Tag Archives: stocks

Will Santa Claus Bring Volatility?

Summary Historically, the holidays provide a brief period of decreasing volatility. This December is filled with unknowns. These unknowns will determine whether stocks finish naughty or nice this year. Hello everyone, I hope you have been doing well. Volatility has turned its head again and is close to backwardation. The purpose of this article is to examine past volatility events and determine the likeliness of a prolonged period of backwardation here. For the basis of discussion, we will use the iPath S&P 500 VIX Short-term Futures ETN (NYSEARCA: VXX ). During the last spike in volatility, VXX performed well and has still not touched the previous lows set in August, see below: (click to enlarge) Historically, this time of year bodes well for inverse volatility products such as the VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ: XIV ). However, this year, the Santa Clause rally has a Federal Reserve rate hike to deal with. The last spike in volatility came on the back of a decision by the Federal Reserve not to raise interest rates. This was taken as a weak sign for the U.S. economy and investors seemed happy to sell off shares to mark the first real correction since 2011-2012. This spike in volatility created a long period of backwardation, see below: (click to enlarge) Now it appears that solid jobs data has put the Federal Reserve back on track for a December rate hike. Financials rallied for a couple of sessions but have since given back the bulk of their gains after news of new capital rules. Retailers were hit hard after very weak guidance from Macy’s (NYSE: M ). Oil stocks continue to take a beating due to stubbornly high inventories and a very strong dollar. What does all this spell for volatility? A very interesting holiday season. Remember back to the article where we discussed the two types of volatility events. You have economic events that drag out over longer periods of time and you have political events that tend to be very short lived. Volatility markets are now struggling with economics. Even though the market recovered, volatility has remained elevated from the ultra-low numbers we saw in the first half of 2015. Volatility investors are becoming more fearful that the U.S. economy may go from slow growth to none at all. Judging by the jobs numbers, the U.S. economy is doing better than most have expected it to. It is going to be a very competitive holiday season for retailers and a warning from one company does not spell doom for the entire industry. After Macy’s warned on traffic, most online retailers remained unchanged. Wal-Mart (NYSE: WMT ) has even changed course and opted to offer almost all of its Black Friday deals online. Times change and industries must change as well to remain competitive. What to Watch For I have three things on my volatility radar right now. Retail sales and the Santa Claus rally deserve to be recognized this time of year. Typically, a positive start will result in subdued volatility. Will online retailers more than make up for slow foot traffic? I believe the answer is yes. Score one for Santa. The mid-December possible government shutdown. I absolutely hate gridlock in politics and government shutdowns really aren’t the image we want to portray. But, those events were some of the easiest money ever made on volatility trades. Here’s a look at VXX during the last government shutdown: (click to enlarge) Score one for volatility. All eyes will be on the Federal Reserve’s December meeting. To hike or not to hike. I believe over the next month or so, the market will price in a hike in rates only leaving the possibility of disappointment in not getting the rate hike they were expecting. Score two for volatility. Conclusion My scorecard shows a higher chance of volatility than we typically see this time of year. If volatility begins to enter overbought conditions by the beginning of December, I will be looking for a short-term short position in VXX or a small long position in XIV. Keep your eye on the ball and wait for an event to play out before you jump in too soon or chase after something that is already gone. It is important to analyze the situation as it develops. We saw during the last volatility event how trigger-happy investors are right now and we could see more of the same should conditions worsen. This should be in your volatility game plan. Thank you so much for reading and for more information on timing the VIX, volatility ETFs, and related volatility education, please check out my library of articles here on Seeking Alpha .

