Contents
Chevron Corporation (CVX) released its Q2 and YTD2019 results and provided Q3 2019 guidance on August 2, 2019.
Management demonstrated cost and capital discipline when it withdrew its offer to acquire Anadarko Petroleum Corporation.
Long-term investors would be wise to closely look CVX's current valuation.
Summary
- CVX recently released Q2 and YTD2019 results and has communicated its decision to resume its $5B annual share buyback program.
- Management has indicated it will direct spending toward shorter-cycle, less capital-intensive projects such as unconventional production in the Permian Basin and brownfield expansion of existing projects that provide flexibility and deliver high returns.
- CVX demonstrated cost and capital discipline when it decided to withdraw from the Anadarko Petroleum Corporation acquisition and to pocket the $1B termination fee.
- It has very conservative Debt and Net Debt ratios as at the end of Q2 2019 and is back to generating strong FCF.
Introduction
In my April 8th Chevron Corporation (CVX) article I disclosed the following two Out-Of-The-Money Covered Call option trades (trading fees are nominal and are excluded in my calculations below) I had just placed on CVX shares which are held in two different ‘Core Accounts’ within the FFJ Portfolio.
On April 8, 2019 I wrote 3 September 20, 2019 calls with a $130 strike price. This generated $3.90/share or gross proceeds of $1,170.
I also wrote 9 September 20, 2019 calls with a $135 strike price through another account. This generated $2.21/share or gross proceeds of $1,989.
With the pullback in CVX’s share price subsequent to April 8th, these option contracts are currently profitable. It is not my intent to close out these positions at this juncture but if I were to do so, it would now cost me $0.09/share for the $130 Calls (a $3.81/share profit before commission) and $0.03/share for the $135 Calls (a $2.18/share profit before commission).
With CVX’s share price having pulled back to $115.81 as at the August 16th market close from ~$126.70 on April 8th and the release of Q2 results on August 2nd I now take this opportunity to determine whether this is an opportune time to acquire additional CVX shares.
Recent Events
Just prior to me writing my April 8th article The Supreme Court of Canada rejected a request to review a decision of the Court of Appeal for Ontario that a $9.5B Ecuadorian judgment against CVX cannot be enforced against Chevron Canada Limited, an indirect subsidiary.
Within days of The Supreme Court of Canada’s decision, The Supreme Court of the Netherlands ruled in favor of CVX, rejecting the Republic of Ecuador’s attempts to annul decisions of an international arbitral tribunal in The Hague that ordered Ecuador to take all steps necessary to prevent enforcement of a $9.5B Ecuadorian judgment against CVX anywhere in the world.
On July 8th, a group of Ecuadorian plaintiffs whose litigation against CVX had been exposed as a fraud and bribery scheme by courts in the United States and elsewhere ended its Canadian lawsuit against CVX. Following dismissals of their claims in Argentina and Brazil, findings against them in the United States and Gibraltar, and a ruling in The Hague that the Republic of Ecuador’s failure to prevent the continuation of the fraudulent litigation scheme violated international law, the plaintiffs ended their only remaining lawsuit by dismissing the Canadian case. The plaintiffs further agreed to pay costs to CVX.
Another piece of good news came about on May 9th when CVX announced that under the terms of its previously announced Merger Agreement with Anadarko Petroleum Corporation (APC), it would not make a counterproposal and would allow the four-day match period to expire.
CVX had expressed an interest in acquiring APC because in recent years APC had dramatically increased its reserves from 0.5B barrels of oil and oil equivalents to 2.41B barrels of oil and oil equivalents.
APC had essentially become an ideal acquisition target for an oil and gas major looking to add to its portfolio because it owned all of these proven reserves in Western Texas and Eastern New Mexico and also had the possibility of having even more “unproven” reserves that could be developed.
The folks at CVX obviously did their homework before offering to acquire APC. What they saw was a company earning $0.7B in annual profits with the capability to increase profits to $1B - $1.2B over the next decade. Given that oil prices can be highly cyclical it is prudent to err on the side of caution when making forecasts well into the future and this is exactly how CVX approached its decision to offer $33B for a company that might generate earnings of $1.2B; this is a 27.5 earnings multiple.
At a 27.5 earnings multiple CVX would be paying up for APC but when you consider that APC has great Permian assets it is not surprising that CVX would be prepared to pay top dollar.
