Listen on:

Mark LaMonica: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It doesn't take into consideration your personal situation, circumstances or needs.

So, Shani, one thing we've been talking about lately, and hopefully your husband isn't listening, is that you are on Bumble.

Shani Jayamanne: Which is traditionally known as the dating app, but it's got several purposes. So, it has the dating purpose, but you can also network. So, there's a networking section, and then there's also a BFF section. So, it's to meet new people, to just like go get drinks and hang out. And I've just moved to a new neighborhood, and I feel like I've turned 30 and I'm having a bit of a crisis. I don't have any friends from high school anymore. I have a couple, but I don't really – and I'm kind of in this weird transition phase. So just seeing what's out there.

LaMonica: Okay. Well, we'll see how you go. We can keep people updated. I would like to do that and find someone to play squash with.

Jayamanne: Well, maybe you should do that. You can put on your profile that you want to find someone to play squash with.

LaMonica: Okay, maybe I will.

Jayamanne: Let's get you on Bumble today.

LaMonica: This is making friends in 2023, apparently.

Jayamanne: Okay, but let's move on with the episode. We have another listener-requested episode. It is a share deep dive. And we've been asked to take a deep dive into Woodside with the ticker symbol WDS.

LaMonica: And Woodside is an Australian gas and oil provider. Their operations range from liquid natural gas, natural gas, condensate, and crude oil. Their main ventures are in Western Australia, and they're extremely cost efficient. And that all forms the foundation of Woodside's business, which we'll get into a little bit more. So, yeah, tell us about Woodside, Shani.

Jayamanne: Okay. So, they've got future LNG or liquid natural gas developments in the pipeline, and these center around the Pluto project.

LaMonica: Which is nice, right? Because Pluto has had a tough run. So, it's no longer a planet, which is not great. So, it's good that somebody named something after them.

Jayamanne: I feel like you shouldn't do the dad jokes on Bumble if you're looking for your squash partner, you know.

LaMonica: As opposed to your joke about espresso martinis.

Jayamanne: I thought that was pretty good. The Pluto venture processes gas from offshore sites in Western Australia. It's piped through 180 kilometers of trunk line to a single onshore processing plant. This project is underpinned by long-term contracts with a couple of companies, Kansai Electric and Tokyo Gas, both that have stakes in the company.

LaMonica: And they're also looking to develop a second gas processing train. And this project encompasses a large percentage of the company's intrinsic value. And before you get excited and start imagining some sort of futuristic train, a gas processing train is just industry jargon – and I did look this up – and it's for the various components to process, purify, and convert natural gas to liquefied natural gas.

Jayamanne: I don't think any of us were imagining a futuristic train. But Woodside is unique amongst Australian energy companies. It's successfully managed quite a few LNG projects for over 25 years. And no other company has been able to do that. Adding to this, they've got long-term agreements, as we mentioned, when speaking about the Pluto project. So, these are long-term 20-year agreements with Asia's blue-chip energy retailers, so the ones that we mentioned before.

LaMonica: And that means they've got cash flow and financing coming in during the continued development of Pluto, which will bring stability to Woodside's cash flows once the projects are over. They've also had first mover advantage. So, they've invested more than $27 billion since the 1980s. But they've built all their infrastructure at a fraction of the cost of today's developments. So, there's still a lot more to go with their projects, but they've got a huge head start on their competitors from an expense standpoint and also with the regulatory approval process.

Jayamanne: So, does this mean that they have an edge over their competitors?

LaMonica: It does not, Shani. So, cost advantages alone are not enough to protect them from competitors over the long term. And the regulatory hurdles aren't insurmountable. We've spoken about competitive advantages with commodities a little bit before, but basically the summary is, it's difficult for them to sustain one.

Jayamanne: And this is because commodities are a resource, and resources are treated the same regardless of who produces them. Generally speaking, a commodity company is a price taker. And what is a price taker, Mark?

LaMonica: All right. Well, a price taker is an entity that just takes whatever price is out there in the market. So, it's a little bit self-explanatory. And this is certainly the case for commodities, because there's a set price that they trade for, and the prices are transparent, and they're widely known. So, we have a decent amount of exposure to the price of iron ore because of economic dependencies. And we hear about it a lot with oil, because of course, a derivation of that goes into petrol tanks, and that of course impacts people's day-to-day lives.

Jayamanne: And in general, a price taker is not a company that has a sustainable competitive advantage or a moat. And we want to buy companies that have an economic moat because they're able to fend off that competition, which is good for us as shareholders. It means that they can earn higher returns on invested capital. And it also means that they're able to maintain strong margins.

