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“Saudi America” by Bethany McLean

oil

The Book

I recently finished “Saudi America” by Bethany McLean. The book was excellent, timely, and aligns with my interest in the subject of energy. The book tells the story of the renaissance of American energy production that occurred in the last 10 years as a result of fracking.

The book is exceptionally current and fresh. Bethany talks in depth about very recent events, such as the rise to power of MBS in Saudi Arabia and the Trump administration’s odd obsession with coal.

The book doesn’t take sides and presents all sides of the argument. Bethany shows the side of the fracking optimists: those who think that the United States has a vast energy supply that we’ve barely scratched the surface of. The energy supply could end our connection with the Middle East and lead to American dominance of global energy production.

There is the other side of the argument: the environmentalists and short-sellers like David Einhorn who don’t believe that fracking can generate enough free cash flow to be sustainable, and she also shows that a world of destabilized oil powers isn’t necessarily a good thing for the United States. Saudi Arabia, for instance, uses their oil wealth to supply their population with bread and circuses. If the Saudis went bust, do we really want the country to become unstable and slip the region into more chaos than it already is?

The book doesn’t come to firm conclusions and presents all sides of the argument. This is chiefly because the story isn’t over yet. We don’t know how all of this will shake out and this is a new, revolutionary development.

For all of the books written about social media and the growth of the internet in the last decade, I’m shocked that more people haven’t tackled the incredible phenomenon of the U.S. energy boom. While the media is obsessed with our smartphones and Facebook, this energy renaissance is the most important economic and geopolitical story of the last 10 years. The impact is more far-reaching and significant than the phenomenon soaking up all of the media attention lately: crypto, social media, and the 24/7 cable news cycle focused almost exclusively on unimportant shenanigans in Washington.

Peak Oil Worries

I was attracted to this book due to my fascination with the concept of peak oil. I first encountered the idea of peak oil in high school in the late ’90s and have been obsessed with it ever since.

The idea of peak oil is simple. There is a fixed amount of oil on the planet. When it peaks, we inevitably need to reduce our use of it. This is problematic because nearly all of the improvement in human living standards over the last 200 years was caused by capitalism combined with human beings figuring out how to harness fossil fuels.

Per capita GDP was flat for more of human history. Then, in 1800, it began increasing exponentially. For most of human history, people were really just expensive livestock. Every person was another mouth to feed, and most of our ancestors lived lives that were miserable, poverty-stricken, and short. We take our standards of living for granted today. It’s truly staggering to imagine that most of the human race for most of history lived in a state of extreme, grinding poverty.

The growing and widespread use of fossil fuels changed the dynamic.

Everything we enjoy about the modern world is made possible because we can harness fossil fuels. This makes the inevitable reality horrifying: at some point, we will run out of them. Estimates vary, but the Earth only has so many hydrocarbons in it. At some point, our use of fossil fuels will peak. This is what is the theory behind peak oil: at some point, our extraction of it will be peak and with it, our civilization.

This is the future pictured in the Mad Max films. A brutal, post-apocalyptic world where we’ve burned all the fossil fuels and the return of the scarcity the characterized most of human history. It’s also the future depicted in Ready Player One, which described a decades-long Depression caused by the exhausting of our energy reserves.

The chief proponent of peak oil was M. King Hubbert. He theorized in the 1950s that the U.S. would peak in oil production around 1970 and it would decline from there. It turned out that he was correct. Conventional U.S. oil production peaked around 1970 and then entered a steady rate of decline.

The U.S. itself did not reign in its thirst for oil. We sought more oil from the world, chiefly Saudi Arabia. The Saudis had an ocean of oil which we increased our dependence upon. The biggest field in Saudi Arabia is the Ghawar oil field, which pumps out 5 million barrels of oil a day.

Since U.S. oil production began declining in the 1970s, President after President paid lip service to “energy independence” and did little about it. In practical terms, the only real legislation passed to encourage U.S. energy independence was a ban on U.S. energy exports in 1975.

While U.S. production peaked in 1970, there were many competing theories for when world energy production would peak. I worried in the mid-2000s that peak oil was upon us and the peak of our civilization had been reached.

In the summer of 2008, I was cash-strapped and paying $4 a gallon for gas. I watched the money drain away, and I thought to myself: this is it. This is peak oil.

Not the peak, after all

I was wrong. Oil production did not peak in 2008. In fact, the U.S. was about to undergo an energy renaissance that would wind up reshaping the world.

