The price of oil may be up, but many of the biggest energy players are still feeling the ache of the bust.
In this week's episode of Industry Focus: Energy, Tyler Crowe and Taylor Muckerman look at three of this week's dreariest energy stories. Listen in to find out why National Oilwell Varco (NYSE:NOV) is cutting its dividend, what you need to know about Alcoa's (NYSE:AA) earnings report and plans to spin off its aerospace and automotives segment, and the state of coal in 2016.
A full transcript follows the video.
Editor's note: While the Fool wholeheartedly supports financial literacy, we did not create Financial Literacy Month --though we sure wish we had.
This podcast was recorded on April 14, 2016.
Tyler Crowe: We're singing Peabody Energy's swan song on today's show. But, thankfully for the listeners, since we have terrible voices, there will be no actual singing involved.
Hey, everyone, I'm Tyler Crowe for Industry Focus. It's Thursday, April 14, which means it's the energy show, but you know, we do way more than energy. We do industrials, we do materials --
Taylor Muckerman: There's some materials on the show today.
Crowe: All those things your grandfather would recommend that you invest in.
Muckerman: That's right.
Crowe: I'm here with Taylor Muckerman from Motley Fool Canada, and in place of our normal host -- you're probably listening to it on the podcast, but we do have a video of it -- in replacement of our normal host, Sean O'Reilly, we have an ornamental garden gnome. Thanks for having us, Sean. How do you feel today?
Muckerman: Yeah, I appreciate it. He's nodding his head.
Crowe: Great content. Thanks a lot.
Muckerman: He's nodding.
Crowe: So, we're going to talk about Peabody Energy's bankruptcy, some dividend cuts, most notably National Oilwell Varco, and earnings season getting kicked off with Alcoa. But let's start with Peabody Energy filing for Chapter 11 bankruptcy this week.
Muckerman: Yeah. I guess the last of the big four U.S. companies to do so, I think. You have Alpha Natural Resources, Cloud Peak, and...
Crowe: Arch Coal.
Muckerman: Arch Coal, yeah. So, finally. It's been a long time coming. 2011, I guess, was when you started to see prices start their slide, down 75% for coal since 2011. Not many people back then realized exactly what was happening when it started, but a five-year slog these companies have been going through. And 2015, 2016, finally came to a head. You look at China, one of the biggest, if not the biggest, demand centers for coal, they're looking at possibly a third straight year of reduced coal demand. It was down 4.7% in 2015, expectations down 2% more this year in terms of coal demand out of China. And even in coal's backyard, West Virginia, demand down 12% last year. Maryland and Ohio both down 50% since 2005 -- in just the last decade, half the coal production demand that they've been using for coal power plants. And 33% nationally. So it's been a rough decade.
Crowe: Not a good one so far.
Muckerman: Especially in the last five years.
Crowe: I actually have a crazy stat. I did this back in December of 2015, and tweeted it out then. In December 2010, the United States' four largest coal producers by volume had a combined market cap of $32 billion. As of December 2015, that market cap was down to $300 million.
Muckerman: Yeesh! The gnome is just shaking his head side to side.
Crowe: And that's before Peabody Energy went bankrupt, actually, I think even before Arch Coal filed for bankruptcy. So that number has gotten even smaller. They're not even technically companies listed on the stock market anymore because of their liquidation -- sorry, not liquidation, it's Chapter 11, so it's reorganization.
Muckerman: Apparently, they're not even planning to liquidate. I mean, maybe they are, behind closed doors. But a lot of them have kept production up or have grown production over the last year or so, in face of probably understanding that the end is near.
Crowe: And that is something that I find absolutely fascinating about the coal story. You talked about a lot of the weakening demand and the global glut of coal, and everybody just kind of blames that on these companies' demise and downturn. And yes, that has been a huge factor. But one of the things I don't think a lot of people really think about is, these companies made some really bad moves a few years ago that are finally coming to reckoning. To give you an idea: In 2011, the absolute peak of this cycle of coal --
Muckerman: Yeah, that's when we talked about prices being down 75%, since 2011, yeah.
