Indirect Investing

One of the themes that has come up with several companies I'm thinking about or have recently bought is the notion of the "indirect investment", by which I mean the purchase of a company in order to get access to the earnings (or growth,or whatever) of a subsidiary or related company -- either at a discount, or because the subsidiary isn't separately traded, or just for diversification in getting two significant businesses in one package.

Cypress Semiconductor (CY) fits this idea nicely, and I own a few LEAP options in the shares and remain tempted to buy the common stock -- it's a downtrodden semiconductor company which the market doesn't like at all. They haven't had particularly nice margins of late, or anything else to make the Street stand up and cheer, and short sellers are holding about 10% of the float.

Most importantly in my opinion, though, many years ago they bought a tiny company that had technology and designs for manufacturing solar cells, and built manufacturing capacity for that company. They've since IPO'd part of that solar company, called SunPower Corporation, but they still own about 70%. And today, though Cypress is the parent, Both companies trade at similar market caps, with SunPower's enterprise value of about $2.5 billion and Cypress at about $2.6 billion.

So that means, if you buy Cypress you're getting $1.75 billion of SunPower, which means you get the semiconductor business for substantially less than a billion dollars. Now, whether or not the semiconductor business is worth more than that is another question -- but even though it's not growing as fast as solar, there is certainly a market. The Semiconductor Industry Association (they're unbiased, right?) reported 9.2% growth year over year in January, so if Cypress was a proxy for semis as a whole you might be tempted. They do work in many different segments of the semiconductor marketplace, so perhaps there's an argument to be made there.

This may be too widely understood an "indirect investment" to make any money from, especially since Cypress has resisted "unlocking the value" of their SunPower subsidiary by selling it or spinning it off ... Cypress is probably already trading primarily on the value of their SunPower holdings.

In solar power, there's another way that I've held on to a somewhat indirect investment, too -- my shares of MEMC Electronic Materials (WFR) were initially bought because they were cheap, the share price didn't reflect the great position they held in the semiconductor wafer business because of their integrated supply chain and good supply of polysilicon in a tight market. But one of the reasons I've held the shares after a huge advance,and in the face of an uncertain balance between burgeoning silicon supply and hopefully booming demand, is their growing exposure to solar power -- including warrants to purchase five percent of Suntech Power (STP) that they received in exchange for a long-term silicon supply agreement. That doesn't yet move the needle at WFR, but it could very well do so in the future -- or at least cushion any blow from a slowdown in semiconductor demand, should it come.

Moving away from silicon, Naspers (NPSN) is another investment along these lines -- I bought shares recently, and while I like the cash generation of their core media (South African newspaper and pay tv) assets, what I really like is the growth potential of their partially owned division, Chinese IM leader (with the QQ product) and portal company Tencent, and their acquisition spree in emerging markets media and internet companies.

The impact on the market cap is big here, too, since Tencent is roughly a $6 billion company and Naspers owns about 36% ... and NPSN itself has a market cap of about $7 billion, so roughly a third of Naspers' market cap is attributable to their not very profitable (in earnings terms) Tencent holdings, which significantly depresses the company's PE ratio and makes them seem a bit more expensive than they really are.

Tight relationships among corporations can give us opportunities to do this kind of investing in nearly any industry -- Ship Finance Limited, a company I've owned in the past, gets an indirect ride on the profits of former parent Frontline. They own Frontline's ships and get a steady lease rate for them, which they churn out as a high, steady dividend yield ... but if the tanker business takes another turn up they'll get a bonus from a profit sharing agreement whereby they get a portion of all profits over a set level on their tankers. Which is probably why the shares are just about at all time highs while the more leveraged Frontline languishes on the currently tepid prognosis for tanker rates.

This kind of investing is not unusual, of course -- a lot of what professional investors do is try to find hidden values in the companies they're interested in, and many arbitrageurs spend their days figuring out which companies are likely to move to unlock those values in a particular time frame.

Other examples abound -- buying Roche a few years back to get a cheaper bid on the future of Genentech comes to my mind as one example ... and in a related way, biotech and other IP-heavy industries also give us the opportunity to invest in companies because of royalties they receive from successful or promising products.

Using the Genentech example again, this might mean buying PDL Biopharma (PDLI) because of the humanized antibody royalties they get from several of Genentech's big products, including Avastin and Lucentis (though PDLI also has its own issues, including a looming fight with a big investor about their spending habits).

Whatever your focus, it sometimes pays to look a little deeper into the companies that interest you -- maybe the companies that don't appear to be publicly traded are really available for investment as subsidiaries of others, or maybe the shares that look a little too pricey are hiding an unusual gem.

full disclosure: I own shares in Naspers, MEMC Electronic Materials, and PDL Biopharma, and call options on Cypress Semiconductor. I have no position in the other companies mentioned.

