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Gone fission - alpha options in nuclear

The nuclear industry has struggled in the wake of the Fukushima disaster, but the Far East also holds out long-term promise.
June 26, 2014 & Mark Robinson

To no one’s real surprise, the UK’s Nuclear Decommissioning Authority (NDA) has revealed that the final bill for remedial work at Sellafield and other domestic nuclear sites will be £6.6bn in advance of previous estimates. The NDA puts the total clean-up bill for the UK’s existing nuclear power facilities at £110bn over the next 120 years, with the bulk attributable to Cumbria’s Sellafield site. (At the end of last year, BP’s total costs linked to the Gulf of Mexico spill were around £25bn).

It’s widely held that the nuclear industry, together with its proponents in government, has consistently underestimated the full extent of decommissioning costs, perhaps even wilfully. But, then again, it’s debatable whether the remedial activities of big natural resource companies are scrutinised to the same extent as the nuclear industry.

Nevertheless, the news comes at a difficult time for advocates of nuclear power - at least those in Europe and the US. The latest news flies in the face of misconceptions in the post-war period about the cost benefits of nuclear power. Critics claim that far from being "too cheap to meter", nuclear power has turned out to be a far more costly option than fossil fuels. And though environmental lobbyists are quick to point out the link between the use of fossil fuels and climate change, many are still reluctant to advocate the use of nuclear generated power as a low-emission alternative. Even France, which currently generates three-quarters of its electricity through nuclear, is now intent on significantly reducing its reliance on the industry by the introduction of a cap on nuclear generating capacity.

 

U-235 meltdown

France’s pull-back will inevitably weigh on already depressed sentiment. Prices for uranium ore went into meltdown earlier this month after industry analysts at RBC Capital Markets cut this year’s spot price forecast by 30 per cent to $31.50 (£18.50) a pound. The team at RBC also reduced the target range for 2016-18 by nearly half to $40-$45. Though supply/demand estimates diverge across the industry, the RBC downgrade was predicated on the view that the market remains in surplus three years after the Fukushima disaster in Japan.

It's clear the immediate problem is that Japan's nuclear power network is taking longer than expected to come back on line. At best, only around half of the country’s 50 reactors are expected to be up and running by 2018. Only the US and France have greater generating capacity than Japan. So with reported mine output on the up, there will be limited upward pressure on prices while the post-Fukushima outage drags on, particularly if the country’s utilities are dumping excess inventories on the market. The RBC analysis runs that even if remedial work on Japan’s network is carried out according to schedule, the global market will remain in surplus for another seven years.

That's hardly an encouraging outlook, particularly for big producers like Cameco (NYSE: CCJ). There is certainly evidence that miners are paring backs costs to mitigate a weakened pricing environment. Rio Tinto (RIO) has detailed a new operating plan for its Rössing uranium mine in Namibia, under which it will cut about $95m from its fixed operating costs and reduce the number of employees by a fifth. Meanwhile, Canadian-based miner Uranium One Inc. has slashed the workforce at its Honeymoon mine in South Australia. The mine has been placed in ‘care and maintenance mode' until economics move back in its favour. However, though producers have been temporarily hamstrung by events in Japan, analyst opinion on prospects for the wider industry is far from uniform.

 

An opaque market

As mentioned, there are differing - and in some cases incompatible - views on the supply/demand balance. This divergence stems from the fact that the uranium market is relatively opaque; it’s difficult to arrive at a clear view of the fundamentals. Unlike other commodities, there are obvious sensitivities linked to both technological and security issues. And with no dedicated uranium exchange, the overwhelming majority of supply contracts are brokered one-on-one, well outside the public domain. Most deals are also secured on a long-term basis, so the spot market isn’t exactly a hive of activity. In terms of transparency and price discovery, this obviously presents something of a problem.

In a fragmented industry, perhaps the most widely sourced price series (Ux U3O8 Price) has been cobbled together for over 20 years by US-based industry consulting specialist UxC (http://www.uxc.com). The consultancy provides a daily valuation based on the most competitive offer provided by brokers and buyers of ore for nuclear facilities. The system is far from fail-safe - a recurring theme within the nuclear industry. But UxC has established a sound reputation based on its broad expertise and longevity as an industry consultant. A point borne out by the fact that NYMEX utilises the data as the official settlement price for its UxC Uranium Futures Contract (UX). Nevertheless, the pricing model for uranium isn’t exactly reactive - so to speak - when compared with some other commodity markets. There may be limited opportunities for arbitrage, but when you consider the relative paucity of deal volumes, an indicative price is better than no price at all.

