Credit: Shutterstock photoBy Thomas Lott :
This article first appeared at sharpeequities.comhere.
Chevron ( CVX ) is richly valued cyclical with diminishing returns on equity ((ROE)), whose cash flow doesn't even cover its dividend. With a $188BB market cap, it is one of the major integrated oil companies, along with Exxon, Shell, BP, Total and Conoco. Unlike its peers, Chevron a few years ago began spending aggressively to grow liquids production - right at the peak of the market, as it turned out.
While this should imply production growth, Chevron is actually forecasting only 0-3% growth this year. Even with higher production forecasted for 2017, cash flows seem unlikely to improve meaningfully (barring $100 oil), since production growth predominantly comes from higher-cost shale and offshore sources. Indeed, Chevron has not actually grown production at all over the past 8 years. Despite spending an exorbitant $88BB since 2012, it will likely see low or perhaps negative ROE on that capital.
Even if oil prices recover, we see little upside in the stock. Assuming $70 oil, as implied by the forward curve, and granting 25% more oil production than today per guidance, we estimate 2017 forward cash earnings in the range of $5/share. At a liberal 15x multiple (higher than the historical average), the stock is worth $75/share . While GAAP EPS will certainly appear higher, investors should be focused on real cash earnings and understand that higher capex today will eventually flow into D&A, dragging down results over time.
Basics
Let's look at some basic numbers for CVX, going back to 2005:
Revenue
Note: Chevron purchased Unocal in August 2005
Earnings Per Share
Historical Production
I have not gone back to 2006, since the Unocal deal skews results, but the trend seems quite apparent: Chevron has not grown production in 8 years. This year's guidance is for growth of 0-3%. The chart illustrates the midpoint of 1.5% growth. While management points to a production figure of 3.0mm+ barrel per day in 2017, margins will be far lower, since these projects (many large international LNG projects and deepwater resources) were developed when the price of oil was $90-100.
Historical P/E Ratios of the S&P 500 and Chevron
Note that this is the first time in 10 years that CVX has traded at a higher earnings multiple than the market.
Below is a graph illustrating the difference in multiples between Chevron and the S&P. Historically, the stock traded below the market by an average of 5.5 turns. Said differently, if the S&P traded at 16x earnings, then CVX typically traded at 10.5x. Today, Chevron remarkably trades at 24x 2015 earnings, whereas the S&P trades around 18x.
That is 2.75 standard deviations higher than its ten-year historical average (i.e. the standard deviation of the P/E differential is 3.7, and today the stock exceeds that by 10.1 multiple points).
Free Cash Flow
It is fairly safe to say this is not a company that has grown during the last decade. Even more disturbing are the recent trend of far higher Finding & Development costs and the company's failure even to cover its dividend. It probably won't cover its dividend unless oil prices recover meaningfully and production grows.
A great balance sheet can carry an uncovered dividend for only so long. Without a recovery in oil prices, the dividend will probably languish while the balance sheet deteriorates. The dividend appears to be a sacred cow at the company, so it probably won't be cut. Taken on their own, however, a "reliable" dividend and the odds of pricier oil make for a horrible investment thesis.
Here is a summary of the company's cash flow going back 8 years, pre-dividends:
This shows that cash earnings (which I deem to be real economic earnings) have averaged an abysmal $1.76 per share since 2008. Indeed, cash earnings appear to be worsening, even when oil prices were quite high. With capex jumping from $20BB to over $35BB last year, one would expect production growth to begin to accelerate. But with substantial cost overruns and delays on its major capex projects, production growth likely will end up lower than anticipated and at lower margins.
Based on FCF, Chevron is not generating enough cash to cover its dividend. In the last 3 years alone, it has taken on some $30BB of debt to fund it. The company will argue that much of cash flow was spent on major oil finds and LNG projects in places like Angola, Nigeria and the deepwater Gulf of Mexico. But this growth capex is peak pricing exploratory drilling in disguise. We can expect low returns on equity.
This table illustrates that Chevron has taken on an astonishing $30BB of debt since 2012:
One could argue this is oversimplified, considering the capex dollars spent on growing oil production, so let's take a look at another approach and determine the economic returns on capital assuming normalized Finding & Development (F&D) costs.
