Even at Record Prices, Oil Stocks Barely Budge

If you are in the camp that oil will be heading back to $40 or $50 per barrel anytime soon, I'm afraid you are sorely mistaken. After hitting new record highs earlier in the week, crude prices are still above the previous highs set last hurricane season. Surprisingly though, energy stocks mostly sit decently below their 52-week highs.

I haven't written about energy lately, but I am still bullish on the sector and recommend investors continue to overweight the group in their portfolios. Single digits P/E multiples coupled with attractive outlooks make the stocks very attractive, especially in a market where very few stocks have worked thus far in 2006.

Energy bears will focus on the lack of supply constraints currently in both the crude oil and natural gas markets. However, merely focusing on what the situation is right now misses the point. Barring a global recession, energy demand will continue to rise and supply will have a hard time expanding at a rate that keeps pace. Surely there will be periods of both low and high supplies, based on weather patterns and other factors, but investors should focus on the big picture. As long as annual oil demand continues to rise, and few new wells are discovered across the globe, the bull market for energy will continue.

As far as where to look for investment opportunities, I continue to focus on the producers and sellers of the actual commodity, as opposed to the equipment and drilling suppliers. Rig owners, for example, will profit based on day-rates, or the price of renting out their rigs. There is nothing stopping more rigs from being built, thereby reducing the prices the equipment companies can charge to lease them. And who knows what would happen to the fortunes of a company like Halliburton (HAL) after the Bush administration has left office.

Conversely, it is much more difficult to find new sources of oil. As a result, those exploration and production companies with the best assets will continue to thrive in a tight energy market. Leading E&P companies can be had for between 6 and 9 times earnings, quite a bargain if you ask me. 

Anadarko Announces Two Large Buyouts

I can't recall a time when a company has announced two large acquisitions at the same time. Today we hear that Anadarko Petroleum (APC) will buy both Kerr McGee (KMG) and Western Gas Resources (WGR) for more than $21 billion in cash. With Anadarko's market cap around $22 billion before the deals were announced, they are essentially doubling the size of the company overnight, creating the country's largest independent exploration and production company.

Both of these purchases show just how undervalued energy companies are in the public markets these days. Anadarko is paying a 40% premium for Kerr McGee ($16.4B) and a 49% premium for Western Gas ($4.7B). Despite these huge cash premiums, the deals will be accretive to earnings. Few seem to disagree that our natural gas needs will continue to rise, but for some reason the stocks trade at exceptionally low valuations. This has resulted in a lot of M&A activity, and likely will continue to do so.

Caterpillar Sets Growth Goals

Yesterday at their annual meeting Caterpillar executives laid out a growth outlook for the next five years. The headline peaked my interest because it seemed aggressive. Cat CEO James Owens announced that sales will grow to $50 billion in 2010 and earnings per share will grow at a compund annual rate of 15%-20% between 2005 and 2010.

For a fairly large, mature business like Caterpillar, as much as 20% annual EPS growth over a five year period sounded very optimistic to me, but upon doing a little further number crunching I realized that the plan really wasn't all that aggressive after all. Current estimates for 2006 and 2007 imply earnings growth of 31% this year and 13% next year. This comes on the heals of a 40% surge in 2005, the first year of the period in question.

So, from 2005 through 2007, earnings are expected to grow 28% per year on average. In order to hit the midpoint of the 15-20% annual goal for the entire six year period, profits in 2008-2010 will only have to average about 7% annually.

Given this outlook, are Cat shares a buy at the current $68 per share price tag? Let's assume the midpoint of the growth plan is achieved (17.5%). That puts 2010 earnings at about $7.30 per share. Let's assume a modest 12 P/E on those profits, given that we are talking about a cyclical heavy machinery company. We get an implied share price of $87 four years from now, about a 30% gain from current levels.

Not a horrible return, but not as good as you might expect based on the headlines we saw yesterday. This also assume that the global economy remains strong for many more years. A global recession will likely hurt very cyclical businesses like the one Caterpillar dominates.

L-3 Shares Rally Despite Succession Uncertainty

"L-3 Shares Climb After CEO Death" - API can't make this stuff up. That is the headline of an Associated Press story talking about the $5 jump today in shares of L-3 Communications (LLL), a large defense contractor. L-3 has been a small Peridot Capital holding for several years. I wrote back in November that a sell-off from $85 to $74 was overdone. The stock subsequently hit a new all-time high of more than $88 per share.