Crowe: Right. So since then, right at that time, Peabody Energy buys Macarthur Coal for $4 billion. Alpha Natural Resources buys Massey Energy for $7 billion. Arch Coal buys International Coal for $3.4 billion. Walter Energy buys Western Coal for $3.3 billion. Every single one of these companies made a massive, massive purchase at the top of the cycle, took on huge debt to do it --
Muckerman: It's a gold rush right there. Everyone's competing with each other, trying to get bigger and bigger and bigger.
Crowe: Yeah. So, when you see those huge moves, four or five years ago -- and I think this could be a good long-term investing view for people -- when you get in these big commodity boom cycles, when everybody's like, "We're going to grow like crazy because there's this booming demand somewhere overseas, and it's looking great," and you see these sorts of moves, that can kind of be a little bit of a yellow flag, be like, "Whoa, there's some people making some very aggressive moves." And when you're looking at something like energy, it can grow in fits and starts, but it's never a massive growth engine -- multiple, double-digit growth every year that you see in other industries. It's a slower-growing industry. And you have to understand that when it comes to the commodity cycle, because if you grow too fast, you're going to hit a bust like we're hitting now. And that was a perfect example of it.
Muckerman: Yeah, I remember I first started at The Motley Fool in 2012 as an energy and materials analyst, and --
Crowe: I think we landed right about the same time.
Muckerman: Yeah. It was just, all talking about, "When will coal turn around? When will coal turn around?" And here we are, four years later, and still, even worse off than we were.
Crowe: We were trying to call the bottom, and everybody was like, "Oh, it can't get any worse than this." Well, it did, and it's still getting worse.
Muckerman: Yeah. We even were talking about, "Oh, there's certain basins like the Powder River Basin out West, which is like, some of the cheapest coal to mine." So, you think, hey, Peabody has great exposure there. That was their saving grace for a minute, and now they're the last ones to be exposed to bankruptcy court. Any upside that you see out of coal in the future? Maybe not companies to invest in, but just the industry?
Crowe: I'm going to play a little bit of a devil's advocate here. You hear the things, coal still represents 32% of our generating capacity, we have to have coal for a while longer, and that's fine. I understand that. But just to play a little devil's advocate -- for investors, you want to play both sides off of each other -- as much as it could be prominent, I think it's going to be very difficult to be a very good place to invest over the next several years, regardless of the company that you choose, whether it's well financed or not. And here's one of the things, just to give you an example of what we're looking at. We've been talking about oil, this massive inventory overhang in oil. We have so much that we don't know what to do with it, and it'll take years for that amount of oil to clear. Which, if you break it down into consumption, it's about 60 days' worth of consumption in the United States. If you look at coal's inventory, basically, how much is built up in inventory for --
Muckerman: If we ceased all production, this is what they could live off of.
Crowe: Right. You could go for 200 days.
Muckerman: See, now, that's what you kind of want in your nuclear bomb shelter right there.
Muckerman: You want 200 days' worth of food and water, and this is what the coal industry has.
Crowe: But when you have companies that are bankrupt that are still producing because they have to pay off debts, and companies that are still producing because they're trying to still make a buck to stave off bankruptcy, when is the glut going to clear? That's the biggest thing that I look at, as one of those things where, how can we take that much oversupply in a declining industry and really make money? I think it's going to be a very hard thing, and anybody who's looking at this space should be well aware of that risk. And, I would say, tread carefully.
Muckerman: Yeah, exactly, especially when you think about, not only is coal cheap, but natural gas is really cheap, it's cleaner, and nuclear power plants, they're the base load that is even cleaner than natural gas, much more expensive to turn off and turn on. So you have these two base loads that are cleaner, somewhat more efficient, and now you have this huge overhang of coal. So I'm wondering if they're going to start some negotiations together, and be maybe like a miniature OPEC of coal producers in the U.S., because I doubt one company in particular will be like, "Oh, yeah, we'll just rely on... "
Crowe: "We're fine, don't worry about it, we'll take care of it."