LaMonica: And most of the companies with moats are price makers. That means they have pricing control because of the attributes that lead to them having a moat in the first place. And we used this example before, but Apple is a good one that I think most people intuitively understand. They have a wide moat rating. And we believe Apple has a moat because it's a company that has high switching costs for consumers. And what that means is once you're an iPhone customer, it is difficult to switch away from it. So, we speak about this in detail in another share deep dive episode we've done on Apple, as I just referenced. So basically, it's because Apple has their tentacles into you in a bunch of different ways. So, whether that's the apps you purchase like Bumble, iCloud or other devices that are connected to their ecosystem. And it's basically just a nightmare to leave Apple because you have to set everything up again. And Apple hardware just isn't as frictionless when you're connecting it with different brands or operating systems.

Jayamanne: And this is an example of consumers not wanting to switch. It gives Apple the ability to maintain market share and at the same time maintain pricing levels and potentially raise their prices. And we see this in consumer research. 90% of iPhone users say that their next phone will also be an iPhone.

LaMonica: And of course, the whole point of that little diatribe on Apple is just to contrast that with what we see with commodities. We have no idea and frankly, we don't care which companies produce the commodities that we use. The very nature of it being a commodity means we don't care who you buy it from.

Jayamanne: Exactly, Mark. In the example of oil, do I really carry if I buy it from Exxon Mobile or Woodside or Chevron? No, of course, I don't because it's the same product.

LaMonica: But Woodside has gotten great at basically creating this template where they keep delivering these successful projects. And these projects are in demand. So, gas is the fastest growing primary energy market behind coal. And the seaborne traded LNG portion of that gas market is growing even faster still.

Jayamanne: And this of course seems contradictory to a lot of the movements by Australian state governments to stop new builds having gas.

LaMonica: And as people probably have heard from the 1st of January, 2024, any new dwellings, apartment buildings, knockdown rebuilds and residential subdivisions in Victoria won't be able to have a gas connection. And there are no new gas connections in the ACT either.

Jayamanne: And this movement is because of the environmental concerns surrounding gas. We've spoken it before in a guest episode with Adam Fleck how investors need to consider their whole risk spectrum.

LaMonica: Yeah, that's right, Shani. And investors increasingly view sustainability as a new way to understand the vulnerability of their investment portfolios to ESG factors. And that is very different than impact investing, of course, which is what many people think about when it comes to ESG. And it's an important distinction because of course risk and return are intertwined. As an investor, I want to be compensated for taking on risks. It is taking on risk that enables me to earn returns. However, in order to actually do this, I need to look at the full spectrum of risks and how they impact the long-term cash flows generated by a company.

Jayamanne: So how is Australian-based regulation impacting this Australian-based company?

LaMonica: Well, it's not really a risk for Woodside. So, 84.9%, to be very exact, of their revenue comes from Asia and just over 4% comes from Oceana as a whole. The revenue from Woodside is extremely concentrated in one region.

Jayamanne: And we've done an episode on China and the risks that companies could face if there's a downturn. So, we'll link that in the episode notes because a lot of the points discussed in that episode are relevant to Woodside.

LaMonica: But although their revenue is extremely concentrated in one region, the sources of revenue are relatively diversified. LNG makes Woodside less susceptible to the volatility of pure oil producers. Gas is a primary component of Asian base load power generation.

Jayamanne: So, what is the outlook for future earnings for Woodside?

LaMonica: Well, our analysts, so Mark Taylor, great name of course, thinks that Woodside's WA Aussie gas assets are large, they have a long life, they're low cost, and there's the potential to expand production.

Jayamanne: And he thinks that their geographical location close to Asia is a huge plus.

LaMonica: And the plus of course is because of shipping. So, shipping unsurprisingly is a huge cost in the commodities industry. You're of course transporting millions of tons of material. The shipping to China is around one-third of the cost to ship from the US to Asia via Panama, or one-fifth of the cost to ship from the US to Asia via South Africa.

Jayamanne: So, what this means for Woodside is that they have low operating costs that will ensure cash profit throughout commodity cycles and expandable assets that will enjoy economies of scale as Woodside keeps building up their ventures.

LaMonica: And we do speak a little more about commodity cycles in the commodity sector spotlight, which is another podcast, of course we did. So hopefully you should know a little bit about that right now.

Jayamanne: However, it's important to note that LNG is an upfront capital-intensive game, so they're not reaching their potential at the moment as they build out these ventures.