F&D Costs
It's vital to understand E&P company F&D costs to really grasp their economics. To calculate Chevron's three-year average F&D costs, we go to the Supplemental Financials and divide costs incurred in Exploration and Production activities by reserve revisions/extensions. This takes out the noise of asset acquisitions and divestitures and normalizes for reserve revisions. To be conservative, I included all the positive reserve revisions over the past 3 years.
Based on 2012-2014 figures, their F&Dcosts are a quite high $31 per barrel equivalent (( BOE )) level.
Here is the math:
Costs incurred 2012-14: $88.8BB
Revisions: 1.634 BB BOE
Extensions and Discoveries: 1.157 BB BOE
Total Reserve Additions: 2.79 BB BOE
F&D Costs: $31.45 per BOE (88.8/2.79)
Lifting costs lately have been running $17.69 per BOE, with revenue at $43 per BOE. That means cash earnings per barrel are negative ($43.00 minus 31.45 minus 17.69 = -6.09 per BOE).
While I have no idea where the price of oil is headed, oil futures in 2017 are $64 and $70 per barrel for WTI and Brent respectively.
In the table below are cash figures, assuming 1) the company meets its production growth forecasts for 2017 and 2) Finding and Development costs decline substantially to a more "normalized" $25/barrel equivalent. F&D costs are $31 today, and given the deflation in rig costs and oilfield service costs, normalization to $25 is probably reasonable.
Assuming average downstream earnings, CVX will generate cash returns of only $5/share in 2017. That means investors today own it at a pretty dismal 5% FCF yield on 2-year forward numbers, assuming oil recovers and the company is able to execute on its production growth plans!
Thus, applying an 11-12x multiple, the stock is worth $60-70 even with dividends .
Base Case
Street GAAP figures are $8.63 for 2017. For a stock that historically has traded at 9.6x earnings, I ask, where is the upside to owning CVX, even if Chevron hits growth forecasts and oil recovers by another 10%? 10x $8.63 in EPS in 2017 is obviously $86.30, and dividends will add $8 to that in a couple years, for a worst case (from the perspective of a short seller) of $95.
Here is what makes sense to me given cash earnings, using the assumptions above.
Quick Note on Growth Projects
While we assumed that production does ramp up as guidance assumes, there appear to be cracks in some of the big LNG projects and offshore wells at Chevron. The Big Foot Gulf of Mexico deepwater well has experienced engineering problems as 9 of the 16 tendon anchors sunk last month. The platform alone costs over $5BB. It's unclear if this delays production meaningfully, but certainly costs will be higher.
The Gorgan LNG project in Australia, originally budgeted at a $37BB, now looks to cost an astonishing $55BB plus. Shell, one of Chevron's partners, believes production will not start until 2016, although Chevron still is aiming for 2015 production.
Angola LNG, originally budgeted at $4-5BB, will end up costing $12-14BB according to one source. Design flaws and delays have been hallmarks here. The plant opened in 2013, but cargoes have been limited and roughly 1/3 of the plant will need rebuilding it appears.
Conclusion
Chevron is admittedly a levered play on oil and liquids prices. The company guided back in 2011 to grow production to over 3mm BOE/ day by 2017. It made this decision at precisely the most expensive period in history to grow organically. In 2011, ROEs were 21.6%. Last year they fell to a mere 10.9%, even though oil prices were almost identical (WTI averaged $87 per barrel in 2011 and $86 in 2014).
Chevron may succeed in growing production, but the returns will be very poor. The dividend has not been covered for 2 years now, despite very high oil prices, and cash burn over the next 2 years will continue to diminish shareholder value.
Insiders offer little in the way of comfort either. Net of buys, insiders have unloaded over 1mm shares, or over $110mm of stock since 2012. There has been only one insider purchase in the past year (made by John Stumpf, CEO of Wells Fargo and a director).
The downside to a short position is obviously that oil may rally meaningfully. For every $10 increase in the price of oil, Chevron's EPS goes up around $2.25. If the forward curve projects $70 oil and oil ends up at $80, then cash EPS will increase from about $5 to $7.25. Still, considering that the company historically has traded below 10x earnings, there seems to be a major disconnect in its stock price today.
I would not ignore the best-case scenario for the short seller either: that is that oil prices slip further and the company fails to generate meaningful earnings at all. If oil stabilizes at $50, look out below.
See also SVB Financial Group ( SIVB ) CEO Greg Becker on Q2 2015 Results - Earnings Call Transcript on seekingalpha.com
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