The oil production that was long on the wane in the United States wound up turning around. At this point, U.S. oil production now exceeds the 1970 peak.

oil

Catalysts of the Revolution

What caused the fracking revolution? This is a question that Bethany answers in depth in the book. The answer is two-fold: cheap capital made available from Wall Street combined with technological ingenuity.

The first catalyst was technology. The technique of fracking involves breaking apart rocks underground and unleashing natural gas and oil trapped within the rocks. The rocks are “fracked” and broken open and the gas/oil is unleashed. The tech and engineering behind it are over my head, but the fracking technology which existed since the 1940s had advanced in the 2000s to the point where it was economical to pursue in the United States. Oil prices also increased to a level where the technology was worth the investment.

The second catalyst was cash.

After the financial crisis, with interest rates at historic lows, Wall Street wanted to lend money. They wound up lending a large amount of high yield debt to the frackers. The money flowed into fracking ventures of various kinds, from the semi-respectable to the dubious.

Critics like David Einhorn believe that fracking will never generate sufficient free cash flow to be sustainable. In other words, the frackers will be destroyed by the high capital expenditures involved in successfully pursuing fracking.

When oil prices collapsed in 2015, it appeared that the shorts may have been correct. Many frackers went bankrupt. Others used it as an opportunity to restructure their loans.

The pessimists were disappointed, though. Fracking wound up surviving, but it’s unclear if this is a testament to the fiscal soundness of their operations or the willingness of Wall Street to throw cheap money around for the purpose of minting fees.

The new era was solidified in December 2015 when the 1975 ban on drilling was lifted. This was a momentous decision that was barely covered in the press. The era of declining U.S. energy production which began in the 1970s was over.

The Future

The future for fracking is uncertain. No one is sure how much oil exists within our shale deposits. Estimates vary wildly. The optimistic projections estimate that the U.S. contains trillions of barrels of oil. To put this in perspective, the Saudis produce about 10 million barrels of oil per day.

Skeptics believe that these estimates are too optimistic. They also think that fracking still hasn’t demonstrated its ability to generate cash flows that exceed the cost of capital.

Another concern is that regardless of the estimate, the supply of oil is finite and we will run out of it. At the end of the book, Bethany cites Charlie Munger, who advises prudence. He makes a good point that oil is used heavily in our farming industry and, because of this, it is one of the most precious resources that we should use prudently. Munger explains:

“Every barrel that you use up that comes from somebody else is a barrel of your precious oil which you’re going to need to feed your people and maintain your civilization. You want to produce just enough so that you keep up on all of the technology. And you shouldn’t mind at all paying prices that look high for foreign oil. You will be better off because you delayed gratification, instead of grabbing for it like a child.”

There are also environmental concerns. The burning of fossil fuels makes modern life possible, but it is also contributing to climate change and threatens our long-term survival as a species.

The story of the American energy revolution isn’t over, which is why the book doesn’t try to moralize and clearly define who is right and who is wrong. It tells the story. It also contains fascinating portrayals of the characters involved: from the risk-taking fracking executives to the skeptical short sellers.

From my point of view, I think Munger (as usual) is right. We should exercise prudence even if our newfound energy supply is abundant.

Oil is a critical, precious, non-renewable resource. We shouldn’t waste it. As a nation, we need a coherent energy policy that seeks to produce as much energy as possible without the use of fossil fuels. We need to plan for the reality that, eventually, we’re going to run out of it. It might be 50 years from now. It might be 200. Regardless of when it happens, the end is coming and, for the sake of our children, we should develop a coherent plan to deal with that future. When we run out of oil, it could potentially have far-reaching economic implications. Let’s mitigate those consequences. Let’s plan for the future.

Prudence will likely lead to a better world. We don’t want to live in the world of Max Rockatansky.

Whether you agree with me or not, I recommend Bethany’s book. It will give you perspective on the most important economic event of the last decade and help you come to your own conclusions.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Q3 2018 Update

Q3 Performance

Overall

Another quarter, more underperformance.

Value investing continues to underperform, and I continue to make mistakes. Regarding value’s underperformance, YTD to the 50 cheapest stocks in the S&P 500 has returned 3.62%. The 50 most expensive have delivered a 17.95% YTD return, outperforming the S&P 500.

I believe this will end, but I have no idea of when or how this will happen. The current cycle has looked like 1999 to me for nearly three years. I always suspect we’re close to that magical March 2000 moment, but it never seems to happen and expensive stocks continue to rip.

It looks like we’re late in the bull market to me, but no one really knows. There are no clocks on the walls, and everyone is flying blind, despite their assertive declarations to the contrary.