Muckerman: "That's right, we'll reduce our production for everyone." Yeah, right.
Crowe: Yeah. And just, on a small aside from the talk of Patriot's bankruptcy, one of the great things, when it comes to financial media, or businesses in general, is, companies like to slide bad news in under the radar as much as they can.
Muckerman: Good old Friday-at-five-o'clock press release.
Crowe: Yeah. So, a great one, another bankruptcy actually hit this week, a company by the name of Energy XXI (NASDAQ: EXXI), they're a specialty in offshore oil and gas exploration. They were a big acquisition company. Right on the heels of Peabody Energy's bankruptcy, which is going to generate a ton of media, they slip a little, "Oh, we're going into Chapter 11, too."
Muckerman: Another debt-laden acquisition company bankruptcy.
Crowe: Golf clap for them for finding a nice, quiet time to go bankrupt. Moving on, we talked a lot about bankruptcy, and sticking with the bad news theme, let's talk about some dividend cuts.
Muckerman: Yeah, people are probably scratching their heads, "Oil prices are up, why such dour news about the energy space today?"
Crowe: Yeah. So, earlier this week, National Oilwell Varco, a company both Taylor and I are big fans of --
Muckerman: Yeah, we've both been to HQ down there in Houston.
Crowe: Yeah, talked to the CEO of the company at various times, and I think we're both personally invested in the company, at least I am.
Muckerman: I'm not, but it's definitely a company that I follow closely.
Crowe: But, they cut their dividend by 89%, to $0.05 per quarter. One of the biggest reasons CEO Clay Williams is basically saying, "We want to treat shareholders right, but with the market acting the way it is, we had to cut it." And, something you just kind of hinted at for a quick second there is, we're starting to see oil rise again.
Muckerman: Yeah, a little bit.
Crowe: All this good news is coming out.
Muckerman: Above $40.
Crowe: Production is starting to slide, it's above $40, and everybody is optimistic again. So, in your opinion, why do you see this happening? If it's getting better, why now?
Muckerman: I guess, a dividend, we always say, is never a guarantee to be paid out. And with National Oilwell Varco, it's a company that is very heavily tied to offshore rigs. I think that's a little bit further out in terms of recovery. We're still seeing land rig declines. Until you start to see land activity pick back up, you're still a ways off from offshore activity -- not to say that this company has no exposure to onshore activity. When that picks up, their revenue likely will as well. But I think it's a prudent move by a company that's been around. And they do have great diversification across the sector. But offshore is still a big portion of this business, and you continue to see rigs being cold-stacked, put back at the docks, or trying to be sold in auctions.
Crowe: Or even cannibalized. You've seen a lot of companies doing that, where they're just basically taking either land or offshore rigs and being like, "Well, we're not going to use this thing for a while."
Muckerman: They just break it down.
Crowe: "Let's strip it down and use it for parts."
Muckerman: So that's my opinion -- it's going to take some offshore activity to really get this company back. I don't think it's going to take offshore activity to turn the stock around, but it's going to take offshore activity to get it back close to where it was a couple years ago.
Crowe: As much as somebody who's personally invested in it, I'm not a fan of losing the dividend.
Muckerman: Absolutely not, yeah. It's a tough pill to swallow.
Crowe: But at the same time, I do have to golf clap them a little bit for deciding to do a dividend cut while the finances for the company still look good. If you look at the company's balance sheet, it still has a ton of cash, it's still actually net cash positive in terms of the debt. Don't quote me on that, I don't have the numbers up.
Muckerman: They were getting a swirly from the energy market. They were getting bullied into it.
Crowe: Exactly. So, they're doing it as a prudent move now to be ready for when the market does turn, that they'll be well financed and have capital ready and available to either make an acquisition or something like that, which they do very, very routinely.
