Ray Saleeby: I buy stock in companies that are discounted to the intrinsic value of their operations. This differs from growth investing, which focuses on companies that outpace their peers for earnings. It differs from momentum investing, which attempts to time stocks on a short-term basis. My philosophy of value is more long term and contrarian. I buy companies when they are out of favor.
"I buy a lot of utilities because there are tremendous barriers to entry to that sector."
I handle $220 million ($220M) plus, of which about $100M is in the utility and energy industry. I buy a lot of utilities because there are tremendous barriers to entry to that sector. One does not find a gas utility popping up every other week! For the same reason, I like the construction aggregate business. And I absolutely love the water business. It's a resource that we're going to need forever. I also invest in defense electronics and oil and gas. There are also barriers to entry in the drugs and medical device space.
TER: Tell us about your research process.
RS: I have a library of 60,000 different research articles going back 20 years. I subscribe to about 60 different periodicals that provide financial reports and different types of information about various companies. I look at annual reports and presentations by companies. But before I buy a stock, I call up the management and ask detailed questions.
TER: How do junior gas and oil companies fit into this model?
"I like companies that have a first-mover advantage in acquiring developable property."
RS: With the juniors, I take a very hard look at management. Does it have a track record of success? Are the managers personally invested in the firm? Second, I like companies that have a first-mover advantage in acquiring developable property. Clusters of wells provide economies of scale where drilling rigs can easily be moved around. Energy is a commodity business and access to capital is very important. And being a low-cost provider is crucial when dealing with commodities, as we never know when the market will fall. And, last but not least, I want companies that have a good hedging strategy. And for tax reasons, I look toward MLPs (master limited partnerships).
TER: Let's talk about discounted utilities with exploration and development arms. Where are the undervalued opportunities in that space?
"The typical oil and gas analyst does not generally understand how to analyze utility operations, whereas the typical utility analyst does not understand how to value oil and gas assets."
RS: One of the positives about operationally diversified utilities is that they can spin off resource development divisions. Now, a utility analyst is completely different than an oil and gas exploration analyst. With a spin-off, suddenly there are two different types of analysts following two related companies, and the new firm can get double coverage. Secondly, the new managers may have more incentive to produce than they did when they were operating under the parent company's top management. Also, utilities are heavily regulated; spin-offs are usually nonregulated.
The negative aspect of a divestment is that utilities are generally financially stable and can provide a cushion for commodity capital into its development divisions through boom and bust times. And the flip side of a spin-off in the analytical marketplace is that the typical oil and gas analyst does not generally understand how to analyze utility operations, whereas the typical utility analyst does not understand how to value oil and gas assets. So the double coverage can turn into a negative, a discount of real existing value.
TER: What are some promising names in this space?
RS: Questar Corp. (STR:NYSE) is a perfect example. Originally, Questar was a utility that also had a gas exploration business. About two years ago, it spun it off as QEP Resources Inc. (QEP:NYSE), and it's been very successful and is leveraging the resource needs of its parent. Questar supplies natural gas to a lot of customers. It is very competitive with electric and it steals customers that have a choice between electric or gas meters. It is well diversified; its Wexpro division also develops and produces gas for the utility and it is very attractive on its own merits. Another factor to consider is that a lot of natural gas companies are not able to make a profit in the current price environment, unless they are hedged. Some are starting to shift their exploration dollars toward oil, rather than gas, because oil is holding up relatively well relative to gas prices. QEP Resources is well positioned in gas but has recently made a couple of acquisitions in the oil business to help balance things out. It's even buying back its own stock.
An example of a well-diversified company that has not split is National Fuel Gas Co. (NFG:NYSE). It is a combination of utility, pipeline, storage and explorer and producer (E&P) company with, I believe, some of the best assets in the U.S. It has 800,000+ acres in the Marcellus fields close to the New York consumer markets. It's been around for 100 years, it has a good balance sheet, and it has a history of paying increasing dividends. Looking deeper, it had some problems with executing on oil-producing land it owns in California. And it was not able to get a joint partner for its Marcellus field after natural gas prices went down. If gas prices start popping up again, National Fuel could be a takeover target. The Marcellus acreage is extremely valuable and it can be better exploited if natural gas goes higher. Mario Gabelli has a position in the company, as do I.
TER: How hard is it for an exploration company to switch over from natural gas to oil?
RS: Some fields are more attuned to gas, some to oil. It is hard to get out of leases to switch over from one to the other resource. And drilling crews have to be shifted around, which is expensive. But there's a glut of gas right now in a lot of different markets. And that's one of the reasons why the MLP sector is a very attractive sector going forward.