The only thing that I can do is continue to pursue my strategy: cheap stocks, good balance sheets, high probability of mean revision.

As for my mistakes, the biggest one appears to be abandoning my strategy a year ago for 20% of my portfolio and buying a bunch of international indexes that wound up vaporizing my money. The meltdown in Turkey caused me to wise up (or capitulate, depending on your perspective) and get back to the basics – buying individual value-oriented U.S. stocks.

Trades

This quarter, I sold all of my international indexes and bought specific U.S. stocks that I thought were undervalued. I was also paid out for my shares of the net-cash situation Pendrell. I reached a one year birthday on my position in Foot Locker and re-evaluated the position. The stock has been fantastic to me, and I’ve taken many of my gains off the table as it ran up over the last year. Evaluating the position on its birthday, it looked much more expensive than when I bought it a year ago, so I exited the position. I still think it’s a reliable company, but it is too rich for my tastes.

With the money from these sales and portfolio events, I purchased the below positions. Each position is linked to a blog post in which I outlined my reasons for buying it.

  1. Sanderson Farms
  2. Thor Industries
  3. United Therapeutics
  4. Reinsurance Group of America
  5. Micron
  6. MetLife

Of these buys, I am most excited about Micron, which strikes me as absurdly cheap. It is, in fact, the cheapest stock on an EV/EBIT basis in the entire S&P 500.

Overall, I still think Argan is the most compelling bargain in my portfolio, and the thesis continues to pan out.

Goodbye, Cruel World

I initially pursued my international strategy for two reasons: (1) In Q4 2017, about 60% of the cheap stocks I was screening were in the retail sector, and I didn’t want to have that level of concentration in one industry. (2) The US valuations look terrifying to me, so I thought an excellent way to diversify would be to buy cheaper foreign markets.

So what happened?

Many of the cheap retail stocks I didn’t buy went on to perform magnificently. Here are a few picks I didn’t invest in because I had 20% of my portfolio devoted to international indexes:

Williams & Sonoma (up 32% YTD)
Best Buy (up 16%)
DSW (up 31.26%)

I ignored my thesis about the retail sector (that the popular “Amazon eats the world” hypothesis was wrong, and retail valuations were unusually cheap) and pursued another strategy that wound up falling apart.

Experience the carnage:

international indexes

Nearly every one of them declined, due to a combination of weakness in those markets and strength in the US dollar. I lost $1,090.30 overall on the experiment, which is 2% of my portfolio. Meanwhile, the stocks that I otherwise would have invested in did better.

I abandoned my strategy and underperformed as a result.

With all of this said, I still think that low CAPE ratio international indexing is a viable option that will outperform in the future. I also know it’s not for me. I need to understand my investments. I don’t know anything about the monetary policy or political situation of Turkey or Russia. I don’t know anything about foreign currency speculation. In short, I don’t know enough about the positions to stick with them when times get tough, as they are right now.

I also bought these indexes for all of the wrong reasons. Mainly, I am freaked out by the valuations of US stocks and thought this would be a way to diversify away from the risk of US overvaluation. The truth is, with the US comprising over 50% of the global market cap, when the US pukes, everything else is going to go down with it. There won’t be a place to hide, even among cheap international markets. And that’s what I’m terrified of — I’m not concerned about a gradual underperformance of the U.S. versus the world, I’m worried about the markets puking in a 2008 style event. Aside from hedging strategies, there isn’t much way to avoid this inevitable pain.

Should I just shut up and buy the damn screen?

I tweeted this back in April, and I think it’s true:

tweet

For my stock selection, I need to understand the companies to remain invested in them. I know if a sell-off is related to an actual problem (i.e., the woes of my sold Francesca position) or if it’s pure market noise (i.e., volatility in Argan). My understanding of the companies helps me stick with the strategy. Research helps me behaviorally.

Behavioral folly is also the reason I don’t go full quant even though I am very quantitative in my approach. I start with a screen of cheap stocks, research the output of the filter, and try to identify the opportunities which I think are best.

This approach has flaws due to the “broken leg” problem. One of the best examples of this is Joel Greenblatt’s brokerage service that was designed to help people implement the magic formula strategy. Greenblatt established a brokerage firm that would automatically invest in the magic formula for clients. Some clients automated the magic formula stock selection, while others chose from the list. The clients who picked their stocks from the magic formula list underperformed. Those who purchased the screen outperformed the market. Joel Greenblatt explains it here.

