Apache (APA): undervalued with an enormous optionality on natural gas upside

Current price: $87

Expected price: $122

Time: 1-2 years

Catalysts: recent strategic acquisitions which have huge potential still to be capitalized, room to improve margins, significantly undervalued to peers, trading below 2008 levels on valuation basis, diversified asset base, enormous optionality on natural gas upside, capex peaking out in 1-2 years, divestures to reduce debt, recently initiated buy-back program, possible shareholder activism.

Price	85.04	P/tangible book	1.11	Forward P/E	9.1
Market cap	33,235	P/E	17.26	P/Sales	1.95
EV/EBITDA	3.73	EV/OCF	5.34	EV/FCF	-44.23
Leverage   (Debt/EBITDA)	1.01	P/OCF	3.91	P/FCF	-32.36

 

 

Underperformance:

While many oil names just touched their 52-week high, Apache recently touched its 52-week low. The stock reached a peak of 130 in mid 2011 and is currently trading at mid 80s. The fall has been due to significant acquisitions financed via new debt and excessive capital spending (capex) on the newly acquired assets, resulting in significantly lower profits, low dividend payments and slower than expected growth. Significant capex outpaced operating cash flow in FY12 resulting in negative free cash flow (FCF). FY12 EPS declined by 56% and recent 1Q13 quarterly EPS declined by 12%. Revenue for the recent quarter (1Q13) declined 10%, on a y-o-y basis.

Additionally, political turmoil in Egypt, where the company generates 20% of its current production, 30% of its current operating cash flow and has 10% of its reserves, is also one of the main problems for the stock to remain undervalued.

Situation in Egypt:

In February 2011, the former Egyptian president Hosni Mubarak stepped down, and the Egyptian Supreme Council of the Armed Forces took power, announcing that it would remain in power until the presidential and parliamentary elections could be held. In June 2012, Mohamed Morsi of the Muslim Brotherhood’s Freedom and Justice Party was elected as Egypt’s new president. This political turmoil comes with potential threats such as deterioration in the political, economic, and social conditions or changes in laws or regulations in the region, export restrictions, nationalization of APA assets and/or forced renegotiation or modification of existing contracts with the government of Egypt. Management is completely aware of this problem and has met with Egyptian officials, kept production steady, and is actively monitoring the situation. A per management, assets are in very remote areas, and hence the drilling wasn’t affected even while protests engulfed the major cities. The problem is the fear of nationalization of the assets. Losing Egyptian assets would mean a direct 30% hit to APA’s operating cash flow. Apache does mention that as a risk in its recent filing. However, the company continues to receive development lease approvals for drilling in Egypt and plans to invest USD 1.1bn in the region in FY13, highlighting that the situation is not as bad as it seems.

Grown on acquisitions:

The company has grown through acquisitions financing it via debt. The strategy has been to acquire strategic and rich assets at a decent price and then focus on getting value out of them. From 1999 to 2003 it went on an international acquisition spree to acquire oil rich international assets. From 2009 until present it did the same in the US, focusing on shale plays in the mid-con. During FY10-FY12, APA completed USD 17bn in acquisitions (compared to current book value of USD 30bn), leaving a lot of room for growth in the future. The timing of these acquisitions has been right due to low cost of financing. Debt on balance sheet has increased by 144% during last 3 years to USD 12.3bn (as of FY12), while its tangible equity only by 66% to USD 30bn during the same period. Below is the list of acquisitions:

2012 (Canada): Kitimat, BC, partnership with Chevron: In December 2012, entered an agreement with Chevron to build and operate the Kitimat LNG project. Each will become 50% owner of the proposed Kitimat LNG plant, the Pacific Trail Pipeline, and 644,000 gross undeveloped acres in the Horn River and Liard basins.

2012 (US): Central Anadarko basin acquisition:   In April 2012 acquired Cordillera Energy Partners III, LLC (Cordillera), for USD 2.7bn in cash and approximately 6.3 million of APA common stock, increasing the diluted outstanding shares by 4%, from FY12. Cordillera’s properties include approximately 312,000 net acres in the Granite Wash, Tonkawa, Cleveland, and Marmaton plays in western Oklahoma and the Texas Panhandle, basically doubling APA’s position in liquids-rich Anadarko Basin. APA issued USD 5.0bn fixed-rate long-dated notes in 2012 at an average rate of 3.5% for the acquisition and to pay down maturing debt and commercial paper balances.

2012 (Australia): Yara Pilbara Holdings Pty Limited acquisition:  In January 2012, acquired a 49% interest in Yara Pilbara Holdings Pty Limited (YPHPL, formerly Burrup Holdings Limited) for USD 439m. YPHPL is the owner of an ammonia fertilizer plant on the Burrup Peninsula of Western Australia.

