put into vacuum cleaners, no matter how smart or practical.

This is why the company is looking for greener pastures (pun intended) in a new sector: Lawn mowing.

Robotic lawnmowers are now where robotic vacuums were five years ago. They are getting more popular, and people are starting to see their neighbors using them, which is instilling consumer confidence.

iRobot is not oblivious to this trend, as the technology is essentially the same, except a lawnmower blade replaces the vacuum system. They had initially planned to launch the Terra robot lawnmower in 2020, but postponed it due to COVID-related delays.

iRobot Terra lawnmower

The company was already in the middle of relocating its production to Malaysia, so risking disrupting even more its supply chain with a new type of device would have been too much.

I imagine easily that management also wanted to see the effect of COVID on sales before risking launching in the largest new market in a decade.

The new launch date for the Terra is not yet decided, and management seems to have become quite discrete about it. I suspect that they used the extra time to do a redesign on the Terra.

Most robotic lawnmowers use a system of cable to delineate the area that should be cut (the grass) and the area that should not (the flowers and bushes). This means that while the technology works, it will not be working for all garden designs. It also means that the initial setup of a robotic lawn mower is quite a hassle, and will take at best several hours, if not days, for the most elaborate gardens.

The most expensive systems bypass this with GPS mapping, but this adds $600-$1,000 to the bill, making it a not so attractive option for most homeowners (it is mostly used currently by parks and corporations).

In comparison, Roomba already uses smarter systems that learn to avoid “sensitive areas” through a process similar to machine learning. If you tell it to avoid somewhere, it will “learn” to do so in the future too. This is already in place for the vacuum models.

The initial design of the Terra was supposed to use wireless beacons, instead of the more clunky cable system. But I imagine that with the recent release of more advanced AI for the home Roomba, the Terra went back to the drawing board to incorporate it and make it truly unique, and the best product on the market.

Because of the 2020 Terra’s cancellation, most comments about iRobot are focused on the vacuum product line. I think this is a mistake, as the return of the Terra, maybe in an upgraded version, is likely to become the next big thing for the company.

The robotic lawnmower market is already growing at 12% a year, despite the offer being far from being attractive: prices are high, setup is really difficult. On top of that, the people the most likely to invest time or money in their garden are the ones with more complex designs and landscaping. And the existing robot lawnmowers simply cannot be trusted to not stray and mow down cherished flower beds and rare plants.

Even with all these limitations, the robotic lawnmower market was already worth $737 million in 2021. If iRobot could capture just 30% of this market (a short target compared to the vacuum segment), it would add around than $221 million of revenue. This would add another 15% to iRobot’s current income and a new source for growth.

Even with troublesome or imperfect geofencing, robotic lawnmowers offer more than just less garden work. They are almost completely silent, which make for good neighbors on Sunday mornings.

Fuel lawn mowers have especially inefficient and polluting engine, to the point that one hour of lawn mowing generate as much pollution as driving a car 100 miles. Robots are in comparison electric, meaning a lot less emissions, something that might get government subsidies in the future. With approximately 20 millions acres of lawn in just USA, this is actually a LOT of pollution right in residential areas.

But I doubt the current robotic lawnmower market tell the whole story.

With the image of quality associated with the Roomba brand and the company’s advances in AI, the market is poised for explosive growth. Especially in the segment of the population the most likely to have been frustrated with iRobot competition. Many of them already using a Roomba indoors for that matter.

As soon as a product they actually can trust gets released, they are likely to give it a try. The Robot-as-a-Service offer recently launched will come in handy for an initial test to convince the skeptics.

Chapter 3: Tumultuous Stock Price Activity

The Short Story

The last year has seen a flurry of speculative activity from both professional and retail investors. None got more attention and headlines than the short squeezes created by a group of Redditors in r/WallStreetBets, managing to corner several hedge funds.

In simple terms, a short squeeze can occur when a fund is shorting a stock and the stock price rise. If it keeps rising, the fund is exposed to margin calls. If it cannot keep covering the rising cost of margin calls, it is forced to buy the stock at any price, pumping it up even further.

Notably, GameStop or AMC have been the most prominent stocks exposed to this. Both were quasi-bankrupted companies whose stock, that due to market manipulations, rose to pretty crazy highs.

What does all this have to do with iRobot? Surprisingly, iRobot fell victim to this shorting scheme early this year.

In January, it rose by as much as 50% in a day. That’s the insanely high black bar on the top of the late January 2021 high in the graph below. Of course, buying at the lowest in the middle of the COVID panic was probably best, but hindsight is 20/20.

The pessimistic opinions about iRobot in March 2020 were the reason for a lot of short interests on the stock. Looking back, I found this article at peak pessimism, that quite literally called the bottom. To sum it up, consensus was negative about tariff-related issues (soon solved with the move to Malaysia), COVID, competition and negative momentum, all making it a “stock to avoid for now”. This article was really a bell ringing for any contrarian looking for an entry point.

Source: www.finbox.com

As you can see, things have calmed down a little since, and the stock price is back to its 2017 levels. To me, this makes very little sense, as the 2021 iRobot is a radically different company than 2017 one.

Here are four things iRobot has accomplished since 2017 that make it a more valuable company today:

• Almost doubled revenues
• Limited exposure to the USA-China trade war
• Increased the value of its customers and brand
• Preparing to take on a whole new market.

But the effect of the short squeeze is for but a moment and the fundamentals are irrelevant to the stock price.

Speculation is seemingly the only game in town these days.

Two Possible Outcomes

Can iRobot stock go even more down, pushed by short-sellers, and abandoned by speculators? Well, obviously yes. Could it go crazy again and explode +50% overnight because it became a meme stock? Yes, again.