It’s worth mentioning that the RBC team, along with the bulk of industry analysts, are more bullish over long-term prospects for uranium prices, even though the metaphorical fall-out from Fukushima wasn’t confined to Japan’s eastern flank. In the wake of the disaster, both Germany and Switzerland moved decisively away from a nuclear future, while countries with active development programmes like China and India slowed the pace of expansion to better appraise safety considerations - at least initially.

 

Eastern promise

Though the Communist Party temporarily suspended the approval of new nuclear plants in the immediate aftermath of Fukushima, China’s President Xi Jinping recently told a government meeting that development of nuclear energy should now be accelerated. Any hiatus in development programmes was always likely to be short-lived given China’s seemingly insatiable appetite for energy. By 2034, the US Nuclear Energy Institute (NEI) estimates that power demand in China will have grown by more than the existing aggregate demand of Japan and the US. Over the period, the NEI forecasts that global investment in new generating capacity and grid expansion will be in the region of $17 trillion.

China accounts for 32 of the 71 reactors currently under construction worldwide. The last internal energy audit revealed that less than 2 per cent of China’s energy requirements are met through nuclear, but that’s set to change rapidly. Last year, Chinese reactors generated 14.5 gigawatts (GW) of power. The country’s utilities intend to scale-up operations to an aggregate installed capacity of 58 GW by the end of this decade, rising to 150 GW by 2030. (Peak electricity demand in the UK during 2012 was 57.5 GW).

It’s well known that China is moving to diversify its energy sources from a strategic desire to regulate price inputs, but environmental issues - specifically air quality - have risen up the political agenda as the pace of industrialisation threatens the nation’s health. The country needs to replace - as far as possible - coal-fired power plants in favour of cleaner sources of energy. The LNG industry is a frontrunner in this regard, but China needs a range of solutions to meet its energy requirements. Another factor influencing strategists is that the most populous, energy intensive conurbations are dotted along China’s east coast - well away from the country’s older coal-beds and oil fields.

The roll out of China’s generating capacity is creating lucrative opportunities for international contractors. It’s unsurprising that French companies - with their unrivalled sector expertise and long-term links with China - are heavily involved with the roll-out of next-generation reactors in the People’s Republic. Both Electricite de France SA (EDF: SP) and Areva SA (AREVA: PA) signed development contracts last year. The latter, along with German electronics giant Siemens AG (SIE: GR), is to provide instrumentation and control systems for the fifth and sixth pressurised water reactors at the Fuqing plant in Fujian Province. And the expansion of China’s nuclear capacity has even fuelled activity on an otherwise becalmed Hong Kong equity market. China General Nuclear Power Corp., the country's biggest nuclear-energy company by installed capacity, plans to raise $2bn through an initial public offering (IPO) in the third quarter of this year.

Of course, French contractors and Chinese capital are also holding sway closer to home. EDF Energy will lead a consortium, largely backed by Chinese capital, to build the Hinkley Point C plant in Somerset. Areva will hold a 10 per cent stake, while China General Nuclear Power Group and China National Nuclear Corp will hold between 30-35 per cent. There could be significant knock-on effects for UK engineers. Amec's (AMEC) nuclear division has previously provided architectural engineerings services to EDF's UK nuclear new build programme, although any substantial benefits from the planned UK roll-out are unlikely to accrue for some time given the long lead times involved.

The industry faces no shortages of challenges, particularly in light of reaction to the Fukushima disaster. However, the renewed expansion of capacity in China holds out significant opportunities for contractors over the long-run. Meanwhile, European governments have done precious little to address looming energy deficits, so we expect that government policy will have to be re-framed at some point. The following list of UK firms exposed to any uptick in nuclear industry activity is by no means the end of it. Companies such as James Fisher, Costain, Porvair, Bodycote, Goodwin and Hardide all make money from the nuclear industry. We’ve just picked a selection of the most interesting.

 

Rolls-Royce (RR.)