2011: North Sea acquisition:  In December 2011, acquired Mobil North Sea Limited from Exxon Mobil for USD 1.25bn, adding to other North Sea assets it acquired from BP a decade ago.

2010: Gulf of Mexico Shelf acquisition: In June 2010, acquired oil and gas assets in the Gulf of Mexico shelf from Devon Energy Corporation for USD 1.05bn.

2010 (US): Permian acquisition: In August 2010, acquired acreage and infrastructure in the Permian Basin for USD 2.5bn, net of preferential rights, from BP’s oil and gas operations.

2010 (Canada): Canadian acquisition: In October 2010, acquired BP’s upstream natural gas business in western Alberta and British Columbia for USD 3.25bn.

2010 (Egypt): Egyptian acquisition: In November 2010, acquired BP’s assets in Egypt’s western desert for USD 650m.

2010: Mariner merger: In November 2010, acquired Mariner Energy, Inc. for stock and cash consideration totaling USD 2.7bn. APA also assumed approximately USD 1.7bn of Mariner’s debt with the merger.

 

 

Catalysts:

1)       Focusing on extracting value from assets acquired: CEO, Steve Farris, mentioned in the 1Q13 earnings call that the company has done enough acquisitions and will now focus on extracting value from them. This would mean high initial capital expenditures on these projects to get them started. APA has an expected capex of USD 10.5bn for FY13. Capex (excluding acquisitions) has increased significantly by 36% in FY10, 44% in FY11, 35% in FY12 and an expected 10% in FY13. Of the USD 10.5bn in FY13, main focus will be onshore North America shale play regions with a dedicated USD 4.6bn capex. USD 2.2bn will be on other projects such as Australian oil developments, Gulf of Mexico deepwater, Wheatstone project, and Kitimat, BC. These significant capex spending would have noteworthy increases in production in the future. Also, with capex peaking in 1-2 years, it would decline in the future boasting free cash flow considerably in years to come. Below are details of the future projects:

i)                     US shale play: The US contributes 40% of the total production (17% oil, 4% NGL, 18% gas). The Permian, Anadarko and Central Region assets (on-shore U.S. assets related to shale) have huge potential in horizontal drilling with over 88% of the company’s resource potential going forward. That’s where APA has seen the most growth in recent years with liquid production (oil and natural gas liquids (NGLs)) in the US growing by 16%, 28% and 19% in FY10, FY11 and FY12, respectively. In 1Q13, oil production from the US was up 19% and NGLs production 121%, on a y-o-y basis. Natural gas production was only up by 4% as the company is keeping gas production flat due to depressed prices. The US is the strong growth region for the company with its huge recently acquired shale plays. As of 1Q13, about 44% of the current production and 50% of the estimated proved reserves are in the US, a very safe region. In FY13, Apache plans to direct USD 4.6bn of total capex (USD 10.5bn) toward North American onshore regions (mostly in the Central and Permian regions). This focused drilling program should help Apache deliver 25% y-o-y growth in North America onshore liquids (oil and NGL) production.

ii)                   Kitimat, BC: Canada contributes 16% of the total production (2% oil, 1% NGL, 13% gas) and has 19% of the estimated proved reserves. In Western Canada Apache is working with Chevron on developing the Kitimat LNG project to provide an export route for 50 billion cubic feet of gas reserves in that region. This will increase the total production by 3%. In FY12, Chevron paid Apache USD 400m to buy a 50% stake in Kitimat. The Kitimat plant has received all significant environmental approvals and a 20-year export license from the Canadian federal government. Kitimat is one of the closest ports to the Asian markets, especially Japan, where LNG prices are currently at USD 16 per Mcf, 3x as compared to that in Canada.

iii)                  Australian oil developments: The company has interests in 30 exploration permits, 17 production licenses, and 13 retention leases that cover a total area of 7.9 million gross acres located in offshore Western Australia. Approximately 90% of this acreage is undeveloped contributing 12% of FY12 estimated proved reserves. Australia contributes 9% of total production (4% oil and 5% natural gas). The production in the region will more than double, increasing by 110% over next 4 years and contributing additional 10% to the total production, with major projects including Macedon (2013), Balnaves (2014), Coniston (2014) and Julimar/Wheatstone (2016) coming online.

iv)                  Wheatstone LNG: In Australia APA has a 13% piece of Chevron’s giant Wheatstone LNG project, which will come on line in 2016. After coming online, the production is expected to be 11 million barrels of oil equivalent (4% of current total production) annually for 20 years. LNG rates in Australia are at USD 8/MCF, more than double that in the US. APA will be the biggest domestic gas supplier in Western Australia by FY13. APA’s Australian subsidiaries have been already signing long-term sales and purchase agreements for supplying LNG to Asian companies.

