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Finding Value in an Economic Tsunami

(Guest Commentary by Rick Konrad – March 18, 2011)

Dear Subscribers and Readers,

For those who want to learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have brought in Mr. Rick Konrad to pen a guest commentary.  Rick has been our regular guest commentator for several years and offers his unique insights to us twice a month.  We highly appreciate your investment insights and general wisdom, Rick!

In this commentary, Rick again discusses the impact of the recent natural disasters in Japan, and the potential investment implications, with a focus on the energy industry.  Rick also discusses in detail three companies/opportunities that supply the solar industry, as well as a quick discussion on the importance of developing a smart grid.  Without further ado, following is Rick's biography:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator on (please see “Innovation and Creating Markets – What to Look for” for his last commentary).  Prior to his founding Value Architects, Rick was a professional portfolio manager for institutional investors for over 25 years.  A more complete profile of Rick is available on his blog.  You can also email Rick at the following address if you have any questions or thoughts after reading his commentary.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Rick has also run the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had graded CFA examinations.

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.

“The happiness of most people we know is not ruined by great catastrophes or fatal errors, but by the repetition of slowly destructive little things.”

What a tough market it has been. Earthquakes, tsunamis, nuclear catastrophe, a shell-shocked Japan that clearly has a deflationary impact on Japan…consumerism collapses under these circumstances.  The stock market has given many believers a great deal of doubt. What is the collateral damage to the global recovery? Are we potentially facing an economic tsunami?

Part of the economic confusion arises from the very size of Japan. The repercussions of a Caribbean island being wiped out have huge social and tragic human consequences, but barely any global economic impact. This is entirely different. Japan is the world's third largest economy by Gross Domestic Product (GDP), behind only China and the United States. 

Country Size of Economy as measured by GDP (in $ billions)
United States 15,157
China 6,422
Japan 5,683
Germany 3,358
France 2,590
Source:  International Monetary Fund, October 2010

For additional perspective, we need to look at Japan's importance historically versus its current standing. Japan's gross domestic product has shrunk as a share of global output from about 18 percent in the mid-1990s to 8.7 percent last year, when it lost its rank as the second-largest economy to China. Nevertheless, Japan's economic stability, and the purchasing power of its government and citizens, plays a critical role in the ongoing global economic recovery.  Japan's economy was far from stable prior to this earthquake and is anything but stable afterwards.  Early estimates put the potential losses from the natural disaster at the 14-15 Trillion Japanese Yen level – that equates to approximately 170 - 183 Billion U.S. Dollars!  This will likely force the Japanese Government, working with the Bank of Japan, to take a number of actions; call it QE3 Japanese style. Efforts will include buying assets, keeping interest rates low and maybe even raising taxes, in order to maintain liquidity in their markets and pay for the non-insured damage.

Most reinsurers are still reeling from the New Zealand quake, yet it seems that many have simply not found reinsurance rates in Japan sufficiently lucrative to attempt underwriting. Somebody's going to get hit but at this point, it appears to be primarily European and Japanese companies.  But ultimately, significant burden will fall on the Japanese government.  These necessary expenditures may limit the Japanese Government's willingness and ability to purchase further U.S. Treasuries which could then impact our own economic recovery efforts.  It won't be pretty.

However, putting aside for a moment these concerns as well as the horrendous human toll of the 4th largest earthquake on record since the 1800s, there are also potential short-intermediate term positives that may come from this negative event.  Behind every cloud, and believe me, I am not attempting a clever pun here, there is some silver lining. What potential positives come out of this kind of a mess?

  1. Recoveries from natural disasters have generally been positive over the intermediate term for the affected economies due to the reconstruction work necessary and the job creations that result from the rebuilding efforts.

  2. The crisis in Japan could alleviate some of the recent supply pressures related to the price of crude oil as Japan is one of the world's largest importers of oil and may reduce their oil needs temporarily as it absorbs this tragedy.  Oil price pressures have also somewhat relented somewhat as of late as the threat of further “government protest contagion” seems to have slowed in the Middle-East (though tensions clearly still exist in Libya).

  3. The recent events in Japan and the Middle East should force Washington to re-visit our own country's short and long term energy plans in terms of their effectiveness and viability. Can natural gas and alternative energy focus develop in Washington?