L-3's CEO Frank Lanza, 74, passed away suddenly yesterday and when I saw the headline this morning, I figured we would see some selling pressure today. Lanza co-founded and led L-3 on an acquisition spree that built the company into a $12 billion a year defense giant. Given Lanza's age and lack of a solid succession plan in place, many investors have been wondering what would happen if Lanza left, or worse, passed away.

Such uncertainty usually breeds fear on Wall Street. Not so today, however, as the stock is rocketing ahead by 7 percent. L-3 itself has been rumored to be an acquisition target, and with no clear leadership in place right now, investors seem to think one possible succession plan will be to sell the company. I'd put the odds at no better than 50/50 that such a scenario materializes.

Different Paths Taken by Enron's Past Management

Last week Ken Lay and Jeff Skilling were found guilty on numerous charges related to the demise of Enron. Today we hear that Richard Kinder is heading up a bid to take Kinder Morgan (KMI), his energy pipeline company, private in $100 per share deal. It's very interesting that these two events are coming only days apart.

For those of you who are not familiar with Richard Kinder, he was the President and Chief Operating Officer at Enron ten years ago and was seen as CEO Ken Lay's successor. However, Kinder left in 1996 after a falling out with Lay, and Jeff Skilling took his job. We all know how that ended up.

Kinder, however, always saw the future of Enron as a dominant pipeline company. Owners of oil and natural gas pipelines act much like toll booths, collecting fees as energy is transported over their infrastructure, regardless of the price of the commodity. Conversely, Lay wanted Enron to focus on energy trading and much more risky ventures.

Kinder, along with partner Bill Morgan, co-founded Kinder Morgan Inc (KMI) and actually bought Enron's pipelines from Lay. It's not hard to see which strategy turned out to be right. Kinder is the majority owner of KMI and sees so much value in the company that he wants to take it private for $13.5 billion. Enron is, well, completely worthless.

Lampert Sells a Third of AutoNation Stake

SEC filings reveal that Eddie Lampert, hedge fund manager and Sears Holdings (SHLD) chairman, has been selling his shares of AutoNation (AN) aggressively over the last month. Between April 19th and May 16th Lambert sold more than 26 million shares between $22.50 and $23.00 each, netting proceeds of about $600 million. Should we go out and short AN off this? There are probably better trades to make. I suspect he is raising cash for reasons other than to avoid an upcoming collapse in AN (after all, he stills owns over 50 million shares). It will be interesting to see where he puts the money.

Chesapeake Delivers Again

If you are going to invest in a natural gas company, I doubt you can do any better than shares of Chesapeake Energy (CHK). CHK has everything investors should want; a great management team, a low valuation, and strong business fundamentals.

The company did little to sway my opinion after reporting first quarter earnings last week. Net income excluding one-time items came in at $1.07 per share, well ahead of expectations. The conference call was equally impressive, but you wouldn't really know it from the share price. After jumping about 4% after the numbers came out, the stock has barely budged.

I want to point out a few things that I think investors are missing when it comes to analyzing Chesapeake. As is the case with many commodity-related companies, the day-to-day movements of the stock tends to track commodity prices (in this case, natural gas) and not company-specific fundamentals. Of course, the prices energy companies get for their production is a key component of how their financial results will turn out, but focusing simply on daily fluctuations in natural gas prices, and trading CHK shares based on that, is very misguided for long term investors (yes, it does make sense for day traders since we know that is how the stock has been trading lately).

What is interesting about Chesapeake is that they are actively engaged in a natural gas production hedging program that seeks to lock in prices for their gas well into the future, in order to ensure that they can earn returns on capital that are acceptable for shareholders. Amazingly, CHK has hedged 80% of their 2006 natural gas production at $9.45 per mmbtu. Why is this amazing? The current natural gas price is about $6.65, so CHK is getting 40% more for their gas than their competitors who have not hedged. As a result, it doesn't take a rocket scientist to figure out that not ALL natural gas stocks should track natural gas prices.