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Making Money from a Cleaner California?

Probably everyone saw or heard the news about California passing new emissions rules a week ago -- there was an interesting editorial on it in the Salt Lake Tribune recently, and the Washington Post ran a more detailed article when the bill passed. The Financial Times ran a story on the political debate, and the possible business impact on our most populous state.

So what does this mean for investors? Is there money to be made on the tails of this initiative to clean up California's air over the next 20 years and push toward reaching the standards of the Kyoto Protocol?

California already gets most of its energy from relatively clean sources (if you ignore transportation), compared to many states. You can see from this CA Energy Dept. summary how the citizens of the left coast get their energy -- coal is pretty low, renewable sources fairly high.

But they're committing to reducing emissions over the next 20 years even as their population may be expected to grow significantly ... so what companies might benefit from that?

I think there are a few categories that might be worth looking at:

1. Natural Gas. The biggest impact on the electricity market in California is that the state will essentially no longer accept power from the current coal-generated plants. This accounts for about 20% of in-state generation and an unspecificied but probably significant part of their imported electricity (as the Utah story referenced above would indicate, the plants that rely on cheap Rocky Mountain coal and sell electricity interstate will be cut out of the CA market).

To me, that means natural gas will be in higher demand in California because it is the only efficient, relatively clean power source that's likely to be able to take up much of the slack as coal plants go offline. Who benefits? You've got the big natural gas producers like Chesapeake (CHK) or XTO (XTO), the drillers like Nabors (NBR), which has some gas exposure, or Grey Wolf (GW), which is focused entirely on gas.

You might also look to the pipeline companies, since most of California's natural gas is going to have to come in via pipeline from the key producing areas in the Southwest and the Gulf. Here's a map of the pipelines that currently serve the state, you can see that they've got excellent distribution from the big basins already ... but volume should grow, which is how pipelines make money. I'd guess El Paso's (EP) western pipelines are probably among the biggest beneficiaries, but I haven't looked at it in detail.

2. Coal Scrubbers. Alternatively, instead of boosting natural gas usage for electricity generation, you might see an aggressive push for cleaning up coal plants. That says to me that the engineering and construction companies that build and retrofit power plants, and the manufacturers of emissions scrubbers for coal plants, might get some additional business. That could be a lot of folks, but URS (URS) is probably more focused on coal scrubbers than the other big E&C guys, though most of the coal scrubbing I've heard of is focused on removing sulfur dioxide, not carbon dioxide which is the bigger issue here.

It might even be possible to see some of the coal technology companies climb, too, if coal gasification or newer clean coal technologies might get a boost from this renewed focus on emissions -- that could perhaps be folks like Sasol (SSL) with their coal liquefication system, or Headwaters (HW) with their various coal technologies, for example, though I can't claim to know much about that business.

3. Power plants that already run on natural gas. This could conceivably allow for some significant rate hikes in California, if the demand for energy continues to grow but the suppliers shrink. That tells me that the folks who are already online with environmentally friendly or natural gas-powered power sources will have a competitive advantage (as much as the market remains competitive, at least).

PG&E is the big provider here, but I'm not so interested in getting involved with a huge company like that with a checkered history and significant regulatory risk. I've looked a bit lately at a tiny company that might benefit down the road, MMC Energy (MMCN.OB) is a small OTC stock that recently went public (and is moving soon to the ASE to attract more institutional buyers). MMCN is building a holding company for the small power plants that have been divested by larger (and sometimes bankrupt) utilities in high-growth areas ... and they're planning to refurbish and expand those plants with new natural gas turbines to serve peak overload periods at peak rates.

They came to my attention because they recently bought two natural gas power plants in San Diego (Chula Vista and Escondido) that were offline (they're also buying a decommissioned plant in Bakersfield, and have a letter of intent to buy a Utah plant that's under construction) [September 13 update: MMC Energy yesterday terminated their letter of intent to buy the Utah plant], and got them online for summer peak season, with plans to expand at least one of them. This is certainly a risky company, and it's largely unknown so far (though it has been touted heavily by Energy and Capital, a service I know nothing about ... which makes me nervous). I've read the company's filings (if you're interested, please read at least the 10-QSB) and didn't see any red flags, but it's going to continue raising lots more money to buy and upgrade or restore plants so I'd say there's a good chance of significant dilution in the near term.

4. Renewable Energy Companies. This is the sector that immediately comes to mind for most folks when we talk about reducing emissions, though CA will be hard pressed to replace their coal-fired electricity with solar or wind power within the next 20 years. They are, however, trying very hard to subsidize the growth of renewable energy ... as are other states to lesser degrees, and as are several other countries (notably China and Germany).

This is good news for lots of companies, but there aren't many profitable, reasonably priced renewable energy companies ... even though prices are much more reasonable now than they were last winter in the peak of our oil and natural gas panic.

