Japanese Vision for Growth Gets a Poke in the Eye

For four decades the Japanese economy secured more than its fair share of coverage in the financial press. Dominating the economic headlines were the manufacturing and export expansion of the 60’s and 70’s and the phenomenal market rally that took the Nikkei to almost 40,000 during the 80’s. Thereafter commentators focused on the lost decade of the 90’s caused by the property market crash, bank balance sheet shrinkage and the death of Japanese equity wealth by a thousand cuts.

This decade has seen the rise of China’s economic profile, with the PRC now destined to replace Japan as the world’s second largest economy. Such is the dominance of Chinese related articles it’s easy to forget Japan is still an economic goliath, albeit in relative decline. And the cause of that decline can be summed up in one word; deflation.

There’s something deeply embedded in the Japanese economy and psyche of Japanese businesses and consumers that has caused deflation to be a secular and persistent challenge for the Bank of Japan for the past 20 years. The problem with deflation is that it maintains the real value and burden of debt, whereas a healthy rate of inflation, 2-3%, over the years gently erodes the real economic cost of borrowed capital. It is inflation that has given the western economies the luxury of consuming more in the present, with debt in nominal terms eroded by the passage of time. Deflation throws another spanner in the works of economic growth. Why buy a new car, or new machinery, in fact why buy anything today that will be cheaper in a few months? The result is structurally weak demand, an interest rate so low it’s barely visible to the naked eye and a flight of capital to higher yielding currencies (the New Zealand and Australian dollars have been a favoured destination for retail and institutional investors for years). Deflation is a nasty poke in the eye for demand, capital investment and growth.

In fact Japanese interest rates have been so low for so long, the Yen has been systematically sold (shorted) not just by Japanese investors but by a legion of hedge fund managers for years with the proceeds placed just about anywhere that offered a higher return. Admittedly that carry-trade, along with most risk embracing investment strategies, grew to bubble proportions and burst in 2008 but with investors embracing risk again, greed replacing fear, that transaction (short Yen, long anything else that moves) is likely to re-surface.

Investors unsure about the viability of continued Japanese deflation, preferring to focus on the unprecedented global stimulus measures, that should be inflationary, should look closely at the latest Japanese consumer prices data. Prices fell 1.7% in the year to June, prolonging the sequence of deflationary months (year-on-year) to four in row. The main contributor to the decline in prices is energy, with oil settling into $60-$70 channel compared to last years roller-coaster ride to $147.

Investors could suggest that the global economic recovery could re-inflate energy and commodity prices, prompting inflation and thus curing the Japanese “I’ll buy it later when it’s cheaper” philosophy. Unfortunately, higher energy costs are paramount to poking the Japanese economy in the other eye. Japanese energy imports can peak to 97% of its oil and 96% of its gas needs. Japan is similarly deficient in other key energy and mineral related commodities. Higher energy and commodity prices just leave Japanese consumers with less to spend on domestic goods, further hurting demand.

ROC Solid Growth Potential

ROC Oil is listed on the junior UK AIM market as well as the ASX Australian stock exchange and is a fasting growing and acquisitive upstream oil and gas producer. The firm has assets in four regions, Australia, Africa, China and the UK. The key assets are Asian focused with 80% of current production in Australia and China. ROC’s strategic preference is to secure large stakes in assets and to manage day to day operational matters.

Some basic financial statement analysis supports the firm’s claim that it is on track to becoming a serious production player. Revenue over the 3 years to 2008 has grown spectacularly from $109.7m to $358.2m, a compound growth rate of 80% whilst trading profit has progressed even more impressively from $22.7m to $163.8m over the same period. Net cash flow from operations, an even more useful measure, rose from $47m to a very healthy $182.5m. Due to ongoing investment, balance sheet debt has increased from $137.5m to $168.7m 2006-2008 though the burden appears to be more than manageable considering operating cash flow growth.

ROC has also built strong strategic alliances with global producers and interestingly is the only foreign company that has an operating contract with PetroChina (Source: ROC Oil).

The ROC share price (AIM listed) has faded over the past two years and the market wide recovery since March has failed to re-coup the majority of those earlier losses. The price is now loitering under 40p, compared to a grossly oversold low of 13.5p seen in January 2009 and a somewhat optimistic 165p seen late in 2007. Even taking recent and temporary production cuts into consideration and possible future dilution, (in the event the firm needs to raise equity capital to fund further expansion or acquisitions), the downside risk seems limited. ROC is as likely to receive a bid, as make one, over the course of the next year as global players with deep pockets seek to boost their reserves and secure ROC’s valuable strategic and commercial influence in China.

Wood Group PLC (WG.L)

Wood Group has ably taken advantage of the growth in energy demand since the 1970’s. Now, its 28,000 employees provide engineering and maintenance services to oil and gas exploration and production partners in 46 countries. ‘Engineering’ and ‘maintenance’ to be fair, hardly scratches the surface of the technical expertise required to overhaul gas turbines and provide engineering support on deep water exploration projects, two of Wood Group’s specialities. Such expertise is not easily replicated on a global corporate scale and after years of above average growth, Wood Group has secured itself a seat at the top table of integrated energy services companies.