Enter into the equation Occidental Petroleum Corporation (OXY) with a $38B bid for APC. You know a company can’t raise financing the conventional way when it has to turn to Berkshire Hathaway Inc. (BRK.b) for financial assistance!
As much as I like BRK.b as an investment and am impressed with BRK.b’s astute team of investors, I can’t help but think that when you make a deal to obtain financing from BRK.b you are very likely ending up on the weaker side of the deal; the BRK.b folks are no dummies and you can bet your bottom dollar that any financing deal they strike is weighted toward BRK.b’s advantage.
So…what deal was struck? Well, BRK.b’s cash enabled OXY to issue ~$7.56B of stock making the deal an 80.1% to 19.9% cash/stock deal.
Delving a bit further into the details of the financing arrangement we see that in exchange for extending $10B to OXY, BRK.b will collect $0.8B in annual dividends until 2029 and extending indefinitely beyond such time until OXY redeems the preferred stock issued to BRK.b; it would need to arrange this financing once it can find cheaper financing from another source.
We also see that BRK.b will also have the opportunity to purchase up to 80 million, or ~10% of OXY, at a price of $62.50 at any point within a year of the redemption of the preferred stock. In essence, after 2029, BRK.b will get to see at what price OXY is trading and to the extent that OXY is trading $62.50, it will be able to pay $5B and then capture the price increase instantly in a riskless manner.
As a BRK.b shareholder I am thankful for that the team at BRK.b has the negotiating power to structure these types of deals.
If you are remotely curious as to why the deal is 80.1% to 19.9% cash/stock….
OXY’s corporate charter requires it to hold a shareholder vote in the event that 20% of its stock must be issued in any transaction. Look at this list of mutual fund and institutional clients (all sophisticated investors). One has to wonder how many of these sophisticated investors would question a $38B price tag where there is minimal/no margin of safety.
I do not hold any APC or OXY shares but as an existing CVX shareholder I take comfort that management is looking out for the best interests of its shareholders. In the May 9th Press Release, CVX’s Chairman and CEO stated:
‘Winning in any environment doesn’t mean winning at any cost. Cost and capital discipline always matter, and we will not dilute our returns or erode value for our shareholders for the sake of doing a deal. Our advantaged portfolio is driving robust production and cash flow growth, higher investment returns and lower execution risk. We are well positioned to deliver superior value creation for our shareholders.’
In my opinion, this statement demonstrates the extent to which CVX is disciplined in growing its business.
I also like that upon termination of the Merger Agreement, APC was required to pay CVX a $1B termination fee!
Q2 and YTD2019 Results
CVX’s Q2 and YTD results can be accessed here. Further information is provided in CVX’s August 2019 Investor Presentation.
CVX has benefited from an oil-leveraged portfolio that has led to margins and returns on capital that are typically superior to that of its peer group. This should continue as CVX leverages its large Permian Basin, Gulf of Mexico, and Western Australia exposure.
FY2019 Guidance
Despite a modest increase in capital spending during the past few years, CVX should experience an improvement in Free Cash Flow over the next 5 years because of cost-cutting and the addition of higher-margin volumes. CVX will also be directing its spending toward shorter-cycle, less capital-intensive projects such as unconventional production in the Permian Basin and brownfield expansion of existing projects that provide flexibility and deliver high returns.
Looking at CVX’s guidance from a much shorter term perspective we see that a component of CVX’s plan is the repurchase of $1.25B of issued and outstanding shares.
Source: CVX – Q2 2019 Earnings Presentation – August 2, 2019
Credit Ratings
In April 2016, Moody’s downgraded CVX’s credit rating to Aa2 from Aa1 with a stable outlook and there has been no change subsequent to this downgrade
S&P Global assigned its AA rating in December 2018.
Both ratings are the middle tier of the High Grade rating category and are satisfactory for my purposes.
I also draw to your attention that CVX’s Debt and Net Debt ratios as at the end of Q2 2019 were 16.4% and 12.4%. I view these ratios as very conservative.
NOTE: The Net Debt ratio is defined as debt less cash equivalents, marketable securities and time deposits divided by debt less cash equivalents, marketable securities and time deposits plus stockholders’ equity.
Free Cash Flow (FCF)
While there are many important metrics to be analyzed when looking at a company, the extent to which a company is able to consistently generate strong FCF is of key importance to me.
