The median stock in the energy sector trades right at our fair value estimate.
We made several changes to our pricing assumptions in 2006, all of which increased our fair values for the companies affected.
?Natural Gas. In February we raised our midcycle price assumption for the NYMEX Henry Hub benchmark to $5.67 per thousand cubic feet (mcf) from $4. We based our midcycle price decision on several longer-term trends. Unit costs have been on the rise over the past two years, with the higher-cost, marginal producers experiencing the most mar
ked increases in costs. We don't see this trend changing over the next few years, as firms are paying top dollar to acquire new properties, and day rates for rigs are still well above normal. Further, as LNG becomes a larger contributor to supply over the next decade, we expect that it will support our midcycle price. Although LNG could displace high-cost domestic producers, we think that it should improve the reliability of supply--helping to stabilise gas prices near our midcycle price, rather than creating a glut of low-cost gas.
| Segment | Average Star Rating |
Median Price/Fair Value |
Stocks Covered |
|---|---|---|---|
| Pipelines | 3.58 | 0.91 | 25 |
| Coal | 3.30 | 0.95 | 10 |
| Oil and Gas | 3.03 | 0.98 | 70 |
| Oil and Gas Products | 2.53 | 1.08 | 17 |
| Oil and Gas Services | 2.14 | 1.16 | 29 |
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| Data as of 31-12-06 | |||
?Oil. In September we increased our long-run equilibrium oil price assumption to $46 in 2010 from $39. The case for higher industry costs over the next decade has strengthened, and we expect that OPEC's influence will also continue to improve in the years ahead. In particular, the case for OPEC's increased market power appears especially strong. Much of the incremental supply forecast to come online over the next decade or two is likely to come from OPEC countries. With the call on OPEC supply likely to be large, the cartel's influence should expand in the future.
?Pipelines. In December, we lowered our cost-of-equity assumptions for pipelines. To determine the appropriate COE for each company, we started with a baseline COE of 9%, representing our assessment of a "best in class" pipeline operator. From that baseline, we increased our COEs for each company based on the relative stability and quality of its assets and the diversity of its customer base. We also added a small penalty for general partners, recognising that their inherent leverage increases their risk profile relative to their underlying partnerships. This results in a much more uniform and logical distribution of COEs across our pipeline coverage. Our most stable, strongest companies now carry COEs of 9%-9.25%. Average pipeline companies, which have slightly less attractive asset bases, now carry COEs of 9.5%-9.75%. And we've assigned COEs ranging from 10%-11% to a handful of pipelines with lower-quality assets, small customer bases, or both.
What companies are we bullish on? Large unconventional basins will be a big driver of incremental natural-gas supply in the years ahead, and that's good for Newfield Exploration and Southwestern Energy. We also like Devon Energy because of its deep-water fields in the Gulf of Mexico and its reserves in the Barnett Shale. We think liquefied natural gas could play a major role in meeting domestic natural-gas demand over the next several decades. That's why we love Cheniere, which owns several proposed LNG terminals. Another winner will be BG Group, whose gas production we forecast to growth 10% annually between 2005 and 2012, and some of that gas will be shipped in LNG form. In the company's LNG business, we're forecasting volume growth of 25%, compounded annually, between 2005 and 2012.
With the change in regulatory scheme for the Canadian income trusts, we expect to see lots of consolidation in Canada, with the big winners being U.S. exploration-and-production firms. One firm we'd highlight is Quicksilver, one of the fastest-growing producers we cover.
Utilities Sector
Utilities stocks rose sharply in 2006 thanks to low long-term interest rates. Heading into 2007, we think the sector is unattractive, with both natural-gas and electric utilities appearing slightly overvalued. Particularly if we see flat or rising interest rates, we would expect mediocre to poor returns.
| Segment | Average Star Rating |
Median Price/Fair Value |
Stocks Covered |
|---|---|---|---|
| Water Utilities | 3.00 | 1.05 | 2 |
| Natural-gas Utilities | 2.81 | 1.00 | 18 |
| Electric Utilities | 2.70 | 1.04 | 64 |
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| Data as of 31-12-06 | |||
In terms of growth, we expect merchant generators--companies that sell power on the open market, as opposed to the regulated monopolies of the industry--to perform well over the next few years. We see capacity shortfalls on both coasts, which gives merchant generators opportunities for expansion. Among the merchant generators, we like NRG Energy (whose recent acquisition of Texas Genco gives it scale advantages over peers) and Entergy (whose nuclear plants enjoy an enormous cost advantage over gas-fired plants right now).
We don't expect any major consolidation as a result of the repeal of the Public Utilities Holding Company Act (PUHCA)--at least among the major regulated utilities. We wouldn't be surprised to see some M&A among smaller firms, and merchant generators should continue to both consolidate and attract interest from private equity groups.