Let's take this silliness one step further. For some reason (which I cannot explain in a way that makes logical sense) Wall Street analysts exclude any gains from CHK's hedging program in their quarterly earnings estimates. The company's first quarter numbers were reported as $1.07 versus estimates of $0.98 per share. Estimates for 2006 are around $3.40 per share, putting Chesapeake's P/E under 10. But the hedges aren't even factored into these numbers!

Chesapeake made $122 million in Q1 from their hedges, which comes out to $0.29 per share. In reality, the company reported $1.36 in earnings, not the $1.07 that was reported by the press and analysts. Since this is real money that the company is generating, I can't ignore it when valuing the company. After all, investors haven't ignored the hedging program at Southwest Airlines (LUV), which is a big reason they have performed so well even with $70 oil.

Including adjustments for hedging gains, CHK could earn north of $4.50 this year (annualized Q1 hedging), which puts its adjusted P/E at around 7 rather than 10. Yup, that's right, the stock appears cheap and is actually even cheaper! 

It's Tough Not To Like These Guys

For those of you who follow energy companies, and Chesapeake Energy (CHK) more specifically, I highly recommend you listen to the company's fourth quarter earnings conference call that was hosted this morning.

The company's shares have been weak lately as natural gas prices have been cut in half and the company's co-founder and chief operating officer, Tom Ward, suddenly announced his retirement from the company at the fairly young age of 46 years old.

I can't recall a more impressive conference call this quarter. They even had Ward on the phone to address any concerns over his unexpected departure. You don't see that type of focus on shareholders' interest every day from management teams of publicly traded companies.

Time to Unload Commodities?

Days like Tuesday don't feel too great when you have bets in the energy and industrial metals sectors. Many stocks were down as much as 6 percent yesterday alone. Despite the huge moves we've seen dating back to last year, the combination of strong fundamentals and low valuations continue to explain my bullishness.

Commodities are cyclical, and one day the party will certainly end, however I think the bull market in energy and materials still has ways to go. Really, it's simple supply and demand. Even at today's elevated prices, demand worldwide should remain strong. On the supply front, there is no reason to believe the world is going to all-of-the-sudden find lots more oil. Metals such as copper and gold take years to be mined, and unmined supply is fairly limited as well.

The stocks will always be very volatile, as a one-year chart of any company in the sector will show, but I can't help but think sell-offs like the one we saw Tuesday are opportunities for those who have yet to jump in.

Take Anadarko Petroleum (APC) as an example. Late Monday, the company reported earnings of $3.88 per share on sales of $2.25 billion, easily surpassing estimates of $3.35 and $2.09 billion. In fact, actual results even beat the highest printed estimate on the Street ($3.77/$2.23B). However, the stock fell more than $3 to $102 per share as crude oil prices dropped by a decent amount.

APC also announced a 2006 capital expenditure budget of $4 billion versus $3.4 billion in 2005. Production growth is expected to be in the 4-8 percent range this year. It's not just an oil price story, but production is growing too.

After seeing last quarter's results, I have no reason to think the highest 2006 estimate coming into that report, earnings of $15.73 per share, is unattainable. That would put the stock's forward P/E at 6.5x. Most investors will tell you such a multiple signifies peak earnings, and they'd be right. Price-earnings ratios are always lowest at cyclical tops and highest at cyclical bottoms. The bullish case for Anadarko centers around the idea that 2006 might not be the top.

If China and India continue to grow as a percentage of the world economy, and other nations follow their lead, oil could reach at least $100 per barrel by the end of the decade. That might not happen, but I think it very well could, and the odds of $30 oil anytime soon are very, very low. Energy and materials represent 10% and 3% of the S&P 500, respectively. I think investors should be overweight these areas for the next several years.

GM Moves Away From Incentives, But Cuts Prices?

So General Motors (GM) is looking to reduce its reliance on consumer incentives to boost car sales. Sounds like a good idea to me. When you have offered employee discounts and zero percent financing for months on end, the buyer knows they have huge negotiating leverage when they walk into a dealership. Ideally, buyers would be willing to pay market prices for quality vehicles that they want.

The interesting part of this story is that GM is cutting prices by up to $2,500 per vehicle to make up for the reduced incentives in order to entice consumers. It seems like they are changing the name of the discounts, but still don't have the product line to charge full price. Cutting incentives and reducing sticker prices simultaneously seems like a zero sum game to me.