The wind energy bets are few and far between -- you could throw your money at GE, which makes most of the turbines, but wind energy isn't going to move their needle. Or you could look to the composite-materials companies like Hexcel (HXL) or Zoltek (ZOLT) that make or engineer the materials required for efficient windmills.

Solar energy is a much more wide-open business, and with state and local governments also pushing for more rooftop solar cells in new housing production and subsidizing solar implementation elsewhere, demand for photovoltaics should continue apace, with or without California's new emissions rules. You can look at MEMC Electronic Materials (WFR), which I own, as the supplier of the silicon wafers that go into solar panels, or you can look at the manufacturers like Suntech Power (STP -- my favorite among these with their Chinese connection), Evergreen Solar (ESLR) or SunPower (SPWR -- or look at CY to possibly buy control of SPWR on the cheap).

Will California's plan really fly, or will this plan move to other states? It's way too soon to tell, but the California auto emissions rules certainly had a massive impact on the rest of the country and on auto manufactureres worldwide, and as one of the largest economies in the world you have to accept that state decisions really matter (CA is somewhere between the fifth and 10th largest economy in the world, right up there with Italy and France if treated as an independent nation -- just how big depends on who you ask).

I don't know whether they can pull off an emissions trading scheme with just one state, but it's certainly possible -- and they can definitely cut off all "dirty" power supplies, which will impact the energy business writ large across the Western US in a big way ... whether any of these companies, or others, will actually benefit is certainly an open question, these are just the initial ideas that came to my mind.

In the interest of full disclosure, at the moment I own shares in WFR, preferred (series D) shares in CHK, and call options on CY, and I've been toying with the idea of buying MMCN and may do so soon.

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Alternative Energy?

I got a question a few days ago from a reader about why I don't own any alternative energy stocks:

"You have several up-and-comer stocks in various sectors, but one thing I was curious about is why you don't seem to be in any alternative energy plays (both of which have become "major policies" for both the U.S. as well as China), especially given all the recent hoopla over oil prices. Do you simply not like the sector in general? Or are you just unsure about the best way to play it? The reason I ask is because I am trying to find a "good play" in that group at the moment, and thought I would see if you had any ideas. The most commonly mentioned stocks in the category are STP, ESLR, DESC, IMCO, BLDP, PLUG, and CPST."

Well, the short answer is that I do like the sector in general, but haven't done a lot of research yet or otherwise found any particular companies that I like.

I have looked in the past at Ballard Power (BLDP), but they look like they're just as likely to go bankrupt as they are to find success. I haven't looked at any of those other ideas in great detail, but I commend you to the alternative energy thread of articles over at Seeking Alpha -- they have articles and commentary and conference call transcripts for several of those names from folks who certainly know more than I do about the sector. I've been looking there for some ideas myself.

The longer answer is that I do have some exposure to solar energy, at least, through my investment in MEMC Electronic Materials (WFR) and a smallish LEAPs position in Cypress Semiconductor (CY).

WFR I've written about a lot lately, but I like that they are exposed to the solar cell manufacturing industry in that they sell the silicon to those companies -- but thanks to their broad customer base they aren't subject to the whims of national subsidies in solar power to nearly the degree that the pure play solar companies are. I am a little nervous about what happens to solar power subsidies across Europe and in various US states if the oil shock of the last year wears off or oil prices drop significantly.

Cypress Semiconductor you may have heard mentioned over the past few months by a lot of market commentators, including Herb Greenberg, who I don't particularly endorse but who published what I thought was some solid analysis of this company.

CY is 80% owner of SunPower, a former division that they spun off last year and a manufacturer of solar cells. Thanks to the huge bull market in solar power recently SunPower has really rocketed up the charts ... but no one likes CY nearly as much. CY's shares of SPWR account for something like 75% of their market cap at this price, so if you think solar companies are going to continue growing then CY is a lower risk way to ride SPWR's success -- you get CY's semiconductor businesses, which seem to be in a bit of a turnaround (I hope), for a pittance. The former child is now almost exactly the same size as the parent.

This hasn't been entirely ignored, and CY has climbed a fair amount already, but I'm guessing that sometime between now and 2008 when my options expire CY will see a significant boost from either solar power expansion or from their own businesses.

In the meantime, I agree that the growth in alternative and renewable energy is an important trend -- but I haven't really figured out how to invest in it. This is almost like 2004, when anything with China in it's name doubled in price ... now anything associated with Solar or Hybrid or Alternative Energy is booming, in many cases without much regard for current earnings or even potential earnings.

I have taken a glance at Headwaters (HW), which is an established chemical and coal gasification/clean coal company that shows some real promise and has real earnings, but haven't taken a bite yet. If anyone has ideas for alternative energy companies I'd love to hear them ... especially if they're companies that don't depend entirely on government subsidies.

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