2023-11-13 07:00:00 ET
Summary
- Ken Griffin, CEO of Citadel, predicts high inflation to last for decades due to global unrest and structural changes.
- Griffin emphasizes the end of the "peace dividend" and expects higher real and nominal rates.
- Antero Midstream Corporation and RTX Corporation are highlighted as high-quality investments with strong balance sheets and dividend growth potential.
This article was co-produced with Leo Nelissen.
Earlier this week, Bloomberg ran a fascinating headline on its home page, which said: " Griffin Says Peace Dividend Over, High Inflation to Last Decades."
Ken Griffin is the CEO of Citadel, a hedge fund with more than $50 billion in assets under management that has pushed his net worth to $35 billion.
In this case, I'm not bringing him up because he's so much richer than me, but because he and I share the same opinion. He brought up some fantastic points that underline my view on inflation and the need to focus on high-quality investments.
Going back to the article, speaking at the Bloomberg New Economy Forum in Singapore, Mr. Griffin expressed concerns about global unrest and structural changes leading to de-globalization .
He pointed to recent geopolitical conflicts, such as the Russia-Ukraine and Israel-Hamas wars, as indicators of the world facing higher baseline inflation that could persist for decades.
Griffin emphasized that the era of the "peace dividend" seems to be ending, predicting higher real and nominal rates .
While the Ukraine war is certainly an inflationary force, since it impacts energy flows in Europe, agriculture exports, and related commodities, it needs to be seen what the impact of the Hamas war will be.
Nonetheless, de-globalization is certainly a factor that doesn't help on top of two wars, especially because close to 16% of the U.S. GDP is dependent on imports.
This is what Wells Fargo wrote on the matter in March of this year (dated but still relevant):
"That said, structural upward pressure on inflation, even if only at the margin, would be unwelcome, given the price dynamics of the past couple of years. Furthermore, there is a difference between a gradual and partial reversal of globalization, such as what has occurred over the past few years, and a sharp and sudden rupture. The effects on inflation likely would be more profound under the latter scenario."
With that in mind, Griffin also highlighted the potential implications of funding the US deficit, suggesting that the government did not anticipate higher rates during its spending spree, contributing to a $33 trillion deficit.
He urged the need for putting US fiscal spending in order, criticizing the current level as akin to "spending on the government level like a drunken sailor."
He also pointed out that the war in Ukraine has left Europe grappling with economic challenges, especially regarding its energy sources (inflation). He highlighted multiple trends pushing the world towards de-globalization, citing the loss of Europe's cheap energy source as a contributing factor.
Although I believe that a potential recession could pressure inflation towards 2%, I expect a rebound as soon as economic conditions improve, as structural issues are likely to keep inflation elevated for a prolonged period.
This means a number of things.
- We need to find high-quality companies with strong balance sheets.
- We need to find companies capable of solid dividend growth and/or juicy yields.
- We need to find undervalued companies that can withstand cyclical economic headwinds.
Well, in this article, I'll present two gems that achieve exactly this. They are a perfect fit for the bigger macro picture.
Antero Midstream Corporation (AM) - 7.2% Yield
Antero Midstream is, as the name already suggests, a midstream company that owns the pipeline infrastructure of Antero Resources ( AR ), one of America's most efficient natural gas producers.
It is a regular C-Corp, so investors are not dealing with K-1 forms . Some investors prefer that.
In a time of geopolitical shifts, America is the place to be for liquid natural gas.
Estimates are that the U.S. will add more than 6 billion cubic feet per day of natural gas export capacity by 4Q25, followed by another surge to more than 29 billion CF per day.
After the Ukraine war, gas flows between Russia and Europe were interrupted, and America became the force that kept the lights on in the winter.
On top of that, China is increasingly diversifying to natural gas, with additional support coming from rapidly rising emerging markets like India and African nations.
Furthermore, Antero Resources is a key producer of natural gas liquids. The export market of these products has risen from roughly 1.5 million barrels per day in 2020 to currently more than 1.6 million barrels.
Going into this year, Antero Resources owned 29% of Antero Midstream. Needless to say, competition risks of Antero Midstream are subdued, as the company manages the flows of a company with more than 20 years of high-quality, low-breakeven inventory.
No company in the U.S. has more reserves that are breakeven below $2.75/Mcf, which means AM will see strong flows even if others have already cut output.
In the third quarter, the company generated a record $251 million in EBITDA, which is a 12% increase that benefitted from a 9% increase in AR's year-over-year production. Note that AR sells 75% of its natural gas to the LNG Fairway. 100% of natural gas is sold out of the basin. This comes with additional pricing benefits!
- The company also benefits from a 3.4x net leverage ratio.
- It has no debt maturities until 2026, which buys the company a lot of time in this environment of elevated rates.
- AM also benefits from a 28% decline in capital spending between 2022 and 2023, which is one of the reasons why it is looking at consistent free cash flow generation in the years ahead.
