Robust risk management is essential for fixed income investors. In his latest commentary, Marcus Moore explains why our sustainable investing team considers ESG factors as material business risks, similar to the traditional risks they also analyze.
As fixed income investors, risk management is at the heart of what we do. Before we add a borrower to our portfolio, we conduct extensive due diligence to determine the company’s ability to repay its debts. We are fundamental investors, so we generally begin by reviewing a company’s financials. In our view, traditional credit metrics (leverage ratios, margins, free cash flow, multiples, spreads, etc.), are the best indicators of an issuer’s financial strength.
Beyond these metrics, the overall health of a company is dependent on management and the current macro and company-specific themes that are driving results. We have long recognized that having a focus on sustainability adds to this evaluation. It is important for us to invest in management teams that understand the environmental, social, and governance (ESG) risks that exist within their businesses. Talking with companies about how they are being intentional in addressing these risks gives us the confidence that the businesses we invest in will be managed for long-term success.
In the current environment, however, sustainability is not just about managing risk, it is also about seeking opportunities. The focus on cleaner air, recycling, energy management, and employee engagement have the potential to drive differentiation, operational efficiency, and higher margins. Wage inflation has had a major impact on companies, given the very tight labor market. Overall wages have gone up 6.1%, but job switchers have seen their wages go up more than job stayers. Companies that have been able to maintain their workforce have been less at risk to these inflationary spikes.
Meanwhile, the ongoing global commitment to addressing climate change has seen countries and companies make significant climate-reduction investments. The EU has committed 30% of its annual budget to climate-related projects until 2027, and the Biden Administration has committed over $500 billion to be spent on clean energy and climate-related projects over the next 10 years. Many public and private institutions have also established carbon reduction targets to be achieved by 2030, including AT&T, Colgate-Palmolive, Toyota North America, and the University of Chicago. This focus on climate change, clean energy, and infrastructure is more than just another set of risks to be managed. It can also present opportunities for established companies with the right priorities to grow into the future.
Case Studies: Going Green to Find Greener Pastures
Companies are making the transition to sustainable business models because they feel their current practices pose an existential threat to their long-term viability. The turmoil of the last few years (Covid, rising inflation, higher rates, etc.) has been a catalyst, and companies that have evolved have emerged stronger than they were before the pandemic.
Below, we highlight a few issuers that successfully pivoted away from shrinking markets and into faster growing, greener segments of the economy, substantially enhancing their enterprise values. Each case demonstrates why we believe ESG investing has the potential to simultaneously reduce risk and increase returns. Sustainable investing is often characterized as a choice between performance versus progress, but in our view, progress has the potential to drive performance.
Howden
Founded in 1854 by James Howden, the company began as a marine engineering firm specializing in the design and construction of steam boilers and engines. In 2019, KPS Capital Partners (KPS), a private equity firm, acquired Howden for $1.8 billion.
KPS immediately recognized Howden’s strengths in technology and innovation and was able to preserve that competitive advantage while pivoting the business into secular growth areas, including energy efficiency, infrastructure, and decarbonization.
As part of this transformation, KPS brought in a new management team that focused on industries with a lighter carbon footprint. Howden developed products for renewable hydrogen processing and energy conservation, as well as a cloud-based Internet of Things platform to help monitor and manage large industrial systems.
Despite pandemic challenges that resulted in lower top line revenue in 2020, Howden was able to grow its EBITDA margins, and in 2021, the company fully capitalized on its new strategic direction by growing both sales and EBITDA north of 10%. In November 2022, Howden was purchased by Chart Industries for $4.4 billion, which represented a near 25% compounded annual return for KPS on its investment. It is notable that the Howden acquisition fits well into Chart Industries’ “Nexus of Clean,” which focuses on providing sustainable solutions to the company’s Clean Power, Clean Water, Clean Food, and Clean Industrials end markets.
MasTec
MasTec is a telecommunications and civil construction company founded in 1994 that focuses on developing oil and gas pipelines. As recently as 2019, the company’s revenue mix consisted of 43% oil and gas projects, 36% communication projects, 15% energy and infrastructure, and 6% power delivery projects. That same year, the company experienced 25% growth in EBITDA, entirely driven by increased profitability within the oil and gas segment.
During 2020, the global pandemic hit, and the demand for oil and gas projects declined meaningfully. MasTec understood the risks fossil fuels posed in terms of price volatility, and management also recognized the potential for greater investment in de-carbonization, renewable energy, and the expansion of 5G telecommunication networks.
Despite their strong presence in the oil and gas industry, the company decided to pivot away from fossil fuels. In 2020, management announced plans to scale up its telecom business, driven by significant investment in the rollout of 5G networks. Likewise, the company planned to ramp up its clean energy business, driven by regulatory changes, increased carbon-neutral power initiatives, and the need to upgrade the existing energy infrastructure. At the same time, they elected to de-emphasize their oil and gas business.
MasTec is now set to achieve its ambitious revenue goals by fiscal 2022 year-end. The company’s most recent acquisition of Infrastructure and Energy Alternatives (IEA) allows MasTec to further expand its presence in the renewable power generation market, making it the company’s largest business segment.
Darling Ingredients
Darling Ingredients is a global leader in the recycling of animal by-products that are used to manufacture collagen, fertilizer, and fats/proteins for animal feed. The company is well-positioned and has seen its business benefit from macro trends in health, beauty, and nutrition. The company also develops renewable diesel, which has become a progressively bigger proportion of its business as management has recognized the strong demand for alternative fuels.
In 2011, the company announced plans to create a joint venture with Valero to create a renewable diesel facility that would further diversify Darling’s finished product mix. The partnership was established to combine Darling’s supply of low-cost feedstock of animal fats and used cooking oils with Valero’s refining capabilities. In 2013, the Diamond Green Diesel plant began production with the capabilities to produce over 9,000 barrels-per-day of renewable diesel fuel with comparable properties to petroleum-based diesel. The creation of this joint venture was in direct response to the Renewable Fuel Standard (RFS) program that was created under the Energy Policy Act of 2005.
The Diamond Green Diesel project has been a success for both Valero and Darling as global low-carbon fuel policies have begun to take hold mostly in California, Canada, and across Europe. The joint venture also benefits from Darling’s supply of animal fats and cooking oils being a lower cost and less carbon-intensive feedstock than soybean oil, the most popular raw material used in the production of biodiesel. Diamond Green Diesel has completed three expansions and has grown from 137 million gallons of capacity in 2013 to 750 million gallons in 2022. Darling continues to keep its eye on the future and has committed to a joint investment with Valero to develop sustainable aviation fuel.
Investors in Darling were rewarded for management’s foresight and willingness to partner with industry experts. Since 2013, the start of production at the Diamond Green Diesel joint venture, Darling’s enterprise value has appreciated substantially.
Final Thoughts
Although there is no way to guarantee a great investment or its timing, we believe thoroughly evaluating a company’s risks, including its business model, market dynamics, and management team, help maximize the odds of success. As sustainable investors, we particularly like companies that are positioning themselves to capitalize on growing areas of the economy. Perhaps not surprisingly, we have found that many of the most compelling ESG investment opportunities are with older industrial companies that have had the foresight to (or have been forced to) adapt to a greener world. Those that can successfully transition often find themselves at the beginning of robust secular growth trends that should drive the business forward for the foreseeable future.
© Osterweis Capital Management
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