Muckerman: And very well. When I talked to Pete Miller a couple years ago, he talked about, they have this huge -- I mean, whether or not it is an actual binder is up for discussion, because he didn't show us, but he was like, "We have like an encyclopedia of our acquisitions that we can turn to to make sure we are following these steps that we've either discovered don't work or have seen play out well over time consistently." So this is a company that has been very good at acquisitions, and you would love to see them with some spare cash at a pretty advantageous time.
Crowe: Yeah, and there's one place they have been pouring a lot of money into as of late. When I talked with Clay Williams last, like six months ago, one of the places they're really putting money into is floating production and offloading facilities, which are basically like, take a supertanker and float it out in the middle of the ocean, it's just going to float there and collect oil, and then tankers come and basically load it off there. So these facilities are much more economical than some of the other things that they have been using for a very long time. They're more mobile, so they can be reused, versus like, stationary infrastructure.
But rigs, 20 years ago, they're not a very standardized, industrialized process. They're all kind of ad hoc put together. National Oilwell Varco wants to take that standardization process that they used in rigs into this market, and that could be a huge boom for them. That could help tide things over, because those projects, FPSOs is what they're called, those are still going to market now, because they were investment decisions that were made years ago, and still need to be moved along. So, if there's anything that'll help them in the interim, that is one place I think investors should take a look at.
Muckerman: Sure. And they're not the only ones who have waited this long to cut their dividends. You said BP is considering it as well?
Crowe: BP is considering it.
Muckerman: Not yet. They haven't done it yet.
Crowe: They haven't done anything, but there were some hints from their chairman, who said, "Look, we might have to. We're not saying we're going to, we want to preserve it as best we can," which is what every company executive is going to say. "But, in the event that we have to, we will."
Muckerman: Yeah. I'm still wondering why any other companies haven't taken on the Silver Wheaton dividend model, where it's predictable because it's a certain percentage of the previous four quarters' free cash flow. So you can model that out, you can see it. The only unpredictable thing is the upcoming quarter that they're going to report. So you've got those three quarters you can rely on. You can kind of see where the dividend is going. And you know it's floating, so you're not really expecting anything in particular. I think that's a great model for resource companies.
Crowe: It is. This was an after-on-camera discussion that was off the record, so I can't say who it was, but I talked with some CFO at an energy company one time and asked him about that idea. I said, "You know, you can try to protect your cash flow as much as you can with various methods, but ultimately, this is a commodity business. Why stay with a fixed dividend?" And he said, "I would love nothing more than to have a set floor dividend, where it's like, we'll pay a nominal 2 to 3 cents a share per quarter, and then pay a percentage of profits or percentage of cash flow. I would love to do that."
Muckerman: Like an adjustable-rate mortgage, you get the floor rate plus or minus, yeah.
Crowe: "The problem is, we would get killed in the equity markets. Nobody would buy our stock." And it's kind of one of those weird, self-fulfilling prophecies. As somebody who's a fan of dividend investing, I want to see a fixed dividend. As much as I understand the concept of a variable rate where it's more sustainable, I still kind of like the fixed dividend. So I can kind of understand him and sympathize, and why, as much as we see it as analysts and go, "This is the best way to do it," why nobody actually wants to take that step.
Muckerman: Yeah, I guess, maybe if you started that way. Silver Wheaton came right out of the gates with this style of dividend. Maybe completely adjusting your model might ruffle some feathers.
Crowe: Little bit. Hey, do you know how many things we celebrate in the month of April?
Muckerman: In terms of daily? National Beer Day last week.
Muckerman: Yeah, I know there's like, National Sibling Day recently.
Crowe: There are a countless amount of things.
Muckerman: Well, it's spring. People want a reason to celebrate.
Crowe: Just an example: National Jazz Appreciation Month. National Soft Pretzel Month.
Crowe: National Soy Foods Month.
