With our 5 D's series at an end, here are four securities that fit the framework. The securities are; ExxonMobil (XOM.NYSE), Enbridge (ENB.TSE), Advantest (6857.TYO) and Rio Tinto (RIO.ASX). IntroductionThis week we finish the series on the 5 D’s by translating our thesis into investable ideas. Feel free to refer to our previous 5D articles to fully understand why these companies are set to capitalise. 1. Debasement (Inflation): We discussed the current economic climate and why it is not similar to the 70s stag-flationary environment. We particularly focused on how current monetary/fiscal policy affects inflation. And how debasement affects energy markets. 2. Debt: We looked into debt on a global and domestic scale, and why it is misunderstood. 3. Demographics: How a growing and increasingly ageing population has implications on global economies and a company that benefits. 4. Deglobalisation: Given Putin's recent weaponisation of the energy supply to the EU, our fourth D looked into how a shift in global supply chain frameworks effects businesses moving forward. 5. Decarbonisation: Our final D analysed how the politicisation of energy markets in recent years affects markets and why investors should be aware of the consequences ExxonMobil (XOM.NYSE)NYSE-listed XOM has been a pleasant experience for investors this year in a sea of red, returning above 60% over the past 12 months. Exxon continues in our view to be a reasonable risk-reward proposition assuming our base case scenario of peak oil as the global economy continues its de-carbonisation trajectory. The name of the game here is cashflows. This is a pure-play exposure to the black gold since the company's strategy has been to steer clear of diverting investment into renewables, unlike its peers, and remain committed to Oil & Gas. While this may not necessarily win the business applause from the ESG-minded investors, the company seems to be ticking the boxes in bringing greater diversity to the board as well as implementing carbon intensity reduction targets. What is interesting to us about the business is the companies culling of previous aggressive spending plans (to the tune of 30%) annually for 2022-26 while keeping the dividend safe. In essence, this business rather than focusing on new supply has a clear strategy to focus on high-margin volumes such as Guyana, which at peak will produce more than 850 thousand barrels while letting the North American assets decrease gradually. This allows the business to fit in with the notion of taking advantage of higher prices and focusing on cost-outs in preference for returning cash to shareholders. On the latter front, XOM has set a plan to more than double from 2019 earnings by 2027. Looking downstream to the chemicals segment, margins continue to increase as key catalysts come through for its higher-value lubricants and diesel segments. Looking purely at the numbers, we expect earnings per barrel to increase to $14.50/bbl at $75 USD/bbl, which remains at the lower end of the target price range. This combined with relatively low debt on the balance sheet and CAPEX reductions (net debt/capital under 30%), bodes well for the dividend-oriented investor. Looking to the future, a reasonable projection for the company that can be achieved is $120 USD per share, assuming a 95 USD/ppb with an EBITDA forecast (at this level) of $85 Billion USD for 2023. To Sum Up: A concentrated exposure to the spot price and a yield play. We like the fact that the company, unlike many of its peers, is not transitioning to renewables (where it lacks the competence or expertise) or bringing on new production. We think that it pays for shareholders of fossil fuels-based securities to focus on cashflows as the de-carbonisation trend plays out. Enbridge (ENB.TSE)We move next to the TSX-listed Enbridge, again a fossil fuels-based play, which is in the business of pipelines, particularly oil and gas transmission. The firm's most important asset is the Mainline system which effectively controls over 70% of Canada's takeaway capacity linked to the mid-west and US refineries. We will sum it up for those not particularly familiar with midstream or refinement. Pipelines are constructed to take advantage of price differentials between two different regions or hubs. They require the following to be feasible:
Once built with significant regulatory oversight, there is a utilities like revenue stream. In our view, what makes Enbridge quite attractive is its particular focus on Oil sands, which are in high demand given the nature of US refinement capacity and the fact that 80% of her revenues are inflation hedged (if you recollect our view on debasement/inflation). This effectively means that in the short run, we should see continued security in its primary operations while effectively using said cashflows to diversify its revenue base. Its focus now runs into natural gas and a small but growing renewables portfolio and carbon capture. The business remains one of the ESG leaders amongst midstream companies in North America, making it reasonably palatable for the ESG-minded investor while providing a long-term growth trajectory. The business continues to make prudent long-term CAPEX and seems to be quite aware of the long-term decline in its heavy oil sands exposure, which is particularly carbon intensive. We see the business as sustaining reasonable longer-term organic growth without necessarily having the necessity to go to the market for new capital. However, the firm is at the forefront regarding regulatory uncertainty and is especially susceptible to stakeholder pushback. Recent multi-year efforts to bring line 3 online came after much pushback from indigenous populations, with another line 5 likely to see protracted legal battles. Not to mention the significant history (as is the case with the industry overall) of oil spills and protests regarding the Dakota access lines and the more recent Governor of Michigan revoking a 1953 easement connecting two parts of the great lakes with the Straits of Mackinac. Numbers-wise, our fair value for Enbridge stands at $55 CAD per share, assuming a 5-7% growth profile with minimal incremental buildout on a scale of Line 3 or 5 and continued debt reduction. The company plans to invest an additional $4 Billion CAD annually across the portfolio for future growth. Most of which we see will go toward renewables, hydrogen, wind and natural gas. To Sum Up: An excellent hedge against our first D i.e. debasement, given the utilities-like characteristics of