  4. Many investors seem to be using these recent macro-shocks to perhaps take some profits, from a Bull Market that just reached its 2 year anniversary, off the table. Every correction is a great opportunity to re-visit one's asset allocation strategies in an attempt to potentially add more diversification to one's portfolio.

In the spirit of our quest for innovation as an economic driver, we have a few suggestions for the alternative energy sector.

Considering solar energy, there are many significant headwinds. Most importantly, prior to nuclear concerns, changing policies and government support for solar systems in general had been dwindling. We've already seen the governments in some key European markets, such as Germany and France, make some adjustments to their policies for 2011. Germany has just negotiated additional midyear cuts to their feed-in tariff or subsidy programs, and France (in December) had instituted a three-month moratorium on these solar projects while they work out some changes in policy. To be optimistic, there may well be policy adjustments as a corollary of more strident nuclear policy. But should these not occur, there have been many announcements and plans for manufacturing capacity expansion in 2011.  This continues the trend from 2010 and there is hence a pretty high likelihood that oversupply conditions will resume sometime this year. Rather than considering solar companies, it may be more practical to consider some of the suppliers to the solar industry, as well as companies that are involved in “smart grid” technologies. Here are a few ideas.

Power-One (PWER)

Power-One makes power supplies that include inverters, AC/DC converters, and voltage power switchers. Its Renewable Energy unit makes Aurora-brand inverters for use in wind and solar plants, along with related infrastructure products. Its Power Solutions business unit offers the company's traditional power conversion, network power, and digital power products, which are used in wireless communications, optical networking, data storage, industrial, and other gear. The company sells more than 2,500 types of power supplies, mostly to original equipment manufacturers. More than half of sales come from Europe; North America accounts for another 25%.

In our view, inverters are becoming the brains of the solar installation and will eventually become part of an improved grid system in many countries. We believe that these requirements will allow inverter manufacturers to continue to add functionality to their products, mitigating the downward pricing pressure that we expect for the solar industry in general. As well, we see the inverter industry to evolve into a consolidating industry where a few suppliers will dominate the worldwide market share.

2010 was an unprecedented year for Power-One. First, the firm recorded over $1 billion in revenue in 2010, up from $432 million in 2009, a 140% year-over-year increase. Second, the firm established itself as a number 2 manufacturer of PV inverters, moving up from ninth place in 2008. The company is expanding geographically into a greater presence in North America and Asia.

As we mentioned, the changing laws in Europe may result in some problems. Though there are some near term concerns about an inventory build-up of inverters in Europe, according to IMS Research, the service markets for inverters will grow five-fold over the next five years. 2010's near-perfect conditions of generous European subsidies and supply-chain bottlenecks are over. But PWER's current market cap of $880 million includes about $225 million of cash and just over $50 million of debt. We do not believe that well-established solar competitors such as PWER are risking sunstroke.

A majority of PWER's sales in the past several years had been to companies in the communications infrastructure industry, and had been highly cyclical; hence, management has considerable experience in handling downturns. This smaller “Power Solutions” business representing some 20% of sales could potentially be sold.

Though there is no dividend, the firm has announced a ten million share repurchase program over the next two years. Who can blame them? EV/EBITDA is a miserly 2.66 times. If Wall Street doesn't care, it doesn't mean the rest of us shouldn't.

Siemens (SI)

Siemens, as one of the largest global electronics and industrial engineering firms, is streamlining its primary business divisions to include Industry, Energy, and Healthcare. As a conglomerate, its operations encompass automation and controls; building technologies; motors and drives; lighting; transportation; power generation; transmission and distribution; heating and ventilation; financial products and services; security products; and diagnostic and imaging systems. Its energy-related products range from oil and gas conversion to wind farms.

Osram, its lighting subsidiary has expertise in LED lighting. There have been rumors of a potential spin-off of Osram. Siemens' Drive Technology division is a world leader in producing energy efficient motors for production machinery and factory automation. Almost 50% of Siemens' operating profits come from energy (for its most recent fiscal year) with about half of that division's profitability derived from renewable energy, power transmission and power distribution.

Global investment in clean energy has risen by 30% year-on-year, reaching a total of $243bn according to Ernst & Young. China has consolidated its position as the most attractive country globally for renewable energy development; however, there are significant disparities between countries, and uncertainty over political support persists.