Crowe: And National Straw Hat Month. So one of the things that's near and dear to our hearts at The Motley Fool is the one that we actually created, which is Financial Literacy Month. We want to use this month to help you all to brush up on personal financing and investing topics that you have always wanted to know more about, so you can take greater control of your financial future.
To help you get started, we are giving away our own e-book, The Motley Fool Guide to Investing for Beginners. It covers the basic information you need to know, like, should you pay off debts or invest first, with that extra money you have, how to develop an investing thesis, and we'll even share with you some of the mistakes that our analysts and even our founder and CEO Tom Gardner have made along the way so you can avoid making these same mistakes. Just head on over to podcasts.fool.com to get your free copy. And while you're there, you can also check out some of the other podcasts we do here at The Motley Fool. Taylor is a frequent contributor to MarketFoolery.
Muckerman: Yeah, just about every Monday.
Crowe: We've got David Gardner, another of our founders, his podcast is Rule Breaker Investing. Great podcasts. Again, head on over to podcasts.fool.com. All of it's free. Who doesn't want free stuff?
Muckerman: Freebies. Investing isn't free, but our educational materials are.
Muckerman: Invaluable. Yeah, and even if you aren't a beginning investor, great way to brush up on it, it's very approachable. You might even think, "Oh, I haven't thought about that in a couple years," and then maybe rekindle some old flames of investing.
Crowe: There you go. So, also, the month of April happens to be the kickoff of first-quarter earnings for 2016.
Muckerman: Here we are, yay...
Crowe: It already happened. I thought we just barely finished the end of last quarter. And, to kick us off, we have Alcoa. The headline number says earnings fell 92%, which always sounds bad. But was it really as bad as that actually sounds?
Muckerman: Expectations were worse! So, they beat expectations, at least on the bottom line.
Crowe: That's a low hurdle to jump over.
Muckerman: That's right, an extremely low hurdle. When your hurdle is almost 100% less earnings than you had the quarter before in the year prior, yeah, you feel pretty good about yourself when you come in at 92% less. Revenue, though, did miss, just slightly. I think it was down 15% year over year. I just need to take a moment to scratch my head, maybe shake it a little bit, because they're about to spin off their aerospace and automotive business, their more high-margin business, in the second half of this year. Arconic is what they named it. Huh?
Crowe: I don't get it, either. You would think, last year, when they said, "We're going to spin it off," and they didn't have a name yet... like you said, expectations were pretty low for the quarter. Expectations were really high for the name, and they came up with Arconic.
Muckerman: My goodness. Anyway, they might have a good reason for it. But it doesn't really sound like even a name I want to invest in. Alcoa just sounds investable.
Crowe: Well, I mean, it's been around for so long.
Muckerman: That's true, maybe it's just branded into my skull. But, much like the coal industry, Alcoa is blaming China turning into a consumer country, and not spending as much on aluminum. Prices are down, like, 40%, I think, from their most recent high. So the company is still struggling, still held back by their smelting operations and production operations. That being said, the automotive and aerospace are still doing very well. So, when that spins off, it's going to give investors access to the consumer on that end with Arconic, and access to the production side with Alcoa. So you won't be constrained to this blended model. They're still talking about shedding more jobs ahead of the split. Personally, I do like what they're doing with aerospace and automotive. It's lighter, it's strong, and you see companies around the world forgoing steel in favor of aluminum in applications across the board.
Crowe: Right. And I have been very interested in a spinoff for a couple of reasons. Like you said, it's looking much more robust in terms of a company. There is certainly some opportunity with the expansion of aerospace and defense, and we're starting to see automotive with Ford F-150 going to a lot more aluminum in construction, for the lighter --
Muckerman: Yeah, aluminum frame. Tesla, all-aluminum frame.
Crowe: It really intrigues me. One of the reasons it also intrigues me is, looking at the financials, specifically of Arconic -- I'm going to hate that.
Muckerman: [laughs] It's tough to say.