Industrial Materials Sector
The industrial materials sector has one of the lowest average star ratings--2.51--among Morningstar's 12 sectors. Partly that's due to our cautious stance on commodity prices in general, which affects many of the companies in the sector, from mining to paper to steel producers.
| Segment | Average Star Rating |
Median Price/Fair Value |
Stocks Covered |
|---|---|---|---|
| Transport Equipment | 4.00 | 0.80 | 1 |
| Building Materials | 3.60 | 0.88 | 5 |
| Machinery | 3.30 | 0.93 | 10 |
| Diversified | 3.14 | 1.04 | 7 |
| Agricultural Machinery | 3.00 | 1.06 | 3 |
| Aluminum | 3.00 | 0.92 | 5 |
| Steel/Iron | 2.95 | 0.95 | 22 |
| Metal Products | 2.80 | 1.01 | 10 |
| Forestry/Wood | 2.75 | 0.89 | 4 |
| Aerospace and Defence | 2.65 | 1.05 | 20 |
| Chemicals | 2.64 | 1.08 | 33 |
| Agriculture | 2.50 | 1.01 | 4 |
| Electric Equipment | 2.50 | 1.04 | 24 |
| Auto Parts | 2.46 | 1.04 | 13 |
| Manufacturing-Misc. | 2.33 | 0.99 | 3 |
| Office Equipment | 2.33 | 1.00 | 3 |
| Construction Machinery | 2.20 | 1.01 | 5 |
| Truck Manufacturers | 2.20 | 1.06 | 5 |
| Paper | 2.15 | 1.17 | 13 |
| Mining (nonferrous and nonmetals) | 2.07 | 1.19 | 15 |
| Agrochemical | 2.00 | 1.13 | 2 |
| Plastics | 2.00 | 1.19 | 15 |
| Rubber Products | 2.00 | 1.19 | 3 |
| Gold and Silver | 1.30 | 1.94 | 20 |
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| Data as of 31-12-06 | |||
On the bullish side, we would highlight three areas. Commercial aerospace has been on a tear the past two years. And several factors--including the expected domestic upcycle, booming international growth in air travel, and high oil prices (which are stimulating demand for more-fuel-efficient planes)--suggest that the current cyclical upswing in aerospace demand could continue beyond the end of the decade. One of our favorite aerospace stocks is Precision Castparts, which sells castings and other parts to airplane makers.
In December, we raised our long-term copper-price assumptions. For example, we now forecast copper prices to be $2 per pound in 2009, up from $0.98 previously. The case for higher industry costs over the next decade has strengthened, and we expect that China's copper appetite will remain high. This means we think copper producers will earn economic rents because of Chinese demand for at least a few more years. The higher price assumptions jacked up our fair value estimates substantially for Southern Copper and Rio Tinto.
In the forestry industry, oriented-strand board (OSB) is replacing plywood; OSB has gone from 0% to 60% market share, in part because it's 15% cheaper. The big winners here are Louisiana Pacific, which controls 25% of the OSB market, and to a lesser extent Weyerhaeuser.
Consumer Goods Sector
In terms of valuation, the standout industry in the consumer goods sector is beverage manufacturing. Each of the nine beverage makers we cover has at least a 3-star rating. Among the 4-star stocks are Coca-Cola, PepsiCo, and Hansen Natural.
| Segment | Average Star Rating |
Median Price/Fair Value |
Stocks Covered |
|---|---|---|---|
| Beverage Manufacturing | 3.56 | 0.89 | 9 |
| Textiles | 3.50 | 0.91 | 2 |
| Shoes | 3.33 | 0.92 | 6 |
| Recreation | 3.20 | 0.94 | 10 |
| Alcoholic Drinks | 3.14 | 0.97 | 7 |
| Audio/Video Equipment | 3.00 | 0.97 | 4 |
| Jewelry/Accessories | 3.00 | 1.07 | 4 |
| Paints/Coatings | 3.00 | 1.02 | 1 |
| Household and Personal Products | 2.81 | 1.04 | 16 |
| Tobacco | 2.71 | 1.04 | 7 |
| Food Manufacturing | 2.61 | 1.03 | 28 |
| Photography and Imaging | 2.25 | 1.13 | 4 |
| Automakers | 2.14 | 1.20 | 7 |
| Apparel Manufacturers | 2.00 | 1.29 | 11 |
| Appliance/Furniture Manufacturers | 2.00 | 1.18 | 6 |
| Packaging | 2.00 | 1.17 | 4 |
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| Data as of 31-12-06 | |||
We also expect several firms in the jewelry/accessories industry to do well, including Coach, Tiffany, and Blue Nile. In the recreation industry, we're bullish on the cruise lines Carnival and Royal Caribbean Cruises, which both benefit from an older demographic.
For automakers, we expect that global growth will accelerate--particularly in Asia--but that the main beneficiaries will be auto-parts makers. We're fairly bearish on the automakers. For General Motors, we expect flat sales, operating losses, and massive restructuring charges for the next two years followed by a slow recovery to a smaller but profitable company. For Ford, we expect average annual growth in the auto business of less than 2% over the next five years and average operating margins below 2%. We're much more bullish on Toyota. We think it will be able to increase revenues by about 7% annually over the next five years, and we expect operating margins to average about 9% thanks to the introduction of innovative products and a continued focus on costs.
Also see:
Information Super Sector: Commentary on the telecommunications, hardware, software, and media sectors.
Services Super Sector: Commentary on the health-care, financial services, consumer services, and business services sectors.