Northwestern Corporation: Great Business Fundamentals

Summary Montana has a healthy, stable population that pays its utility bills. Hydroelectric generation acquisition changed the company for the better. The acquisition did increase leverage. Debt is manageable, but free cash flow should go to paying down debt. NorthWestern Corporation (NYSE: NWE ) is an electricity and natural gas provider that serves the energy needs of hundreds of thousands of customers in Montana, South Dakota, and Nebraska. Unlike many utilities that have diversified into non-regulated activities, NorthWestern remains a pure-play regulated utility. Management has been wise, making strong moves to diversify away from coal-fired generation in a bid to lower regulatory risk. In turn, investors have rewarded this move, with shares returning roughly double the return of the broader utility index since the September 2013 announcement of the purchase. Will this long-term outperformance continue? Renewable Energy Diversification Those that have followed my work know that I have been especially critical of utilities that have not begun to meaningfully diversify away from coal, shifting power generation into cleaner plays such as natural gas and hydroelectric generation. Coal will continue to play an important, but shrinking, role for most utilities in providing stable energy generation for some time. We all know that sometimes the wind doesn’t blow or the water doesn’t run. But its days of dominance are numbered and utilities must position themselves for a future where coal is not the primary source of power generation, primarily due to continued pressure from environmental regulation. From what I’ve found, utilities in the Midwest have been especially guilty of ignoring renewables. NorthWestern Corporation, operating right next door to many of these slow-to-adapt utilities, has not been ignoring industry trends. The $900M acquisition of eleven hydroelectric facilities from PPL Montana was a game-changer for the company, shifting more than 50% of available base-load generation to renewable water and wind. Hydroelectric is a great source of power for utilities to meet light-load requirements on most operational days. There is no fuel cost to worry about, which reduces operational headaches, and the assets are obviously quite clean when it comes to greenhouse gas production and waste. Best of all, NorthWestern got these facilities for a steal of a price. Montana In Focus The vast majority of NorthWestern’s earnings comes from its Montana operations. When you think of Montana, you probably think of something like this: ‘ * Wildnatureimages.com This honestly isn’t too far from the case. Montana is a vast state, with low population density and a high concentration of people over the age of 65. However, this doesn’t make it a poor market for a utility. The unemployment rate has remained under the U.S. national average for many years (currently at an incredibly low 4.0%), and population growth remains stable. * NorthWestern Energy Investor Presentation Along with this, bad debt write-offs for NorthWestern are incredibly low, even during the recession where you would expect a jump in defaults. With more than 80% of Montana revenue coming from residential customers, low unemployment and bad debt write-offs creates a situation of high stability and predictability when it comes to company earnings. For utility owners, this should be far more important than chasing growth potential. Steady as she goes is the name of the game. Operating Results (click to enlarge) Electric operations revenue growth has accelerated, especially for full-year 2015, due to approval of increased rates related to the hydroelectric acquisitions that have come into effect. Gas operations revenue has fallen, but like with all natural gas utilities, this is a function of the underlying commodity price rather than a lack of demand. As natural gas prices have fallen, the cost of gas passed along to consumers as part of rider agreements falls as well, resulting in lower revenue. Investors should remember, however, that NorthWestern’s fixed margin per unit of gas sold remains the same. Lower gas prices mean higher gross and operating margins for the natural gas division, which we can see coming down in 2015’s estimated full-year results. (click to enlarge) As I usually do with utilities, I look to see that operational cash flow can cover capital expenditure requirements and dividend payments. If not, the utility is likely stuck in a cycle of taking on debt to cover its obligations. For NorthWestern, total cash flow from operations will grow greatly in 2015, eliminating some of the slightly larger deficits we saw in 2013 and 2014, likely a result of larger capex requirements for its new hydroelectric facilities. Overall, leverage for NorthWestern has gone up as a result of its hydroelectric and wind acquisitions, which cost a touch over $1B. Total long-term debt now stands at $1.8B, putting its net debt/EBITDA ratio at around 4.5x, which is on the high side but manageable for the time being. Management here has been traditionally cautious – all of NorthWestern’s debt is non-callable, long-term fixed rate debt. The company does have $455M of debt coming due by 2019 ($150M 2016, $55M 2018, $250M 2019), which it will have to refinance. I’d expect this to price around 4.5% on mid-term extensions (coming due in 2030) which will actually reduce the company’s interest expense somewhat given the 6%+ coupons these issuances have carried. Conclusion Overall, NorthWestern is a well-run utility. Management seems to be taking all the right steps and the 3.75% annual dividend yield is solid. 12.5x ttm EV/EBITDA is on the high side, but the company likely carries a premium given the strong growth performance and future earnings profile. I wouldn’t be a buyer at current prices, but I’m keeping the shares on my watchlist.