Rolls-Royce (RR.) is one of the UK’s biggest suppliers of parts and expertise to the global nuclear industry. It’s been making valves, heat exchangers and instrumentation and control systems for decades, and generated just over £600m of revenue from nuclear last year (about 4 per cent of the total). Crucially, it’s already supplying the Chinese and has just agreed to collaborate with a nuclear reactor manufacturer there called CNNC. Rolls expects "good growth in revenue and profit" at the Energy & Nuclear division this year, making up for weakness in defence. Of course, there are lots of opportunities from UK nuclear build, too, and recently-announced £1bn share buy-back removes the risk of an expensive acquisition. Yet, a forward PE ratio of 16, dropping to 14 next year is a discount to US peers. Buy.

 

Amec (AMEC)

Amec (AMEC) is nuclear through-and-through. It has worked on every one of Britain’s civil nuclear plants and has over 3,000 experts helping build them (10 per cent of nuclear revenue), keep them running (60 per cent), then clean up the mess at the end (30 per cent). In 2012, the industry chipped in £272m of revenue and about £140m in the first half of 2013. But it is the £2bn acquisition of American rival Foster Wheeler that’s really exciting. But Amec shares have already risen by a fifth to a record high and trade on 15 times forward earnings. Hold.

 

WS Atkins (ATK)

Heavyweight engineering consultant WS Atkins (ATK) is an expert when it comes to the nuclear industry. It helps utilities, reactor manufacturers, regulatory bodies and contractors get power stations built and has been involved in the nuclear clean-up since the late 1980s. Last year, nuclear generated over a third of its Energy division revenues - £53m in all. It should be more in 2014 following December’s three-year consultancy and technical design with Horizon Nuclear Power. Buying Nuclear Safety Associates also gives establishes a nuclear presence in the US. We like Atkins, although a forward PE ratio of 14 for next year is a premium to peers and prices in all the good news. Hold.

 

Rotork (ROR)

Rotork (ROR) is a British engineering success story. It makes, among other things, valves and gearboxes used to control nuclear power plants, and while it will not publish its nuclear stats, we know power generation made up about 15 per cent of revenue in 2013. Years of consistent growth has been rewarded with a premium earnings multiple, but its safe haven status could work against it if risk appetite returns. Still, with our sell advice recently rescinded, we rate the shares a hold.

 

Carr’s Milling (CRM)

Shares in Carr’s Milling (CRM), the conglomerate which supplies flour to food manufacturers and supermarkets, fell off a cliff earlier this year, largely on concerns about a supermarket price war. But Carr’s makes robotic arms for handling toxic materials, too - engineering generates over a quarter of profits - and business is going well. German unit Wälischmiller supplies kit for Chinese nuclear reactors and the Swindon factory makes critical parts for Sellafield where delayed contracts should feed through next year. Power plants at Heysham II, Hinckley and Hartlepool have demanded upgrades, too. The shares, however, appear undervalued hence our recent upgrade to buy.

 

Hayward Tyler (HAYT)

Hayward Tyler (HAYT) is an IC-favourite with a first-class reputation in the nuclear industry. Since fitting its pumps at Calder Hall - the world’s first civil nuclear power station - in 1956, Hayward has supplied countless others around the world with over 1,000 specialist pumps. Over 60 per cent of US plants use them, and, like Sweden’s ageing Forsmark site, many are getting old and will need new kit. Hayward’s Forsmark pumps cost £1m each. It has already won nuclear funding from the UK Regional Growth Fund, and is winning work in China, too. Despite rapid growth the share still trade at a big discount to the sector. Buy.

 

Ultra Electronics (ULE)

Ultra Electronics (ULE) lives in the aerospace & defence sector; understandable given the military generated 57 per cent of sales last year. But it also has a thriving nuclear sensors and controls business, and with US, UK and French accreditation for numerous products, is now able to supply all the major nuclear reactor constructors. It is already working with France’s Areva and America’s Westinghouse in China, and a new state-of-the-art nuclear instrumentation manufacturing facility has secured £29m of contracts with EDF. That said, a forward PE ratio of nearly 15 - remains a premium to peers - amply reflects modest forecast EPS growth for the next two years. Hold.

 

Weir (WEIR)

Weir (WEIR) has a valve for every occasion, so little wonder the engineer was one of the original valve suppliers to the nuclear industry. "Nuclear remains an attractive prospect in the medium to long term, particularly in China, India and the Middle East," says the firm, although Weir is pushing lucrative aftermarket repair and maintenance work to make up for likely delays in new build projects. Oil & gas and mining are by far the biggest money-makers for Weir, however, and with the strong pound offsetting underlying growth this year, a forward PE ratio of 18 looks fair. Hold.