Energy is a fascinating industry right now from an investment standpoint. It's one of the few sectors where you can find lots of great companies selling at low valuations. Between the previous few years of low oil prices and the wild ups and downs of the alternative energy markets, Wall Street has been giving energy a wide berth. For investors who have a longer-term investment horizon, though, there are some deeply discounted stocks in the energy world.
Two very cheap stocks that stand out and are worth considering are fracking sand supplier U.S. Silica Holdings (SLCA +0.00%) and solar and wind asset operator TerraForm Power (TERP +0.00%). Here's why these stocks are trading at low valuations, and why you should consider buying them today.
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Better business model trading at a deep discount
A few years ago, when most investors were just waking up to the investment opportunities in shale, fracking sand was a scorching hot sector, and investors bid up frack sand stocks to outrageous multiples. As demand for sand plummeted, though, most of these sand suppliers were hemorrhaging money and a few were teetering on bankruptcy. Even though U.S. Silica had a respectable balance sheet and revenue streams outside oil and gas, the company was posting losses from weak sand prices, and the stock was consequentially hammered.
Fast-forward to today, though, and the company's prospects look much improved, but its stock remains at prices that would be more fitting for the bottom of the oil cycle. Shale producers in the U.S. have become much better at drilling and have drastically lowered their break-even oil price, which means that production and drilling activity will be more resilient through the ups and downs of the market. Also, thanks to higher sand use per well, total sand demand is through the roof. According to U.S. Silica, total demand for sand proppant will be more than 100 million tons in 2018, 59% higher than the prior peak in 2014.
U.S. Silica has also used this booming demand to improve the way it does business. It has signed 80% of its production capacity to supply contracts with producers that ensure steady demand and favorable pricing for several years. It's also expanding its last-mile logistics services that improve margins per ton produced, and it recently acquired diatomaceous earth supplier EP Minerals to further diversify its revenue base. These things all coalesced in its most recent quarter to deliver a 78% increase in adjusted earnings.
U.S. Silica's business has changed from a few years ago when it was incredibly sensitive to high-cost oil production. Yet its stock trades at a price-to-earnings ratio of 11. Management expects to grow proppant sales by 25% as its recently completed mines ramp up to full capacity, and the business has the added benefit of EP Minerals' contribution from here on out. With that much growth on the way, this stock looks like an absolute steal right now.
Getting more out of what is already there
An incredibly frustrating thing for investors is finding a business with great assets, only to realize that it isn't living up to its potential for one reason or another. TerraForm Power was a textbook example of this. Under its former parent company, SunEdison, it had a great portfolio of solar and wind assets with long-term contracts in place to ensure revenue and cash flow for years. The trouble was that SunEdison sold those assets to TerraForm at unattractive prices and loaded it up with debt. Furthermore, SunEdison proved to be a rather poor operator and rarely was able to get its facilities to run at full capacity.
Fortunately, TerraForm Power is no longer a part of SunEdison, as Brookfield Renewable Partners (BEP 1.75%) acquired a majority stake in it during SunEdison's bankruptcy proceedings. Becoming a component of the Brookfield family of businesses is in itself a crucial step in transforming TeraForm into a lucrative investment. Brookfield thinks TerraForm can deliver a 16% to 21% increase in its payout to investors without having to add any new solar or wind facilities to its current portfolio. Simple things like using Brookfield's access to capital to refinance its high-interest debt, cutting overhead by integrating it into Brookfield's systems, and improving the availability of its current assets should be enough to significantly improve the bottom line with minimal capital investment.
Beyond these initial few years of cleaning up SunEdison's mess, Brookfield's management has proven its great capital allocation skills, which should help TerraForm grow its business. The suite of various partnerships run by Brookfield haven't ever put up stellar growth numbers, but consistent payout increases in the high-single-digit range, coupled with moderate dividend yields, have made them great investments on a total return basis.
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The formula to make TerraForm Power into a compounding machine like the other investments under the Brookfield umbrella is there, and initial results show management is making progress already. Considering that shares of TerraForm Power have a dividend yield of 6.8% today, now looks like an opportune time to forget TerraForm's past and consider buying shares.