The group’s history dates back much further than the 1970’s. The firm can trace its roots back to a 19th century Aberdeen based small fishing fleet. Two decades later, in 1912, the family business expanded into ship repair and marine engineering. Steady progress was made thereafter and in 1964 Ian Wood (Sir Ian Wood, since his Knighthood in 1994) joined the family company and the business further diversified its engineering credentials and reach. However, it was the development of the North Sea oil industry, largely serviced from Aberdeen, which gave Wood Group the opportunity to build its revenues from the millions, to billions. In 1982 the fishing and oil services businesses were separated and John Wood Group, the engineering and oilfield logistics specialist, was formally born. Through the 1990’s the firm continued to grow impressively through both organic achievements and a series of astute international acquisitions which turned the Scottish business into a global player. Before Wood Group listed on the London Stock Exchange in 2002, the firm was already providing key maintenance and engineering services to some of the very biggest and demanding names in the energy industry including BP, Shell, Talisman, BG, Enterprise Oil, Gazprom and ChevronTexaco.

Sir Ian Wood, Chairman, deserves much of the credit for the success story. Born and educated in Aberdeen, Sir Ian Wood graduating from Aberdeen University in 1964 with a first-class honours degree in psychology. Within 3 years of joining the family business, then John Wood & Son, he became managing director. His deep understanding of business and the energy industry has been frequently recognised since. He received the award for Young Scottish Businessman of the Year in 1979, was awarded the CBE in 1982 in the New Year’s Honours List, and the Knighthood 12 years later. Sir Ian Wood was also the joint winner of Scottish Business Achievement Award Trust in 1992 and winner of the Service category award in the 1992 Corporate Elite Leadership Awards. Following more than a century of commercial success, and worthy recognition, the Wood family have naturally accumulated significant assets and is now one of the wealthiest in Scotland retaining a significant stake in Wood Group. Sir Ian Wood, in particular, is a keen philanthropist and he launched the Wood Family Trust in 2007, with a personal contribution of £50m, to support the economic development of Sub-Saharan African communities. The charitable fund also focuses on the development of young people in Scotland.

Moving from the past to the present for Wood Group. Regular readers of this weekly review will already have a clear understanding of the current recession and its impact over the past 12 months on energy prices. The almost unprecedented fall in prices, both in terms on the percentage fall and the speed of the decline, from $147 per barrel caused understandable concern across the industry and Wood Group was no exception. Several months ago, when Wood Group released its 2008 annual report, the management statement announced excellent figures for the past year but also articulated caution for 2009 unsure of the timing in the recovery of energy prices. As we have already seen, that price recovery is already in motion.

Through the recession Wood Group management have persevered with policy of pursuing growth via both organic means and acquisition and the balance sheet is sufficiently robust to give the company ongoing flexibility in this regard. The firm also extended its bank facilities of $950m to 2012, providing a further buffer against the unexpected. Such is the strength of cash flow generation management had the confidence to increase the dividend, whilst many other companies were hoarding cash in the months of economic uncertainty. Wood Group, acutely aware that a number of its energy exploration customers would delay new green field projects, invested more in its field life extension solutions to help partners squeeze more production and income from existing fields. The policy made sense for both Wood Group and its production partners, building output from existing assets at low risk, rather than speculating into potential higher return, higher risk exploration ventures in a period of falling energy prices and economic uncertainty.

There was another incentive for energy production companies to delay exploration projects. Not only was there downward pressure on fuel prices, there was also downward pressure on the costs associated with the development of such sites. In this challenging environment with associated profit margin pressures, Wood Group has continued, through the quality of its relationships and expertise, to gain market share particularly among new exploration entities that need the reliable and steady hand that a partner like Wood Group offers. Wood Group has also deepened its relationship with the established players with 2008 notable wins including the front end engineering design (FEED) services contract for Chevron’s Jack and St Malo projects in the Gulf of Mexico and pre-FEED services for ExxonMobil’s Scarborough development in Western Australia. The mature North Sea fields also provided a contract win from TAQA, a relatively new entrant in the production business. For those readers unfamiliar with the development life cycle of energy projects, FEED contracts are an early stage, high influence contribution in the planning stage, rather than late stage, low influence contribution like project management contracts.

Currency movements through 2008 also helped earnings, when converted to Sterling, with the strengthening of the dollar boosting profits for UK investors. That bonus, of course, may reverse this year if the current trend of USD depreciation continues, as the majority of profits are generated in US dollars.

Wood Group analyses its financial and management performance using key performance indicators (KPI’s), which primarily focuses on return on capital employed (ROCE), earnings before interest, tax and amortisation (EBITA) and adjusted earnings per share (EPS). Improvement was seen in two of the three KPI’s in 2008, relative to the year before, with EBITA growing to $441m from $318.4m (up 39%) and EPS progressing strongly to 52.1c from 36.9 cents (up 41%). ROCE was almost flat, falling marginally from 19% to 18.2%. Management also assess “safety cases” at work per million man hours, which pleasingly fell to 3.3 from 3.9 whilst non-KPI financial data included an 18% increase in revenues, a 29% increase in the dividend, and a 48% rise in profit before tax. Perhaps most telling is the fact more than 75% of revenues are via long-term contracts, not here-today-gone-tomorrow short term projects.

It’s difficult to pick holes in the performance of the company, which naturally leads investors to ask the inevitable question; has the recent rally in equity prices already squeezed the near term growth potential out of the stock?

Certainly, the chart implies the ‘easy’ gains are behind us. The stock, now 282p, has rallied strongly from a low of 152p seen late in 2008, a gain of some 85%. However, even after the recent rally the stock is still quite some distance from the 2008 high of 503p, though only the most bullish would suggest a return to that heady level is likely over the next year or so. A more likely scenario would be the stock broadly tracking energy prices (a primitive indication of the health of the energy industry) as well as general equity market sentiment. Both of these parameters are progressing well and we are therefore more inclined to predict further gains rather than a retreat, for buy and hold investors. For day-traders needing ‘oomph’ in their day to day volatility, we feel there are better instruments to utilise that offer more gearing.