earnings with continued future growth (i.e. 7%). That said, the significant risks will continue to be regulatory and stakeholder related. Advantest (6857.TYO)This is one business that many of the readership may be less familiar with so let's give a quick summary of the Tokyo-listed and Japanese headquartered business. Simply put, it is in the business of manufacturing and distributing semiconductor test systems with sector applications ranging from healthcare to nanotechnology. Essentially, the modus operandi ensures that production lines that make DRAM (Dynamic Random Access Memory) and flash memory are working and maximising production yields. While we remain aware of the procyclicality of the semiconductor industry, we continue to see it as vital not only for the transition to green (i.e. ranging from EVs to the power grid). Moreover, we know the industry as a net beneficiary of fiscal stimulus (as illustrated by our CHIPS and Science Act) and associated tailwinds. Its geographic spread with a supply chain stretching from South Korea and Taiwan to the US should put it in good stead with an increasingly confrontational white house (its China operations being limited in scope). Tailwinds are also provided by the industry's natural evolution, quoting from shareholder communications "Demand for semiconductor test equipment is influenced not only by change in device production volume but also technological evolution trends in semiconductors. Miniaturisation further improve the performance of semiconductors, reduces their power consumption, and increase semiconductor test time and the complexity of functional test processes." The first part is good for users of technology. The second is good for Advantest. Looking at the numbers, we begin with the most important in our view: the consistently high proportion of its revenue (i.e. 17%) that the business has spent on R&D, which should continue to pay dividends and ensure market leadership. Thus, gross margins remain comparatively elevated at 58.1% (despite higher procurement costs and inflationary pressures), and the company continues to grow across its major divisions (i.e. test components & mechatronic systems). As semiconductor production volumes increase with the wider adoption of EVs, we should see a significant secular upside. For those who prefer rather sticky revenues, the business continues to focus on its maintenance services (i.e. long-term contracts after the sale); the firm now expects to reach the $100 Billion Yen milestone this year. The company retains cash and cash equivalents of $107.5 Billion yen with an attractive PE of 13x. Our fair value remains to the upside at $10 200 JPY per share. To Sum Up: Fits nicely into a de-globalisation theme, given the businesses' centrality to the global semiconductor ecosystem. Long-term secular tailwind comes from the increased need for semiconductor growth in the growing demand for EVs. Rio Tinto (RIO.ASX)It may sound surprising to the readership that we still remain rather bullish on Rio, given the recent price action around Iron Ore majors recently. But we take a somewhat contrarian perspective around the potential for commodity prices to stay elevated despite slowing economic growth. While the story of Rio's fortunes of recent times has been the story of China and its seemingly insatiable demand for commodities (that particular nation accounting for 65% of traded Iron Ore and 50% of copper), we think this is about to change. To return to the 5 Ds, elevated commodity prices fit into the broader de-carbonisation and de-globalisation impetuses. As nations across the developed world seek to reshore supply chains, we posit that this will place tremendous pressure on ore and copper, Rio's two primary cash earners. We've also seen a surprising lack of foresight in investing in new production over the past decade despite the implications for demand as the rollout of both solar and wind speeds up. For example, copper usage increases by 5-fold in renewable energy systems compared to traditional fossil fuels-based systems. Despite the lacklustre growth in demand from China, at least in the short-run with Emperor Xi's insistence on a 0-Covid policy, we continue to see demand for steel and thus, iron ore continues on its upward trajectory and remain at elevated levels over the medium to long term. With that background, let's turn to Rio Tinto, one of the world's largest miners operating across a diversified portfolio of commodities, including Iron Ore, Aluminium and Copper. Notwithstanding the businesses torrid history concerning capital allocation decisions during the previous commodities boom, including the now infamous Alcan acquisition and egregiously high capital costs for expansion, the company has seemingly learnt from its mistakes. Notably, the business has focused on capital discipline and high payout ratios, which we should see continue given its now best-of-breed operating costs that make it profitable through the commodity cycle (just in case we are wrong about the secular bull case for commodities). The assets are primarily located in developed North American and Australian jurisdictions, which bodes well within an increasingly fractious geopolitical environment. Note: The business revenues to the tune of 60% are derived from China but we should see a gradual decline in this percentage. Getting to the numbers, the company continues to remain on track with production targets being met, with Pilbara production at circa. 84 million tonnes (iron ore) for Q3, with a 2022 production number for iron ore likely to be around 325 Million tonnes. A little more concerning is copper production, given upgrade and refurbishment requirements for US smelters, though we still estimate circa. 720 000 Tonnes for 22. Assuming these numbers and an average Iron ore price of around $90 USD per tonne (which remains on the lower end of our expectations), an aluminium price of $2000 USD per tonne and a copper price of $3.30 per pound, our fair value estimate is $130 AUD per share (this compares with the $94 AUD as at time of writing). To Sum Up: Rio offers a fantastic opportunity to hedge against inflation, dividend growth, and commodities' secular growth story. The company remains vital to the global transition towards renewables (i.e. decarbonisation) and offers longer-term investors an effective alternative to traditional dividend plays. Disclaimer: XOM.NYSE, 6857.TYO and RIO.ASX are currently held in TAMIM portfolios.
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