The reason I pay so much attention to FCF is because it represents the cash a company generates after cash outflows to support operations and maintain its capital assets. Unlike earnings or net income, FCF is a measure of profitability that excludes non-cash expenses reflected in the income statement (eg. depreciation, amortization) and includes spending on equipment and assets as well as changes in working capital.
Source: CVX – Q2 2019 Earnings Presentation – August 2, 2019
Looking at CVX’s historical FCF we see low crude oil prices negatively impacted CVX’s FCF in FY2013 – 2016; it recorded negative FCF of ~$22.5B during this timeframe. In FY2017 and FY2018, however, CVX reported ~$23.7B in positive FCF.
FCF for FY2019 is expected to be positive and YTD it is $9.4B.
CVX’s dividend history can be accessed here.
On July 31st, CVX’s Board of Directors declared a quarterly dividend of $1.19/share, payable September 10th to all holders of common stock as shown on the transfer records of the Corporation at the close of business August 19th.
With CVX currently trading at $115.81, the $4.76 in annual dividend payments provides investors with a ~4.11% dividend yield.
CVX typically generates EPS well in excess of its annual dividend but FY2015 – 2016 saw earnings below CVX’s dividend payout.
In the first half of FY2019, CVX generated $3.66/share in Net Income Attributable to CVX versus $2.38/share paid out in dividends.
In Q2, CVX paid over $2B in dividends. Given CVX’s continued strong cash flow, management fully expects to continue to deliver on its commitment to return significant cash to its shareholders.
When we look at the weighted average number of diluted shares outstanding (in millions of shares) for the 6 months ending June 30, 2019 we see 1,901,869 which is down slightly from 1,902,838 as at December 31, 2018.
After terminating its agreement with APC, CVX resumed buybacks and repurchased $1B of shares in Q2. Going forward, management expects share buybacks at the $5B annual run rate or $1.25B/quarter which is in line with updated guidance provided in May.
Valuation
In FY2018, CVX reported full-year adjusted diluted EPS of $8.07 and full-year diluted EPS of $7.74 with adjusted diluted EPS and diluted EPS at the end of Q2 both being $3.68.
FY2019 adjusted diluted EPS guidance from 21 analysts following the release of Q2 results now ranges from $6.09 to $8.83 with $7.16 being the mean. This is a fairly wide range so if we tighten the range to $7.10 - $7.22 and use the current $115.81 share price we get a forward adjusted diluted PE range of ~16.04 - ~16.3.
This forward adjusted PE valuation is higher than that for its peers (see below) but I view CVX as being superior from a risk perspective (lower levels of debt and superior gross, operating, and profit margins).
- BP: 9.08
- RDS: 9.31
- TOT: 8.42
- XOM: 13.73
Final Thoughts
Rather than focus on dividend yield I look at a company’s ability to steadily increase its dividend bearing in mind that the dividend must be adequately covered by earnings and FCF.
CVX experienced challenges on the coverage front in FY2013 – 2016 but I purposely initiated my CVX exposure on August 24, 2015 because I was of the opinion that earnings and FCF from a company of CVX’s quality would bounce back in due course.
I have purposely restricted my oil and gas industry exposure to CVX, Exxon Mobil Corporation (XOM), and Total S.A. (TOT) because I know this is a volatile industry and industry participants need to have the wherewithal to withstand prolonged challenging periods.
I like CVX in particular because it:
- Will be directing its spending toward shorter-cycle, less capital-intensive projects such as unconventional production in the Permian Basin and brownfield expansion of existing projects that provide flexibility and deliver high returns;
- Demonstrated discipline when it came to the APC acquisition;
- Has very conservative Debt and Net Debt ratios as at the end of Q2 2019;
- Is generating strong FCF;
- Is resuming its $5B annual share buyback program;
- Is trading at a fair valuation.
On top of this, the current dividend yield is ~4.11% (before I incur a 15% withholding tax).
I know current market conditions are challenging and CVX’s share price can certainly fall further but given the above I am prepared to increase my CVX exposure and intend to acquire shares for one of the ‘Side Accounts’ within the FFJ Portfolio within the next 72 hours.
I wish you much success on your journey to financial freedom.
Thanks for reading!
Note: I sincerely appreciate the time you took to read this article. Please send any feedback, corrections, or questions to [email protected].
Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.
Disclosure: I am long CVX, XOM, TOT, and BRK.b.
I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.