The company aims to grow adjusted EBITDA by 2-4% per year through 2027, generating at least $3.2 billion in cumulative free cash flow before dividends. After dividends, the company expects to keep $1.0 billion in cumulative free cash flow.
In other words, the dividend is well-protected.
Also, the company is on a path to achieving a sub-3.0x leverage ratio in 2024, which opens the door to dividend growth.
To give you an idea of how juicy the dividend could be, in the next two years, free cash flow is expected to average roughly $670 to $680 million, which is roughly 11% of its market cap.
A double-digit dividend yield is very likely to be achieved over the next few years!
When adding my view on natural gas and the importance of exports, AM remains a fantastic income stock that fits the scenario explained in the first part of this article.
Stock number two is different, yet it also perfectly fits the end of the peace dividend scenario.
RTX Corporation (RTX) - 2.9% Yield
RTX was formerly known as Raytheon Technologies. It's a company I've liked for a very long time. In 2020, the company was born from the merger between United Technologies and Raytheon.
There are a number of reasons to like RTX.
- It has a well-diversified business model consisting of 50/50 commercial and defense aerospace.
- The company owns engine maker Pratt & Whitney, Collins Aerospace, and a segment that includes its defense operations called Raytheon.
- RTX benefits from the post-pandemic rebound in commercial aerospace and elevated geopolitical tensions shifting a focus on defense spending.
- Due to powdered material issues in its P&W segment, the company has done very poorly this year, falling 19% year-to-date. This includes a 20% rally from its lows!
On October 16, I wrote an article titled RTX Corp.: I'm So Bullish It Hurts . Since then, the stock has rallied 12%, which is no problem, as I believe there is a lot of room left for stock price appreciation.
The P&W engine issues are under control, which means analysts are unlikely to be forced to further adjust their financial outlook.
On top of that, the company is firing on all cylinders.
In the third quarter, the company got $22 billion in new orders, boosting its book-to-bill ratio to 1.19. This means for every dollar in finished work, it gets $1.19 in new orders. Its defense operations have a 1.21 book-to-bill ratio.
It now sits on a record backlog of $190 billion and was able to hike its full-year guidance.
The 2023 sales outlook was raised to approximately $68.5 billion (reported) and $74 billion (adjusted), with adjusted EPS between $4.98 and $5.02.
The free cash flow outlook was hiked to approximately $4.8 billion, reflecting improved cash flow driven by recent IRS guidance.
Based on this context, going forward, the company anticipates solid growth in organic sales, segment operating profit, margin, and free cash flow.
It also expects normalized growth in commercial air travel demand and strong international and domestic defense demand.
When adding that the company has a BBB+ credit rating and that its stock price has been depressed, the company decided to start a $10 billion accelerated share repurchase program, which translates to 8.5% of its market cap.
It also has a 2.9% dividend yield, protected by its balance sheet, recovering business, and 48% payout ratio. That's based on 2023E EPS.
EPS is expected to grow by 10% next year, followed by 18% growth in 2025! These numbers are visible in the lower part of the chart below.
2025 is also when we should expect free cash flow to accelerate even further as its P&W engine costs start declining. It expects roughly $3 billion in cash headwinds between 2023 and 2025 due to additional shop visits and (related) higher maintenance spending.
As a result, RTX is extremely attractively valued and in a good spot to boost its dividend and buybacks over time while benefitting from its operations in defense (geopolitical issues) and the recovering commercial aerospace industry.
Since 2002, RTX (it was the United Technologies stock price before the pandemic) has traded at a normalized P/E ratio of 17.2x. RTX currently trades at a blended P/E ratio of 16.6x earnings.
When incorporating expected EPS growth and a return to its fair valuation (I believe 17.2x EPS is appropriate given the fast growth in its business), we get a fair value of $111 per share, which translates to an annual return of 17.9% through 2025 (including dividends).
This is obviously a theoretical performance. However, I believe it shows that the risk/reward remains very attractive.
Hence, I'm not done buying RTX, although it is already my second-largest investment!
Takeaway
As we navigate the shifting global landscape marked by the end of the peace dividend, it's crucial to focus on resilient investments.
- Antero Midstream, with its 7.2% yield, proves to be a robust choice, given its strategic position in the natural gas sector and strong financials that pave the road for an even juicier dividend down the road.
- Meanwhile, RTX Corporation offers a 2.9% yield, presenting an attractive opportunity with its well-diversified business model, rebounding commercial aerospace sector, and promising outlook.
Both companies align with the need for high-quality, dividend-generating investments in a world grappling with geopolitical uncertainties and economic challenges.
Needless to say, this is a very important topic, which I will continue to cover, as it is a driving force in my asset allocation strategy.
Note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.
For further details see:
2 Terrific Dividend Picks In This World Of Uncertainty