LaMonica: So, what everyone is waiting for – the fair value estimate. So, the fair value estimate for Woodside is $45. And currently as we record this, it's trading at $34.90. So that's a 19% discount, it makes it a 4-Star stock.

Jayamanne: And Mark Taylor believes that the group will increase production by more than 20% once the Pluto project is complete. However, because they are price takers, the price of commodities will matter. He anticipates that commodity prices will be well below historically high 2022 levels.

LaMonica: And this of course feeds into Morningstar's uncertainty rating. And we assign Woodside an uncertainty rating of medium. And basically, the reason behind this and that uncertainty rating of course is the business risk associated with the company. But the reason they have a medium rating is because commodity price volatility is that key risk in Woodside. And a high proportion of the fair value is of course coming from projects that have yet to be built.

Jayamanne: And to put this into perspective, all Aussie resource and energy exposures do have this risk. But compared to Woodside's Aussie competition, they're comparatively protected. They have lower operating costs. They don't carry too much debt in an industry which is considered pretty high risk.

LaMonica: And we talked a little bit about those ESG considerations, but they do face some environmental and operational risks, as well as some community specific risks.

Jayamanne: ESG exposure creates a little additional risk for exploration and production. In this industry, the most significant exposures are greenhouse gas emissions. And this is from extraction operations, but also the consumption of the commodities and other emissions and waste. So primarily oil spills.

LaMonica: Woodside also suffers from potential reputational risks. And that of course occurs when there's events like an oil spill, and there are climate-conscious consumers turning away from fossil fuels. And climate concerns can also trigger regulatory interventions. So, this could be a carbon tax or a system like the Emissions Trading Scheme. There could also be fracking bans, drilling permit suspensions, the list goes on.

Jayamanne: That was a lot, but what our analysts say is that these ESG risks are across the industry. So, they're already included in the base case analysis and incorporated into the fair value.

LaMonica: But there's also some positives that come from some of these ESG-related risks. And that just means that potentially there could be an increase in demand for specifically gas which Woodside produces.

Jayamanne: Natural gas is less carbon intensive than coal or oil and stands to benefit from the efforts to reduce emissions.

LaMonica: That's right, Shani. So, we do think of course there's going to be a continued move to renewables like wind and solar. And of course, we also have to be practical and realize that wind and solar can't come anywhere close to meeting the global energy requirements for decades or potentially ever.

Jayamanne: So lastly, let's speak a little bit about the capital allocation. Mark Taylor believes that the balance sheet is sound. The company has modest gearing and is moving towards being unleveraged again as soon as 2025. They also have a very attractive payout ratio of 80%. They've been able to maintain this since 2013. And the official policy is to maintain a minimum 50% payout of underlying earnings.

LaMonica: And we've talked a lot, I think in many episodes, about high payout ratios and the fact that they're a little bit of a balancing act. So, you want to ensure that a company is able to maintain a payout ratio. And with the volatility of commodity prices, this 80% payout ratio needs to be managed and will always be a slight risk. But our analyst Mark believes that there are strong cash flows and a healthy balance sheet. So, dividends should be supported.

Jayamanne: It's also Mark's belief that Woodside should be investing more in expansion endeavors and accelerating growth plans to take advantage of reduced capital costs.

LaMonica: And on the investment side, they haven't been exceptional, but the performance has been fair. Company let itself down on the capital allocation side by overpaying for Pluto T1 during the China-driven resources boom. This has resulted in single digit returns on invested capital over the past six years, well below the cost of capital.

Jayamanne: So ultimately, Woodside is in a good position with their upcoming pipeline of projects. They have a relatively strong balance sheet and are in a position to weather industry risks better than most peers. They are heavily reliant on commodity prices, but their production costs are low. So, they're able to maintain a profit and a high payout rate.

LaMonica: And Woodside, as we mentioned before, is currently trading as a 4-Star stock and it may suit investors that are looking for sustainable dividends.

All right, Shani, we did it.

Jayamanne: We did it.

LaMonica: We learned some new things, mostly about Bumble and your criteria for…

Jayamanne: We're going to set you up for one, Mark.

LaMonica: The squash Bumble.

Jayamanne: Yeah. We can talk about what your profile prompts will be, so what will get the conversation going with any potential squash partners.

LaMonica: Okay. Well, first, maybe you should explain to me what a profile prompt is.

Jayamanne: Okay.

LaMonica: But we can just move on from there. So anyway, thank you guys very much for listening. We really appreciate it. And as this was a listener-requested episode, if you have a request, send it into my email. Thank you.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)