Now, you know me, I am not a big fan of crazy speculations and favors instead a steady and “slow” compounding at 15% a year. So, I would never consider iRobot as an investable company based on speculative activity alone.

But as I see it, iRobot is a great growth company that accidentally happens to also be the center of speculative activities. So, regarding the short squeeze situation, I can imagine 2 possibilities:

Possibility #1.

The speculation is over, and less narrative-driven investors will replace the hedge funds and the Redditors battling for iRobot. In this case, everything else in this report still holds, and iRobot is likely to keep growing at 15-20%/year riding the wave of robotization. Even with poor execution from management, this could happen because its market is still growing quickly.

Possibility #2.

The speculation keep going, with wide swings coming in waves. For reference, we can look at how GameStop stock prices have been doing this year. If this is the case, we can expect iRobot to shoot up again at some random date in the future. Then, it will probably be time to sell, cash in a 30-50-100% profit for the year, and come back when things cooled down again.

Source: www.finance.yahoo.com

Is It Still a Company for Value Investors?

I think there is some misconception about value investing when it comes to highly speculated stocks. Key tenets of value investing are to focus on the company’s real value and fundamentals and know to be patient. This causes a lot of value investors to stay away from “speculative” stocks.

But another tenet is to use the unstable moods of Mr. Market to our advantage. If, post short squeeze, other people want to sell us iRobot at a real P/E of 12 and ignore the likely future growth; this is great!

If in a few months, speculation goes rampant again and the stock double, we should enjoy that Mr. Market got exuberant and gave us a 100% yearly return and call it a day.

A value investor does not count on speculation to make him money. He buys businesses below their real value, something made easier by speculation. Most of the time, a value investor return will come from the real-world performance of the business he bought.

And sometimes, speculation will offer him such a high price that he will just accept this gift thankfully and move onto a new undervalued company. Both cases are still value investing, as both cases use the moods of Mr. Market to our advantage.

Chapter 4: Valuation

I decided to use the Discounted Free Cash Flow method to value iRobot. As the company is likely to keep growing for at the very least the next 10 years, I think this method is rather adequate.

With a return on invested capital mostly stable between 13-19% over the last decade, I feel I can trust management to make smart decisions about how to reinvest the free cash flow into more growth. The company still being led by its founder, which is an extra nice element about management abilities.

Free cash flow grew in the last decade by 19% annually. I honestly do not feel that this would change anytime soon, but I picked a lower growth rate just to stay on the safe side. Similarly, the final value multiple of 15 is probably a bit conservative.

Even with a target of 15% rate of return, the stock would be significantly undervalued at the current $88 and have an intrinsic value of $112. Funnily enough, it means it was not overvalued, but just at fair value the day after the highs of the short squeeze. So irrespective of speculative activity, iRobot seems to be a good prospect for a consumer electronic growth stock.

I wanted to see how far the stock returns could go if all the stars aligned and the free cash flow growth continue unhindered. With 15% growth in the next 10 years and a bit more realistic multiplier, this could go up to a 25% of return. Not bad at all!

Conclusion

I have been thinking for a while about how to play some secular long trends. Automation is one trend that will impact us all, like it or not.

We know that many jobs will be automated away. We also know the road ahead will be bumpy, with likely backlash from the general public and/or governments. However, how to invest in automation is not that clear.

An extra problem about predicting the future of innovation is picking the winner. While it was obvious automobiles were going to replace horses, finding which of the thousands of automotive companies was going to become Ford or GM, and which was going to die on the way, was far from easy. Most technological revolutions played out this way, from railroad to cars to internet companies.

So instead of trying to forecast much more complex automation innovations, like self-driving cars, why not do it differently? Let’s find a lucrative, quickly growing niche market where technological issues about automation have already been solved.

A sector with a clear winner controlling 50-75% of the market, and where automation is welcomed and not feared.

The domestic robot market and iRobot seem to be the safest and easiest way to bet on automation, at least on the consumer side. The recent speculative interest is potentially a way to make a quick buck, but the real value of iRobot is in its brand, its growth, and the low multiples at which the stock sells for right now.

With time, components and technology will keep getting cheaper and better, almost guaranteeing the constant growth of the market. With lower prices, the trouble of doing it manually will be less and less worth it, up to the point where even a minimum wage worker will be better off not wasting his time. Corporate use of robot cleaners is also likely to increase.

It is likely that in 10-20 years, all vacuum cleaners will be robotic, and small hand-held devices will be used to finish the trickiest corners. The same is true for robotic lawnmowers. This gives iRobot an addressable market of tens if not hundreds of billions, where its brand will be by far the most recognized.

The future is likely to be robotic, but not so much creepy humanoid robots, but more likely cute little droids roaming around. The same trend is at play for many other customer-facing robots, like food and parcel deliveries.

A friend of mine lives in Estonia, a European startup hub, and no less than two local startups are following the path of iRobot. No one feels threatened either by the Starship Technology delivery robot, roaming around to deliver ice cream or a pizza. Or by the Cleveron parcel delivery robot.

For that matter, the cash-rich iRobot might even look at such startups and use its $500 million cash for acquisition and expansion in further other markets. Or launch its own, adapting the same technology that made the Roomba so efficient.

For now, the tight focus on vacuum and soon lawnmowers is commendable, but five years down the road, I see the potential for further growth in new sectors.

Droids on the roads and sidewalks, and Roomba in the houses and gardens, the workless Sci-Fi Utopia is maybe just around the corner, and we are simply not realizing it…yet…

The post iRobot (IRBT) Stock Research Report appeared first on FinMasters.