TER: How do MLPs work?
RS: Master limited partnerships are structured so that income flows directly to the investors. It is not double taxed at the corporate level. Investors receive K-1 forms versus 1099 forms for their IRS tax returns. However, it is advisable that you really know what you're doing before diving into a complicated MLP arrangement. MLPs may not be suitable for all investors.
TER: What other utility-centric natural gas companies provide good value for investors?
RS: Enbridge Energy Partners L.P. (EEP:NYSE) is an MLP. It operates one of the largest pipelines and brings Canadian tar sands oil into the United States. It enjoys great access to capital. It is a very well managed company. It has I-units, which allow investors to reinvest dividends and receive a 1099. It's a unique investment for the long term.
Energen Corp. (EGN:NYSE) is a small utility in Alabama that runs a large exploration company in the Permian Basin. It is currently out of favor in the market—discounted to its asset value. It is very conservative. It hedges a lot, and has 30 years of dividend growth. It uses the dividend income from the utility to grow the oil and gas exploration and development business. It's a good value find.
TER: Why is Energen discounted?
RS: As a combined utility and oil and gas exploration company, it is subject to the kind of analyst misdiagnosis I explained earlier. But Energen's cash flow and its EBITDA are cheap comparable to its peers. It has proven reserves. Management is competent, even though it just reported a disappointing quarter: gas prices plummeted and the firm was not as well hedged as it had been previously due to expirations.
TER: Is there a limit on the supply of natural gas?
"Some say that the U.S. is the Saudi Arabia of natural gas. But the real question is: Is the existing supply an economic supply?"
RS: Some say that the U.S. is the Saudi Arabia of natural gas. But the real question is: Is the existing supply an economic supply? Companies simply cannot make money exploring for gas at the current price. Capital is moving into oil. Sufficient cash is not spent on the necessary infrastructure, such as storage and transportation, to take the gas to the domestic consumer and to international ports for export. The other problem is that it takes a while for utilities to shift over from coal to natural gas. Facilities are being built, but it takes time. On the upside, there are transportation uses for gas, especially for heavy trucks and commercial vehicles and government vehicles. Incentives are needed to support that transformation. The more these gas-dependent industries develop, the higher the price of gas will rise, providing more capital for more infrastructure and development. But a lot of E&P firms are keeping the gas in the ground for now.
TER: Are there any energy holding companies that reflect your investment model?
RS: MFC Industrial Ltd. (MIL:NYSE) is a company that has done phenomenally well. A $1 investment in MFC a little over 10 years ago is worth $6.50 today. It's averaging a 20% compounded return. MFC is a true value investor. It turns energy and resource companies around and monetizes them. It recently bought Compton Petroleum. The management is very shareholder oriented; executives own a large stake in the company. It is a small firm, but it sources and delivers commodities and resources throughout the world.
South Jersey Industries Inc. (SJI:NYSE) is a utility in New Jersey. But probably 30% of their business is nonregulated. An investment of $6,000 in 1985—with reinvesting the dividends—would now be worth $720,000. Management has just been top notch in creating shareholder value.
TER: To conclude, are any of these firms looking at renewable energy development?
RS: South Jersey is involved in solar. But with the revolution in cheap natural gas, a lot of the solar and wind ventures have been put aside. A few decades down the line, solar is going to be the solution. The world has an abundance of sun! There are, however, cost and efficiency problems with solar and wind due to storage and transmission of power. Alternatives have a role in the future, but we have an abundance of natural gas at this time.
TER: Thanks for speaking with us, Ray.
RS: Likewise.
Ray Saleeby formed Saleeby & Associates Inc. in 2001 after 15 years working with brokerage firms such as R. Rowland Co. and Forsyth Securities. Saleeby published a newsletter between December 1987 and May 1996 that received national attention. Articles written about him and his recommendations have been published in USA Today, The Wall Street Journal, St. Louis Post-Dispatch, St. Louis Business Journal and other periodicals.
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DISCLOSURE:
1) Peter Byrne of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: Enbridge Energy Partners L.P.
3) Raymond Saleeby: I personally and/or my family and/or Saleeby & Associates Inc.' clients own shares of the following companies mentioned in this interview: Natural Fuel Gas Co., Questar Corp., QEP Resources Inc., Enbridge Energy Partners L.P., Enbridge Energy Management LLC, Energen Corp., MFC Industrial Ltd. and South Jersey Industries Inc. I was not paid by Streetwise Reports for participating in this story.