v)                   Forties Alpha: The start of the Forties Alpha satellite platform should add to Apache’s production growth in 2013 (3%-5%) and more than offset the natural field declines continuing in Australia, Canada and Argentina.

vi)                  Egypt: Egypt is a cash-cow for the company as it generates USD 2.7bn operating cash flow of which USD 1.1bn is spent on capex, with remaining USD 1.6bn in free cash flow, that can be used for other parts of the business. The region provides 20% of total production (13% oil and 8% gas). Average sale price of oil in the region is one of the highest at USD 111 per bbl. APA announced three new discoveries in the Western Desert of Egypt during 1Q13, extending the company’s production. The region has 10% of FY12 estimated proved reserves. Even with all the turmoil, the company have continued to receive development lease approvals for drilling in Egypt and plans to invest USD 1.1bn in the region in FY13.

vii)                North Sea: North Sea provides 9% of total production (8% oil, 1% gas). The region has one of the highest average sale price for oil (108 per bbl) and natural gas (8.95 per Mcf). APA increased its portfolio in the region by acquiring Mobil North Sea Limited in FY11, which provided the region with additional exploration and development opportunities across numerous fields. This resulted in a y-o-y production increase of 37% in FY12 in the region. The region has 6% of total estimated proved reserves.

2)       Reduction in executive pays due to underperformance: Due to significant underperformance of the stock among its peer group, the board has reduced the compensation of CEO, Steve Farris, who is also the chairman, by 18% as compared to previous year and bonus to 150% of the base salary from 200%, as per SEC filings. The shareholders did not pass an advisory vote on compensation of executive officers during the annual meeting on 16 May 2013. Also, the total director compensation was being reduced to USD 300k from USD 350k, with a cut in the equity component of the pay package. Overall, this puts pressure on the management for better performance. I think, the board and the CEO are fully aware that activist shareholders can take greater positions anytime and shake things up if the management does a sloppy job with good assets and doesn’t create value. We have seen a lot of these recently in oil and gas sector such as Hess, Transocean and Chesapeake.

3)       Divestures to reduction of debt and share buybacks: On 9 May 2013, APA reported 1Q13 earnings and announced a plan to divest USD 4bn in assets by year-end 2013. The company recently hired Goldman Sachs to unload shallow water Gulf of Mexico assets. Another likely divestiture could be Argentinean assets, where the government has nationalized oil assets. Fortunately oil prices have remained high, so the company should get good value. APA intends to use USD 2bn to reduce debt and another USD 2bn to repurchase stock under a 30 million share repurchase program authorized by the board. With a current market cap of USD 30bn, this is approximately 7% share buy-back program and puts some floor on the stock price, in case of a fall. Divesting potentially heavy future investment non-core assets, reducing debt and buying back stock would create more value.

4)       Recent hedge fund and Insider buying: In quarter ending March 2013, quite a few hedge funds were buyers of the stock including T Boone Pickens, Wallace Weitz, Brain Rogers, Third Avenue Management, NWQ Managers, Manning and Napier Advisors, Inc. Diamond Hill Capital, Richard Pzena, George Soros, Louis Bacon, Charles Brandes, Jeff Auxier, Paul Tudor Jones, Jeremy Granthan and Ray Dalio. In Feb, March and April 2013, we saw some insider buying as well.

5)       Margins and cost efficiency: APA has lower margins than its peers but that’s where it has the opportunity to improve. OCF margin has declined from an average of 55% in last 6 years to 50% in FY12, due to significant declines in natural gas prices. Also, acquisitions had deviated management from focusing on margins. However, the acquisition spree has ended and APA is now focusing on costs by reducing drilling days and frac cost by self sourcing and optimizing frac design. With shareholders ousting executives and revamping boards because of poor performance, the pressure to improve margins and be cost efficient is real.