Targeting 35% Upside For The AES Corporation

Summary We are adding the AES Corporation to our “buy” list. Both the fundamental and technical analyses indicate a potential for a 35% gain over the next few years. The key risk is our assumption that cash flows do not materially deviate from their long-term uptrend. Introduction The AES Corporation (NYSE: AES ) has been exposed to a number of headwinds recently, most notably falling energy prices across the globe, rapidly appreciating U.S. Dollar and weak demand coming from the emerging markets, particularly Brazil, Argentina and Colombia. The most recent negative surprise was the Q3 revenue miss of as much as $1.5bn, which prompted the management to revise down their 2016 earnings guidance below analyst estimates. Cost cutting measures have been put forward to offset the macroeconomic headwinds by 2018 and we see them as a necessary adjustment. It is difficult to judge whether they work out as planned, but it is encouraging to see that the leadership is taking the appropriate steps to keep the business viable. Furthermore, Andres Gluski (the CEO) emphasized their focus on free cash flow as a source of shareholder value, and we believe that this is an appropriate measure for estimation of AES Corporation’s long-term investment value. Valuation Our valuation model for AES is based on the company’s ability to generate cash. The key measure of cash flows that we use is free cash flow, which is the total cash inflow from operations minus the dividends and capital expenditure outlays. This is effectively the amount of “excess” cash that the company is making and therefore accruing to its lenders and shareholders. While we do look at historic cash flows, cash flows projections are of crucial importance because markets are forward looking. Our estimated cash flows for the next 10 years are simply based on the previous trend, as we do not have access to analyst estimates for AES. After 10 years, we assume that the growth rate of cash flows falls back to its previous trend and remains on it for the next 10 years, after which it normalizes towards the sustainable rate of 3.9% per annum, based on the average real GDP growth over the last 15 years and the average inflation rate of 2%. The chart below shows the historic (blue line) and projected free cash flows (red line). (click to enlarge) To calculate the total value of the firm, we discount the projected cash flows and the company’s terminal value by its weighted average cost of capital ( OTC:WACC ). Our estimate of AES’s cost of debt is 7.28%, based on their interest expense and amount of debt outstanding in the last fiscal year. The cost of equity is calculated using the 10 year treasury yield as the “risk-free” proxy plus the implied equity risk premium of 9.13% times the historic beta of 1.1675 for the stock. Some of the other key metrics summarized below: •Beta = 1.17 •ERP = 5.98% •Cost of Debt = 7.28% •Cost of equity = 9.13% •Debt to Assets = 54.45% •WACC = 7.73% •Current Price = $9.9 •Fair Price = $26.52 (167.9% return) After discounting the projected free cash flows and the company’s terminal value in 10 years’ time, we subtract the current value of debt and arrive at the total equity value of 17,887,985, which equates to $26.52 per share. With today’s share price at $9.9, re-pricing towards the estimated fair value would require a return of 167.9%. The green line in the below chart represents the estimated “fair value” per share, with the dashed lines showing the upper and lower bounds of the confidence interval based on stock’s volatility. (click to enlarge) Relative Valuation American Electric Power Company (NYSE: AEP ), Pinnacle West Cap. (NYSE: PNW ), Firstenergy (NYSE: FE ), Nrg Energy (NYSE: NRG ), Consolidated Edison (NYSE: ED ), Cms Energy (NYSE: CMS ), Dte Energy (NYSE: DTE ), Entergy (NYSE: ETR ), Nextera Energy (NYSE: NEE ), Dominion Resources (NYSE: D ), Xcel Energy (NYSE: XEL ), Exelon (NYSE: EXC ), Ppl (PP and), Pg&E (NYSE: PCG ), Pub.ser.enter.gp. (NYSE: PEG ), Edison Intl. (NYSE: EIX ), Southern (NYSE: SO ), Teco Energy (NYSE: TE ), Pepco Holdings (NYSE: POM ), Eversource Energy (NU) are AES’s closest peers within the S&P 500. The table below can help us understand AES’s valuation in relative terms. Table 1: Relative Valuation Table, S&P 500 peers AES AEP PNW … Median Lower Quartile Upper Quartile PE 11.60 15.10 17.20 … 16.90 13.23 20.50 PC 2.48 6.31 6.33 … 6.31 4.81 6.83 PB 1.63 1.58 1.57 … 1.61 1.56 1.75 ROE 17.02 10.13 9.46 … 10.13 9.08 11.51 EPS Growth (5 year) -1.03 2.39 39.79 … 1.03 -1.73 6.80 Beta 1.17 0.58 0.72 … 0.59 0.55 0.69 AES Corporation benefits from very low price multiples, which indicates that the bad news are already in the price. price to earnings ratio of 11.6x is below the lower quartile for the group (13.2x). The same is the case for the price to cash flow and price to book multiples, currently standing at 2.5x and 1.6x, respectively. (click to enlarge) Even more importantly, the price to book ratio of 1.6x looks very attractive in the context of the return on equity of 17.0%. The chart above shows that this makes the company look significantly undervalued relative to peers, given the current industry relationship between this price multiple and underlying profitability. The stock looks attractive from the technical perspective as well. While in the short term the price could fall to as low as 8.6%, a failure to break below this level would confirm the wedge-like formation in play, targeting roughly 35% upside, depending on the timeframe. While a potential break below the support would imply further short term weakness, we see current price as an opportunity to buy due to the 2.5 times greater upside. Of course, if rate hikes in the U.S. push the U.S. dollar higher, investors will need to exercise more patience until the target is reached. (click to enlarge) Conclusion In summary, the company leadership has already taken action to counter the unfavorable impact of macroeconomic developments across the globe. The cost cutting measures that are aiming to support the free cash flow generation through 2018 may or may not work as planned, but investors should focus on risk management and diversification rather than crystal ball gazing. Our discounted cash flow model indicates roughly 35% upside (the lower end of the fair value range, the conservative target), which is also supported by long-term technicals. AES Corporation looks significantly undervalued relative to peers as well, thereby ticking all our boxes. As a result, we are adding this stock to our “buy” list today.