Why did this happen? In short, investors avoided the scariest looking stocks, which were the ones that provided the best returns. I don’t think this phenomenon only applies to amateur investors. I think it’s the main reason that many value investors underperform simple quantitative “cheap” strategies. You’ll often hear of exceptional value investors outperforming the stock market, but they often underperform the lowest deciles of cheap. They underperform simple metrics of cheap because, to avoid value traps, they often pass over the best opportunities in the market because of how terrifying they appear.

The evidence indeed suggests that I should go “full quant” and buy the damn screen. The reason I don’t do this is that I don’t feel that I would be able to stick with a “full quant” strategy. I want to understand what I invest in so I can stick with the plan through thick and thin.

The low CAPE strategy is a quant strategy as is merely buying cheap stocks. I recognize the compelling logic of a full quant approach, but I can’t fully embrace it because I want to understand the companies themselves. It might worsen my results over the long run, but at least I’ll be able to stick with it.

I set out on this blog to pick stocks within the low P/E, low debt/equity 1970s Graham framework. That’s what I’m going to stick to despite the temptations to abandon it. I am not knocking the low CAPE index approach, the magic formula, or the Acquirer’s multiple strategies. I just don’t think I’d be able to stick with a purely quantitative approach if it ever turned against me.

Random

This is hilarious. “He just wanted to spend time with his family . . . and his robot. Like a normal guy.”

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

MetLife (MET)

fall

Key Statistics

Enterprise Value = $46.727 billion

Operating Income = $5.65 billion

EV/Operating Income = 8.27x

Price/Revenue = .70x

Earnings Yield = 11%

Debt/Equity = 36%

The Company

Met Life is a massive global insurance firm. Their $457 billion bond portfolio makes them one of the biggest institutional investors in the United States. Their business spans the globe with operations in the United States, Asia, EMEA, and Latin America.

A major focus for MetLife is group insurance for large corporations. Another important segment is pension risk transfer when MetLife assumes the pension risk of another company. Another segment is structured settlement, in which MetLife will take on large class action legal claims.

Like Unum Group, shares have languished due to concerns about its long-term care insurance reserves. In other words, with people living longer and medical care costs rising, the market is worried that MetLife doesn’t have enough capital set aside to deal with these concerns. These concerns have caused many insurance names to lag the S&P 500 in the past year and MetLife has not been immune to the pain In the last year, the stock is down 8.39% while the S&P 500 is up 15.67%.

My Take

Cheap insurance stocks are a large segment of my portfolio. I currently own Aflac, Unum Group, Reinsurance Group of America, and MetLife. I like insurance for several reasons: it is boring, it is profitable, and beaten up insurance companies almost always tend to recover unless there is a black swan event or they have been playing it fast and loose with risk management.

As for the long-term care anxieties, I have no idea if MetLife has sufficient capital set aside. What I do know is that long-term care represents only 15% of MetLife’s business and it looks to me like the concerns are already built into the stock price.

Despite the pressures on the stock and worries about long-term care, revenues and profits are up over the last year. In the most recent quarter, year/year revenues are up 38.23% and EPS is up 3.75%.

Met Life is a high-quality firm. Their Piotroski F-Score is currently an excellent 7. Their debt/equity ratio is currently 36%, implying that they have a relatively safe balance sheet.

My main attraction to Met Life is its high level of shareholder yield. In the last year, MetLife has bought back 5% of the outstanding shares and delivers a dividend yield of 3.60%. The share buybacks show no signs of letting up. In May, the company announced a $1.5 billion share buyback.

With most of my picks, I buy ugly situations and wait for significant multiple appreciation once the concerns fade away. I am looking for gains of 50-100%. With Met Life, I’m not expecting those kinds of gains. While moderate multiple appreciate is possible, my expectation is that MetLife has a low probability of blowing up and, in the meantime, it will continue to aggressively return capital to shareholders and ought to deliver an attractive rate of return.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Reinsurance Group of America (RGA)

measurement

Key Statistics

Enterprise Value = $10.10 billion

Operating Income = $1.159 billion

EV/Operating Income = 8.71x

Price/Revenue = .73x

Earnings Yield = 19%

Debt/Equity = 41%

The Company

RGA is a Missouri based holding company for multiple reinsurance entities all over the world.

What is reinsurance? Simply put, reinsurance is insurance for insurance companies. Typically, insurance companies buy reinsurance policies to cover themselves in the event of catastrophic losses that occur outside of the assumptions in their risk models. Insurance companies would depend on reinsurance after an extreme event – a major disaster like a historically unprecedented hurricane, earthquake, or a terrorist attack.