6)       Natural gas play with diversified asset base:  The company is a less-levered play for the potential upside in the natural gas, due to its diversified asset base both within the U.S. and internationally. If gas prices soar, Apache’s top quality on-shore assets could significantly increase profitability. As of FY12, 45% of APA’s production was oil and 49% natural gas. That said, 78% of revenues come from oil and only 19% from natural gas. This is due to drastic declines in natural gas prices, which has forced APA to focus on liquids where margins are higher and keep natural gas production flat. APA can boost its production with an increase in natural gas prices which could have a significant upside on its revenues and bottom-line. Also, APA took heavy write-offs on its various natural gas assets last year due to lower prices. Increase in natural gas prices would also increases the value of those assets on balance sheet, growing the book-value. Below points highlight the potential increase in natural gas prices.

i)                     Natural gas prices have declined by 70% in last 5 years, to USD 3.9 mmbtu in June 2013 from USD 13.2 mmbtu in June 2008. This has created a huge divergence between price of oil and natural gas. The chart below shows price of natural gas (per barrel of oil equivalent) as a percentage of oil price. On average in FY12, natural gas was 24% of the oil price in the US for one barrel of oil equivalent. This means it could be bought at a 76% discount to oil. This energy source will be exploited in the future and price differential will not remain at these levels.

ii)                   Many power plants are opting for the cleaner burning natural gas to replace coal and some of that transition is permanent.

iii)                  Major manufacturers of chemicals, steel, etc are increasing their utilization of, or shifting to, cheap natural gas to lower their overall cost structures. In this case as well, some of the transition is permanent.

iv)                  At present, global natural-gas markets are not integrated. Prices are USD 0.75 Mcf in Saudi Arabia (subsidized by government), USD 3.9 Mcf in the US, around USD 12 Mcf in Europe and as high as USD 16 Mcf in Japan. Overtime market forces will narrow this gap. One such way of exploiting this arbitrage is exporting it to Asia. Export will eventually open up reducing the arbitrage and increasing natural gas prices.

v)                   Compressed natural gas (CNG) vehicles are very common in Asia. As of 2011, worldwide, there were 14.8 million vehicles that run on compressed natural gas (CNG), with approximately 5.7 million in the Asia-Pacific region followed by 4 million vehicles in Latin America. This number has been growing rapidly as CNG is a much cleaner fuel and produces much less pollution, is significantly cheaper than oil (Asian consumers are very sensitive to oil price) and has a lower maintenance costs than hydrocarbon-fuel-powered vehicles. CNG vehicles are encouraged by governments in Asia due to high pollution in these countries.

vi)                  Export of LNG is already on its way with the US sanctioning two LNG export terminals and another 12 still waiting for approval. On 17 May 2013, the US Energy Department announced that it has conditionally authorized Freeport LNG Expansion, L.P. and FLNG Liquefaction, LLC (Freeport) to export domestically produced liquefied natural gas (LNG) to countries that do not have a Free Trade Agreement (FTA) with the United States from the Freeport LNG Terminal on Quintana Island, Texas. Freeport previously received approval to export LNG from its facility to FTA countries in February 2011. In May 2011, Cheniere Energy’s Sabine Pass, in Louisiana, was the first LNG terminal to get authorization to export LNG to non-FTA countries. Freeport’s and Cheniere’s combined capacity would amount to 5.2% of US production. As of 17 April 2013, 12 new LNG export terminals have been proposed in the US to Federal Energy Regulatory Commission (FERC) and there are currently 63 LNG export terminals planned or under construction worldwide.

7)       Discount to peers: Apache currently trades at least 40% discount to peers. Its closest competitor Anadarko (APC) trades at an EV/EBITDA of 7.1x as compared to 3.8x for APA (see table below). Apache has proved reserves of 2.9 billion barrels of oil equivalent (BOE) and is currently producing about 779,000 BOE per day. This is exactly in line with Anadarko. To put things in a future value perspective, Anadarko trades at 16.1x forward P/E, as compared to 9.1x for Apache. APAs stock price would have to increase by 80% to trade at APC’s multiple.

Comp Valuation
Ticker	Price	Market cap	P/tangible book	P/OCF	Forward P/E	EV/EBITDA
APA	85.04	34,017	1.13	4.00	9.1	3.79
APC	86.71	43,360	2.08	5.24	16.1	7.14
under value			46%	24%	43%	47%
DVN	55.3	22,050	1.47	4.54	10.57	6.14
under value			23%	12%	14%	38%

8)       Valuation: Despite taking heavy write-offs on various natural gas assets last year due to lower natural gas prices and increasing its debt to finance acquisitions, Apache’s trades at price to tangible book of just 1.1x (tangible book value per share of USD 77). This is historically low, even lower than 2008 levels. Its peer, Anadarko, is trading at a price to tangible book of 2.1x. Also, on a price to EBITDA (P/EBITDA: 2.73x) and price to OCF (P/OCF: 3.9x) basis its trading close to or below 2008 levels.

9)       Peak in capex: Capex (excluding acquisitions) has doubled from its 5 year average. It has risen from a 5 year average of USD 4.7bn to USD 9.5bn in FY12 and is still growing. As the company is investing significantly in capex to extract value from the recently acquired assets, capital expenditure will peak out in 1-2 years resulting in significant increases in production. Also, reduction in capex in the future will increase free cash flow significantly.