Perhaps greater reliance can be placed on developments in smart grid technology. The current electricity grid is a passive one—electricity flows from utilities to consumers with limited real time data about power quality, network conditions and demand profiles. The ‘smart grid' consists of a group of automation and networking technologies that will provide the electricity network with real time two-way energy and information flows between utilities and consumers, as well as reliability controls and restoration mechanisms, required to efficiently manage supply and demand across large regions. The majority of this technology already exists, but it is used in isolation; the key technical challenge being integration and engineering, not R&D. We believe that Siemens is very well positioned to participate in the growth of smart grids globally. Siemens is active in three areas of smart grid : 1) Smart meters; 2) Grid intelligence; 3) Utilities IT. Another area where Siemens is also doing some startup investment is Electric Vehicles, through its eCar team.

The company generated over €6 billion in free cash flow last year and has established a 15% return on capital goal, a lofty hurdle above its current 7.5% level.

Siemens yields 2.0%. Siemens Energy has the broadest technology portfolio of any large power generating equipment supplier and hence, it is very well positioned to benefit from increased investment in non-nuclear power generation. Given the Japanese nuclear horror, Western politicians are changing their stripes quickly and forgetting last year's pro-nuclear bleating. The generating plants of the western world are generally very old, very dirty, and require replacement not maintenance. A prolonged period of rising investment in non-nuclear power is looking like a strong likelihood.

Telvent (TLVT)

Telvent is an information technology and industrial automation company specializing in SCADA (Supervisory Control and Data Acquisition), GIS (Geographic Info Systems) and related IT systems for pipeline, energy utility, traffic, agriculture and environmental monitoring industries.

Through the delivery and integration of real-time business intelligence, its solutions enable clients to make better decisions as they manage vast infrastructure and complex daily operations. As an example, Telvent systems now manage more than 60 percent of the total hydrocarbon movements in North American and Latin American pipelines. These systems monitor flow and detect leaks. The company started process control engineering, the core of its energy business in 1963 which now represents over 30% of its revenues.

The Telvent energy division's specialized utilities team has been delivering industry-specific applications and support services for utilities since 1980. In the U.S., there have been more than 250 successful project completions. Through this experience, Telvent has gained understanding of the particular requirements of electric utilities. Telvent is able to meet the needs of utilities, including accessing and updating operational data from a variety of locations, and making that information available at a number of different levels of the enterprise to facilitate the decision making process. Telvent's advanced data management can be integrated with SCADA, GIS and OMS Responder, its specific tool for managing power outages. It enables real-time electrical distribution grid control, thus increasing energy efficiency.

Headquartered in Spain, Telvent does more than two thirds of its business outside Europe. Revenues and earnings grew at about a 20% compound growth rate over the last five years. The company has had operations in China and the US since 2003.

Telvent DTN, its agriculture information subsidiary reaches the majority of all major grain and livestock producers in the U.S., and has a leading position with agribusinesses, commodity brokerages, and grain originators providing critical market intelligence to companies such as  Cargill, ADM, Kraft Foods, Frito Lay, Anheuser Busch, for price risk management decisions. This is a highly recurring revenue model.

The company has successfully negotiated some smart grid and utility management contracts worldwide of significant strategic importance, serving as a global point of reference, such as the case of Fortum in Finland, Guizhou Power in China, and Progress Energy in the U.S.

Intelligent Transportation Systems leverage electronics, communications, and IT to improve all facets of transportation. ITS technology improves efficiencies around traffic flow, transportation safety, roadway hazards, traveler mobility, and traveler convenience, among other aspects. ITS at Telvent also serves other forms of transportation, including air travel, railway, and maritime industries. .

Consensus earnings for Televent for 2011 are $1.83 for a PE multiple of about 14.7 times. At an EV/EBITDA, TLVT is trading at 9.3 times. I suspect that smart grid management will become an ever more important aspect of correlation and control for a utility.

In closing, we remind readers that our baseball coach was right. You are certainly guaranteed not to hit the ball, if you aren't in a ready position with your bat. Volatility that instills fear often provides opportunity but only for those who are ready for the fat pitch. The most destructive habit that investors demonstrate is failing to get themselves ready when those inevitable changing tides hit. Let volatility be your friend.

Disclaimer: I, my family, or clients own positions in PWER, SI, and TLVT.

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