RGA is unique in that it focuses on insurance for claims related to health insurance and life insurance. One example of this niche is their focus is longevity reinsurance, a business where RGA insures health insurance companies for the risk that insured people will live longer than the models project. (If Ray Kurzweil’s predictions are true, RGA is screwed. I don’t think we will find the fountain of youth anytime soon, though.) Another area that they focus on is “asset-intensive reinsurance,” which insures annuities for the possibility that their annuity returns might fall short and annuitants will live longer.

RGA has often changed its ownership structure. RGA initially went public in 1993 after years as a division of General American Life Insurance Company (General American retained a majority stake in the company after it went public). It operated publicly from 1993 until 2000, at which point MetLife bought it and took it private. MetLife then spun off RGA in 2008, and it has operated as an independent public company ever since.

A key risk for RGA would be a global disaster affecting human mortality. An example would be a pandemic. Bill Gates has sounded the alarm on this issue for a long time. In addition to an event causing mass casualties, such an event would also create chaos in the financial markets, which would affect RGA’s investment portfolio. A bet on RGA is a bet that such an extreme event won’t happen in the near future.

Reinsurance is also a dull, slow-growing industry that doesn’t command high multiples. Regardless of this, it is essential for insurance companies to maintain reinsurance policies to protect themselves.

My Take

RGA operates a good business that has been steadily growing since it was spun off in 2008. It has grown premiums and investment income steadily since going public, as you can see from the below chart (in billions of dollars):

rgarevenue

While the industry grows slowly, it grows steadily and methodically as the need for insurance grows and more of the world’s population enters the middle class, creating a need for insurance where none existed in the past. Each year, 160 million people globally become middle class. As they enter the middle class, they need home insurance, car insurance, and health insurance. As demand for insurance grows, demand for reinsurance grows. Because RGA has a global footprint, they benefit from the global growth in insurance, as you can see from their results over the last decade.

RGA trades at a discount to industry averages. The average price/revenue for the industry is 1.37 compared to .73 for RGA. The price/revenue multiple implies that RGA’s stock has an 87% upside. From a P/E multiple standpoint, RGA trades at 5.37x versus an industry average of 19.48, giving the stock a 262% upside potential.

Much of RGA’s high earnings in the last year are due to positive gains realized from the tax bill. Even with temporary tax gains taken into consideration, RGA’s forward P/E of 12 is still a discount from the industry average. RGA also trades at a discount to book value, which is currently $147 per share.

RGA is not only at a discount to the industry average, but it is also posting better results than industry peers. RGA achieved a 21% return on equity last year, which is better than the industry average of 6.71%.

RGA compares favorably to two of its biggest competitors, Everest Re and Renaissance Re, both of which paradoxically trade at a higher valuation. Concerning return on assets, RGA beats both of them. RGA delivered a 2.97% ROA in the last year, compared to 1.4% for Everest and -1.55% compared to Renaissance.

comparison

In short, I think RGA represents an attractive discount to the valuation of its peers even though it is performing better than them. Simple multiple appreciation could provide an attractive return for RGA.

I also think it is a possibility that RGA could be bought by a larger insurance company, as it was back in 2000 by Met Life.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Micron (MU)

chip

Key Statistics

Enterprise Value = $59.959 billion

Operating Income = $13 billion

EV/Operating Income = 4.6x

Price/Revenue = 2.23x

Earnings Yield = 20%

Debt/Equity = 26%

The Company

Micron is a rapidly growing semiconductor manufacturer. It represents everything that investors are supposed to love in 2018. Micron manufactures semiconductors for everything from supercomputers to smartphones with a particularly strong niche in memory products.

Business has been fantastic over the last few years, driven by the global growth in tech spending. From 2016 levels, 2017 sales were up by 64%.

The business is in the midst of a massive boom, with revenues and earnings growing every quarter. The Q3 earnings report was the best in Micron’s history, pulling in $7.7 billion in revenue and $3.10 in earnings per share.

My take

In the current tech-obsessed mood, Micron is the kind of business that Wall Street should be infatuated with, but it’s not. Micron currently trades at an absurd P/E of 5.10 compared to industry average of 30.10, a discount of 83%. Micron’s 5-year average P/E is 14.58. An increase to this level would be a 185% increase from current levels.

The crazy valuation is not a result of a sell-off. Micron’s stock price has done well over the last few years. This is an odd situation where the actual earnings growth over the last few years has outpaced the stock price.