Risks:

i)                     Supply demand: As per International Energy Agency (IEA) report, for the period 2012-2018, world liquid capacity would grow by 8.4 million barrels per day, significantly faster than demand, which is projected to grow by 6.9 million barrels per day. This could depress liquid prices on the downside.

ii)                   Revenues heavily dependent on oil: Approximately 78% of APA’s total revenues come from oil.

iii)                  Selling oil at Brent price: Approximately 72% of APA’s crude oil production is priced relative to Brent crudes and sweet crude from the Gulf Coast, which continue to be priced at a significant premium to West Texas Intermediate (WTI)-based prices.

iv)                  Transportation: 71% of the oil consumption in the US is from transportation. In next 3-10 years fuel efficient hybrids, LNG, CNG and electric cars might be more common than we expect and the dynamics of oil industry could change significantly.

v)                   Environmental concerns: Fracking is relatively young, and probably not all of the environmental and geological consequences are fully understood. As time goes by, it is reasonable to expect more government regulations, which inevitably increases costs and could even put smaller producers out of the business.

vi)                  Egypt is the cash-cow for the company and the recent political turmoil in the country is one of the main reasons for the stock to underperform. APA generates 20% of its current production, 30% of its current operating cash flow and has 10% of its reserves in the region. Threats in region include deterioration in the political, economic, and social conditions or changes in laws or regulations in the region, export restrictions, nationalization of APA assets and/or forced renegotiation or modification of existing contracts.

 

Hedge: For the above first 4 reasons, it is better to buy the stock with a hedge, downside protection to Brent oil. This makes sense especially now, as Brent is trading at 105, due to risk in Syria.

Conclusion: In last 2 days stock has gone up by 3%. It is advisable to buy on dips. Market is neglecting APA’s diversified asset base and attractive long-term production growth in its asset rich shale plays and paying too much attention on Egypt, short term results and increased capex spending. Recent strategic acquisitions have huge potential still to be capitalized with room to improve margins and an enormous optionality on natural gas upside. The stock is significantly undervalued as compared to its peers and is trading below 2008 levels on valuation basis. Decline in oil price is a concern, by hedging the same one can bet on relative-value and a natural gas upside.

Company description: Apache Corporation, an independent energy company, explores for, develops, and produces natural gas, crude oil, and natural gas liquids. It holds interests in asset base of 12.3 million gross acres located in the United States; 7 million gross acres in Canada; 9.7 million gross acres in Western Desert, Egypt; 30 exploration permits, 17 production licenses, and 13 retention leases that cover a total area of 7.9 million gross acres in offshore Western Australia; 32 concessions, exploration permits, and other interests covering an area of 4.4 million gross acres located in 4 hydrocarbon basins in Argentina; and various properties located in the United Kingdom North Sea.

As of 31 December 2012, it had total estimated proved reserves of 1,441 million barrels of crude oil, condensate, and natural gas liquids; and 8.5 trillion cubic feet of natural gas. Combining both, Apache has proved reserves of 2.9 billion barrels of oil equivalent (BOE), and the company is currently producing about 779,000 BOE per day.  However, including its Permian/Central resources that number goes up to 11.7 billion barrels of oil, four times higher than the current proved reserves. The company was founded in 1954 and is based in Houston, Texas.

Disclosure: Long APA, short Brent oil (via DTO)

Disclaimer: It is very important to read the disclaimer before making any investments based on the above article.

The Fake New Normal

Everything is great, keep the party going!

 

Europe: European problems are far from over. It is sinking in deeper recession with unemployment in 17 country Euro-zone at historically high levels of 12.1% and increasing. Retail sales dropped 0.1% in March from a 0.3% slide the previous month. Unemployment in Spain is now up 27.2% and mortgage delinquencies are continually rising. Portugal is moving toward a second bailout. Its government is considering to pay public workers in Treasury bills instead of cash. It also plans to slash 30,000 public sector jobs as a part of spending cuts. France’s business survey shows that it could enter recession (see chart below). Germany is faltering too with car sales in March down 12% y-o-y. While Slovenia’s creditworthiness is deteriorating as investors speculate a banking crisis in the region (see charts below). Banks in Slovenia are significantly undercapitalised with toxic loans now standing at 18% of GDP. All that said, Spain’s 10-year yield dropped to 3.8% for the first time since October 2010, yields on two-year Italian notes fell below 1% for the first time on record and 10 year Portugal bond yields dropped to 5.5.%, least since October 2010. This was after the ECB cut its main refinancing rate on 2 May and signaled it was open to a negative deposit rate. Conclusion: deteriorating fundamentals but significantly lower yields. Welcome to Matrix!