Crowe: We'll get used to the name eventually. But if you look, margins were actually pretty good. I mean, they have an operating margin of about 16%, which is pretty decent. And, another reason that that one actually interests me is, another move that happened a few months ago was Berkshire Hathaway buying Precision Castparts. If you look at the two businesses, when you take the spinoff and Precision Castparts head to head, they look relatively similar.
So from an investor's standpoint, Arconic does kind of interest me a little bit, especially from valuation, because if you look at how much Berkshire paid for Precision Castparts, compared to what you could pay for Alcoa today and get both with the split and shed your Alcoa shares, it does look very attractive from a valuation standpoint. The thing that worries me more than anything else is how the company decides to divide up the debt. When you have a company like this, how is that going to break out? And how is that going to affect the company's profitability long-term? Because, if they tie up all of the debt into the new company, Arconic --
Muckerman: Yeah, the interest is going to crunch margins.
Crowe: -- to pay it off, yeah. That's going to be my one issue. So I am watching this one with quite a bit of interest, more than I normally would with Alcoa. So I'd really like to see that happen.
Muckerman: Absolutely, yeah. You look at the automotive parts sector in particular, right now, it's trading at a very cheap multiple on price-to-book compared to other sectors. Gavekal Research put out a great image this morning -- or, at least, I saw it this morning, and it listed probably 20 to 30 industries, not just the main sectors, but industries. And right down there with banking at the very bottom with a 0.9 price-to-book value, automotive parts and suppliers were right down there just above 1. So it's a very cheap sector right now. Not to say that that's all this is tied to, because there's aerospace involved in there as well. But maybe it's something to look at when they spin it off in the second half of this year.
Crowe: So now that Alcoa's kicked off the earnings season, what is the theme, the stock, what's on your radar for the next couple weeks, month or so?
Muckerman: I'm looking at who's going to jump the starting gun on spending in oil, now that prices are back up.
Crowe: Oh, it's to $40!
Muckerman: It's gonna stay here forever again.
Crowe: A year ago, $40 was a death kiss, but today it's the kiss of life.
Muckerman: This whole week has been pretty nutty in the oil markets, in terms of appreciation in the markets. So I'm looking at who's going to jump off the blocks a little bit too soon. Maybe not sign on the dotted line to commit to spending, but at least just bringing up the idea of putting rigs back to use or of going out there and spending money to get oil production back up, not to where it was previously, but who wants to raise the needle first?
Crowe: I'm kind of with you on the same thing, but I'm not necessarily looking at it from an earnings or management call perspective. I'm actually watching it from the spring bank re-determination. So every six months or so, banks look at the credit status of all of these companies and normally, what happens in down times like this is they cut the amount that's basically available on somebody's credit card. And companies can say what they want, be like, "Oh, yeah, we want to spend more money, we're going to put some new drilling rigs out there because it's getting a little better," but you have to have some money to do it. And if the banks decide to cut everybody's spending, where the heck are they going to get the money to do it? We've seen a couple happen already. Like we were talking in the beginning, Chesapeake Energy has basically committed every single asset they own to protect their liquidity.
Muckerman: The garage sale is still open, if need be.
Crowe: Yeah. So that'll be an interesting theme, I think, and one worth watching, because it could impact what happens over the next six months in terms of production increasing pricing and things like that. Taylor, thanks a lot.
Muckerman: You got it.
Crowe: Thanks, gnome, for filling in for Sean.
Muckerman: You performed admirably.
Crowe: If you have any questions about today's show, like if you prefer Sean or the garden gnome as a host for the show, please email us at firstname.lastname@example.org. We love hearing from you and taking your questions, and we would really like to do a complete mailbag show in a couple weeks, it's one of our favorite things to do, so send in a bunch of questions. We'd love to do it.
Muckerman: Or tweet @TMFEnergy. We'll look at both.
Crowe: Yep. As always, people on the show may have interests in the stocks mentioned, and The Motley Fool may have formal recommendations for or against those stocks, so don't buy or sell based solely on what you hear. For Taylor, I'm Tyler. Thanks for listening, and we'll see you next time!