Andrew Penner
The "risk-off" trade, which has pummeled the stock market, has led to the outperformance of defensive sectors, including telecommunication, utility and health-care stocks. Still, energy, the most profitable sector so far in 2011, is holding up well.
S&P 500 oil-and-gas stocks have delivered a median gain of 9.3 per cent in 2011. Crude oil is hovering around $100 (U.S.) a barrel, a sweet spot for producers - expensive enough to generate lofty margins, but not costly enough to cannibalize demand for energy.
On Tuesday, addressing vocal concerns about elevated commodity prices, Federal Reserve chairman Ben Bernanke reiterated his stance that the recent price gains would prove transitory. He also dismissed the notion that speculators are driving up the cost of fossil fuels, noting that emerging-markets demand has long outstripped supply, a trend expected to continue, or perhaps amplify, in coming years.
In consideration of this market fundamental, energy investments are looking attractive from a long-term perspective. Three energy stocks, in particular, are worth considering now.
3. Baker Hughes is the third wheel to energy-services brand names Schlumberger and Halliburton, but its margin upside and growth potential is superior. Morningstar recently added Baker Hughes to its five-star stock list, citing demand growth and margin expansion as catalysts for the equity. Sell-side researchers have a favourable view of Baker Hughes, as well. It receives "buy" ratings from 77 per cent of analysts.
Baker Hughes sells services and parts to drillers, including directional drilling assistance, field chemicals, drill bits and advanced pumping systems. In 2009, the company was largely product, rather than, market-focused, so to compete better with larger peers, Baker Hughes merged with BJ Services in a deal valued at over $5-billion. The move proved accretive to earnings. Baker has tripled trailing 12-month net income. Last quarter, the company doubled adjusted earnings to 87 cents, exceeding analysts' consensus projection by a solid 12 per cent.
Sales, up 78 per cent, also beat consensus. But, business is abnormally cyclical and currently benefiting from elevated crude oil prices. Should that trend reverse, Baker's outlook would drop precipitously. Two weeks ago, Goldman Sachs, in a bullish move, bumped its 12-month oil forecast to $130. Continued price momentum in crude isn't guaranteed as a slowdown in resource-hungry China, the end of the Federal Reserve's QE2 and a strengthening dollar could catalyze a price drop, as the commodity is priced in U.S. currency. On the other hand, if the recovery continues and oil remains above $100 a barrel, Baker will cash in on higher profit spreads and its stock will climb, perhaps faster than peers'.
Last quarter, its operating profit margin extended from 9.3 per cent to 14 per cent, boosting net income. That margin has room to widen, as it ranked in just the 67th industry percentile. Baker held $1.4-billion of cash and $3.8-billion of debt at quarter's end, for a 1.8 quick ratio and a 0.3 debt-to-equity ratio. Goldman has the highest target on Wall Street, expecting Baker to gain 39 per cent to $102. Macquarie isn't far behind, at $102. And, Jefferies values Baker at $96.
2. First Solar is a sector cost leader, manufacturing thin-film cadmium telluride solar panels. Its stock has been punished in 2011, having fallen 11 per cent and 34 per cent from a 52-week high. Goldman predicts that, despite a challenging European solar market, internal cost cuts and a gradual demand rebound will bolster the stock into year-end. The bank has a lofty six-month target of $190, implying 63 per cent of upside.
Piper Jaffray, going even further, values First Solar's shares at $200. However, other researchers have adopted a more cautious stance. About 49 per cent of analysts rank First Solar "buy" while 37 per cent rank it "hold" and 14 per cent rate it "sell." First Solar is unloved relative to other stocks, like Apple, which receives positive reviews from 91 per cent of researchers in coverage.
Goldman, impressed by the company's 13-cent first-quarter earnings beat, expects the stock to continue to decline in coming weeks as the market prices in slowing demand in the second half of 2011, presenting a buying opportunity to savvy investors. With QE2 ending, growth equities, such as First Solar may endure heavy selling, though the fundamental story remains intact. During the past three years, sales, net income and earnings per share have grown 59 per cent, 45 per cent and 41 per cent, annually, on average. Higher global energy prices may assist business in coming months.
According to Goldman, cost cuts are under way, and "tracking on plan for First Solar, less so for competitors and are allowing for ASP declines, larger markets and fewer competitors."
The bank expects significant multiple expansion as interest grows in solar, helped by elevated crude prices, rising energy demand and recent interest from external players. The purchase of SunPower by Total, may be a tell of future acquisitions.
1. Diamond Offshore is a deep-water driller and, like First Solar and Baker Hughes, a top pick at Goldman Sachs. Diamond is expected to benefit tremendously from growth in offshore drilling over the next few years. The bank has a six-month target of $98 on the stock, suggesting tremendous near-term upside of 43 per cent as offshore-drilling reports, ranging from rig utilization to daily day rates, strengthen. According to Goldman, "the pace of jack-up activity and pricing power is accelerating for both high-spec and standard jack-ups. We find it particularly encouraging that there is strength in almost every region," including Mexico and Asia.
Diamond Offshore and Noble Energy are Goldman's "favourite ways to invest in the offshore driller space." The bank likes the cyclical earnings power of their fleets and believes the equities are still notably undervalued. Diamond's stock has taken a beating in 2011, as a special dividend cut catalyzed a mass migration out of the stock. It is up 20 per cent over the past 12 months, but down 1.8 per cent in four weeks. Still, Goldman makes a compelling argument.