source: zerohedge

source: zerohedge

The US: It is not just Europe, the US macro economic data hasn’t been strong as well. 1Q13 GDP missed expectations and came in at 2.5%. Excluding inventory it would be at 1.6%, a very anemic growth. The total of ISM manufacturing and non-manufacturing index declined by 4.1% and 1.8%, sequentially, in March and April 2013. Construction spending tumbled 1.7% in April to a seven month low. Housing market index for the month of April was down. Thomson/Reuters Small Business Lending Index showed small businesses reduced their borrowing for a fourth month in a row and delinquencies on outstanding loan balances rose for the first time in more than three years. The ADP employment report indicated that the US economy added just 119,000 private-sector jobs in April, which was below consensus expectations of 155,000. People employed as a % of total civilian population (the real gauge of employment) in April was at 58.6%, pretty much same as in 2012 and just a little improvement from its historical low of 58.2% in July 2011. Most of the US macro economic data hasn’t met expectations but the market has ignored all of that and has only gone in one direction: north. Below is the chart showing the disconnect between economic data expectations (Bloomberg Economic Surprise Index) and S&P.

Source: zerohedge

Consumer Spending Fundamentals: Y-o-y growth in personal income has also been very anemic and below inflation, with y-t-d 2013 monthly average of 2.5%. Savings as a % of personal disposable income is currently at 2.7%, below 3% is a warning signal. With low income growth and already low savings rate, consumer spending, the engine of the US economy, doesn’t have a lot of room to run. Above all, q-o-q percentage change of personal income excluding current transfers is at recession levels (see chart 3 below). Also, the effect of tax increases (payroll and other taxes) comes at a lag and might be seen in the coming quarters. Lastly, people have forgotten about sequestration as if it never happened. Its impact has yet to begin.

Source: zerohedge

Source: zerohedge

Sales growth and Margin expansion: Macro US data and Europe doesn’t matter, ultimately what matters are earnings and companies are beating expectations. Europe has been this way for a long time and market has understood to ignore it. Earnings is what market cares and companies have been beating expectations.

This is what the bulls argue. It is true, however companies have been beating only bottom-line by low-balling expectations. They have been missing on top-line. Sales growth is declining as the base is already high and the economy is growing at a slow pace. Sales growth is down from 9% levels in 2011 due to a very low base in 2010, to just 4% levels in 2012. So far in 1Q13, more than 50% of the S&P companies have reported earnings with more than 57% missing revenue estimates.

Also, corporate margins are at historic highs. Margins are mean-reverting and cannot keep going higher. S&P operating margins peaked at 9.5% (highest in last 13 year) in June 2012 and were at 8.0% in December 2012. The US corporates are the leanest historically and there is not much to squeeze to increase margins. Also, a lot of debt has been refinanced at super low rates reducing the interest cost which is one of the reasons for high margins. Conclusion: slowing sales growth and not enough left to squeeze to increase margins doesn’t sound like a good profitability recipe.

Source: zerohedge

Source: zerohedge

Current market P/E: market probably not that cheap: But markets are cheap, so all the above doesn’t matter as long we can buy good quality stocks for cheap.

Nothing is cheap in this market. March ending ttm earnings expectation for S&P are: as reported earnings: 88.06 (y-o-y inc of -0.5%), operating earnings: 98.78 (y-o-y inc of 0.7%). At these levels we have

Price to sales:                        3 May 2013: 1.48;               31 Dec 2007: 1.43

PE (as reported earnings): 3 May 2013: 18.33;              31 Dec 2007: 17.36                             (historical long term average is approximately 15.5x)

Price to book:                        3 May 2013: 2.42;               31 Dec 2007: 2.77

All these ratios are above historical averages and equivalent to 2007 peak showing that the market is overvalued.

Flaw in S&P earnings estimate calculation: It doesn’t matter, future earnings expectations are high. Also, on a forward basis (FY13) market is cheap, trading at only 15x PE (reported earnings).

For FY13, analysts are expecting, as per S&P (as of 29 April 2013), a 14.2% increase in operating earnings to USD 110.5 and a 24.3% increase in as reported earnings to USD 107.6 (see graph below) (historical long-term earnings cagr is 4.8%). Considering the high sales base and end of productivity gains, I think, this is an optimistic view which makes S&P vulnerable. However, the main catch is how these forward earnings are calculated. This article on Seeking Alpha beautifully describes the mismatch between actual and expected earnings. The main difference is the pension expense. The crux being actual operating earnings are calculated by a different analyst which includes pension expense as a normal expenditure while estimates are calculated by another group of analysts which excludes pension expense while calculating operating earnings, as they consider pension expense an “unusual item”. This makes the expected earnings look inflated. So if the market is trading at high valuations (S&P already up 10.5% YTD, in just 4 months) based on expected earnings which are already inflated and the economic data is getting worse, probably it may not be a pretty scene. Conclusion: investing when it looks the easiest is at its hardest.