The major risk is that Micron’s business is at a cyclical peak. This is a view I am very sympathetic towards. Micron is mired in an extremely cyclical business. In the last twelve months, Micron posted a crazy operating margin of 46%, which is destined to decline. Eventually, the market will become saturated and prices will decrease.

Where are we in Micron’s business cycle? I have no idea. It’s entirely possible that we are at the peak in this business cycle for Micron. It’s also possible that we are in an early inning. I don’t know. The thing is: no one else knows, either.

This is also an industry facing constant and relentless pricing pressure. That’s why a ’90s supercomputer can now fit into your pocket. Tech gets better and cheaper as time goes by. It’s a bad place to be.

semi

Tech hardware: not a great business

This is a cyclical business with long-term pricing pressure on the downside. This begs the question: why am I buying this thing?

In my view, even if Micron’s business is at a cyclical peak and they are poised to lose pricing power: at 5x earnings, does it matter? What will the multiple go up to, 8x? 10x? That’s still very cheap for an S&P 500 tech company that is growing earnings and cash flow at such a rapid rate.

Why isn’t the same mentality applied to other amazing mega cap semiconductor companies like Nvidia, trading at a multiple of 39x earnings? Or Intel, trading at 19.85x earnings?

The expectations embedded in the stock price completely discount the possibility that the Micron’s good times might last longer. At such a cheap price, I am willing to take the other side of that trade.

There are no signs of financial distress with Micron, with a nearly perfect F-Score of 8 and a debt to equity ratio of 26%. Micron’s solid balance sheet and strong financial position also limit the possibility of a major blow up, limiting the risk on the downside.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

United Therapeutics (UTHR)

dna

Key Statistics

Enterprise Value =$4.454 billion

Operating Income = $998.2 million

EV/Operating Income = 4.46x

Price/Revenue = 3.06x

Earnings Yield = 13%

Debt/Equity = 10%

The Company

United Therapeutics is a biotech firm founded in 1996 by Martine Rothblatt. Rothblatt’s daughter suffered from pulmonary hypertension (high blood pressure within the arteries of the lung), and she founded United Therapeutics to try to find a treatment. They succeeded in creating Remodulin, which was approved by the FDA in 2002. UTHR sells many other drugs, but Remodulin remains the blockbuster core of the business. In 2017, it represented 39% of total revenue.

More recently, in 2015, the FDA approved one of UTHR’s latest drugs: Unituxin. Unituxin is a treatment for neuroblastoma, cancer affecting the kidney. Children often have this cancer. Unituxin helps the immune system fight cancer.

A few years ago, UTHR was a richly valued growth stock. To put the growth into perspective, in 2002 the company generated $50 million in sales. Last year, sales were $1.7 billion. In 2015, it traded at a P/E ratio of 50.

Since the 2015 peak, the stock is down 17%.

What happened? Several patents expired in 2017 and UTHR is facing increased competition from generics. Growth has slowed down, and the market is worried that there aren’t enough drugs in the pipeline to keep the growth going.

My Take

Growth for UTHR likely won’t continue at the intense pace of the last twenty years. The thing is: at this price; it doesn’t need to. The stock is priced like it is a dying business that is being destroyed by competition as if it is one of my beleaguered retail picks fighting the Amazon juggernaut. In reality, this is a Phil Fisher company trading at a Ben Graham price.

The stock now trades at a P/E of 7.63 (down from its 50x peak in 2015). The average for the biotech industry is 29.45, meaning that UTHR trades at a 74% discount to this. It is also a free cash flow machine generating an 11% yield based on its current enterprise value. The 5-year average P/E for UTHR is about 18.55 (which seems like a proper valuation for a growth company). An increase to 18.55 would be a 143% increase from current levels.

In the most recent quarter, year over year sales was mostly flat, and earnings were down. The recent performance deepens the worries that UTHR’s best days are in the past.

The consensus price implies that UTHR has nothing in the pipeline. In reality, they spent $264 million on research in 2017. They are working on many new drugs, but one of the most exciting areas of research is the manufacturing of organs. They are trying to develop the ability to generate engineered lungs, hearts, and kidneys. If they succeed, such a development could save a tremendous number of lives over the long run and, of course, generate significant business for the company.

UTHR is valued as if it is roadkill. It is priced for a no-growth future. Based on its past results and research pipeline, this seems to me like an unlikely fate. With a solid balance sheet and low valuation, the prospects of a significant decline are low. Meanwhile, any whiff of good news on the research front could send the company to a more normal valuation, potentially a 100%+ gain from current levels.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.