All the other asset classes and markets: While S&P keeps going in a straight line at 45 degrees, MSCI emerging market index is down, Europe is down, CRM commodity index is down, copper and steel has had a significant move down, personal income growth in the US is below inflation and banks are planning more job cuts. The market is conveniently ignoring all that. Apart from foreign risks (Europe’s debt crisis, Japan’s reflationary commitment, etc), the current overvalued market has a risk of rising interest rates, stopping of quantitative easing, reversing of historically high margins and probability of missing high earnings expectations.

source: zerohedge

Who is buying?: Recent article by WSJ, Bond Funds Running Low on…Bonds, points out that the number of bond funds owning stocks is at its highest point in 18 years, showing that if bonds are in a bubble, equity is a place to go, even if that’s not their expertise. A sign that typically conservative investors are taking bigger risks to boost returns via dividend paying stocks. A clear consequence of money printing and significantly low interest rates, not benefiting masses at large instead making markets vulnerable. The other class of buyers is traders as no one wants to miss the rally. This has resulted in equity crowded trade. The below graph shows NYSE margin debt, which is at its all time high. Last two highs were in 2000 and 2007, when market peaked. If market falls, margin calls would be all over and the drop could be precipitous.

Japan: Who else is buying? The Japanese? The historically biggest Japanese quantitative easing is resulting in flight to safety from Japanese investors, who sense that their own bond market is on the verge of breaking down. This has managed to send French and Belgian bonds to record lows, the Spanish 2 Year to sub 2%, the German 6 month bill negative in the primary market, the US 10 year below 1.8% and 30 year sub 3%. Also, the yield-hungry-safety-looking Japanese are buying the US equities contributing to overvaluation and the fundamental disconnect. The immediate result is that the bond-equity disengage continues to diverge. Is this a new normal? If yes, it is not healthy and can’t go on for a long time.

FED support: Lets, for a minute, assumes how the economy would look if FED support is taken off. Excess liquidity goes away, interest rates rise and stocks fall. So the economy is still on FED crutches and an overvaluation in such a scenario only shows irrational exuberance. Assuming that the consequence of money printing is just positive is naïve. Also, assuming that a slow withdrawal of money printing would be smooth and easy is an irrational thought. No one has been able to do it, the Germans, the Japanese, the Argentinians  etc have all failed. We have seen countries stuck in the liquidity trap and unable to exit but never there is an instance when a country exited smoothly without any pain. The question now is that if 5 years of massive QEs cannot revive the economy, what can? Also, if the market falls, people will start doubting the effectiveness of QE.

The incomplete cycle: Lastly market operates in cycles. A common saying is that get your companies right and don’t worry about Mr. Market. He will have mood swings but eventually you will be rewarded for picking up the right companies. They forgot to mention the price. Price is everything. Equity market can be dead for more than a decade and make you extremely rich in another decade. The concept of market cycles has been proved historically era after era. Below table shows 16 year market cycles from 1886 until present. The current cycle looks incomplete with a positive return instead of a negative cagr.

Most people fail to recognize that absence of immediate crisis doesn’t mean that we won’t eventually face one and that the consequence of money printing isn’t just positive. In a global central bank money printing environment where economic fundamentals don’t matter, VIX at a complacently low level of below 13, major continents in recession and earnings based on overly optimistic future expectations, I guess one should think twice before investing. What we know for certain is that during the most recent market cycle, the repeated hope that stocks could detach from the economic data proved to be unfounded in nearly every instance: 2010s fall in May and June, 2011s fall in August and September and 2012s fall in May and June. When debt to central bankers or economists doesn’t matter: debt growing from USD 6 trillion to USD 16 trillion in past 12 years, it is time to take a step back and think.

Disclosure: long S&P put spreads

Disclaimer: It is very important to read the disclaimer before making any investments based on the above article.

Long term bull market but short term correction

Fundamentally we are in a bull market: Overall, I think, we are in a bull market. Fundamentally, the US economy is not anywhere close to a bubble. It is slowly getting better, average incomes are increasing and corporate balance sheets are the strongest historically.

Household debt service ratio (HSR) is at 10.61 (lowest 10.51 in 3Q83 and highest 14.08 in 3Q07) while the household financial obligation ratio (FOR) is at 13.9 (lowest 13.3 in 4Q80 and highest 17.66 in 3Q07). These are close to levels we saw in early 1980s which was the beginning of a great bull market. This also depicts that households have significantly delevered. Additionally, as of December 2012, my proprietary index has indicated a strong recovery and stood at -1.9%. This is nowhere close to 13.0%, which is the danger zone depicting bubble like characteristics.

Technological innovations will create jobs and increase consumer spending. Its not just technological innovations, but shale revolution and increased use of electric and fuel efficient cars will also help in declining fuel prices which is only benefit the economy. If passed, Obama’s immigration policy would also provide significant boost to the economy as the immigrants would buy houses, start new businesses and spend more freely. Housing is picking up and some very smart people are betting on the housing boom in the future which would also fuel the growth. So if everything is so rosy, will the market keep going up? Probably not, in the short term (3-6 months), we might see some correction….. mainly because of five reasons below:

1)       Market rally: Market has come up way too fast. S&P has been on a roar. It has gone up 11.5% in last 3 months so a correction wouldn’t be unreasonable and probably healthy. 88% of stocks above their 50 day moving average, and we have the ingredients for a decent pullback.

2)       OECD leading indicator: As of December ending 2012, OECD leading indicator was at 101.04. 102 is the peak and 101.5 is close to a peak zone where you want to book profits and buy some protection. Selling at 101.5 while the indicator is rising has given great results (future annual S&P return less than 0%) 58% of the times, satisfactory results (future annual S&P return less than 7% in a year) 29% of the times and wrong results (future S&P return more than 8% in a year) only 13% of the times, since the data has been tracked (1955). The indicator is close to, but still not at, 101.5.

3)       VIX: VIX is down by 24% in last 3 months. As of 15 February 2013, VIX was at 12.46, a level below 13 shows complacency in the market: screaming out loud that options on S&P are cheap and implied volatility is at its low. In its 23 year history, 9.3 is the lowest and 80.9 is the highest for VIX.

4)       SPY and TLT pattern: Below is a chart comparing SPY and TLT. The chart tells us the fundamental relationship between the two. Whenever there is an open jaw like structure, where the one goes up too fast and the other goes down too fast, they seem to converge. We see one such structure now.

5)       S&P earnings estimates: Wall street strategists have high hopes for the U.S. stock market in 2013. However, S&P operating margins peaked at 9.5% (highest in last 13 year) in June 2012 and were at 8.9% in December 2012. The US corporates are the leanest historically. There is not much to squeeze to increase margins. If you ask an economist, they will tell you that the profit margin cycle is one of the most mean-reverting cycles in the economy.

The chart below shows a clear trend of declining growth in operating earnings. Significant increases in earnings during FY10 and FY11 were mostly due to a productivity-driven earnings boom, which resulted in increased margins. That has gradually lost steam as there is only so much productivity gains that companies can attain. As previously mentioned the US corporates are the leanest historically and there is not enough margin to be squeezed.

So if margins cannot be increased, the top-line should swell to see growth in earnings. However, growth in S&P sales per share is falling. In recent quarters y-o-y sales growth have fallen from the peak of just north of 10% to 1.1% as of 3Q12 (see chart below). With lower base in FY09 and FY10 due to significantly distressed sales during the Great Recession, we saw momentous sales growth. Nonetheless, that’s not easy to achieve with the current high sales base.

So, in a nut-shell, we have peak margins which means boost to the bottom-line can be attained only through sales growth, but the sales growth is declining as the base is already high and the economy is growing at a slow pace. Additionally, analysts have been lowering their forecasts since early October consistently amid rising fears of the fiscal cliff, tax increases, Europe’s recession and China’s slowdown. 4Q12 earnings forecast was revised from 9.9% expected increase (in October 2012) to 2.8% expected increase (revised in January 2013) to -1.7% expected increase (revised in February 2013, 87% of the 4Q12 earnings reported). All that said, many strategists still see the S&P hitting new record highs by the end of 2013 even as profit growth forecasts for the index have fallen sharply. They are expecting, as per S&P (as of 14 February 2013), a 14.7% increase in operating earnings to USD 111.3 and a 14.5% increase in as reported earnings to USD 100.7. Considering the high sales base and end of productivity gains, I think, this is an optimistic view which makes S&P vulnerable.

Conclusion: If S&P rallies another 2% – 3% in a month and if the OECD leading indicator reaches 101.5 levels with VIX declining even further, it would be the right time to buy some of that cheap protection to hedge your portfolio. However, if I am right and if there is a correction, one should look for opportunities to buy as fundamentally we are in a bull market.

Disclosure: Long SPY puts and put spreads.

Disclaimer: It is very important to read the disclaimer before making any investments based on the above article.