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Overview

Chevron (NYSE:CVX) shares have enjoyed a nice, sustained rally over the past couple of years from the $60s to trade at around $107 at the time of this writing. Much of this has been due to a mean reversion of profits that were decimated after oil prices collapsed at the beginning of the financial crisis. Chevron is indeed making more money than it had been in years past but will it continue? This article will take a look at Chevron's prospects as a company and as a dividend stock in relation to its past, future expectations and its dependence upon high oil prices to pay that large dividend. Ultimately, we will attempt to decide whether or not CVX deserves a place in your portfolio.

(click to enlarge)

As you can see from the weekly chart above, after hitting the low $60s in the summer of 2010, Chevron shares enjoyed an almost uninterrupted rally to about $105 in early 2011. Since then, shares have consolidated and bounced between $85 and $117. Why did the rally stop?

Fundamentals

To answer this, we need to understand what is driving Chevron's profits and, therefore, valuation. Chevron's main business revolves around discovering, drilling, refining, transporting and selling crude oil and its derivatives. In addition, like the other oil majors, it is a player in the natural gas space as well. However, Chevron's fortunes still rise and fall based primarily on one variable: the price of crude oil. In looking at the chart below, one can see that Chevron's valuation is almost entirely dependent upon the price of crude oil. This may seem like common sense but the magnitude with which crude oil prices affect Chevron's stock price is staggering. This chart compares Chevron's market capitalization with the spot price of WTI crude oil over the past 10 years.

You can plainly see that whatever happens to the price of crude translates into Chevron shares. Similarly, in the next chart, we can see that trailing 12 months net income is also heavily dependent upon the price of crude oil. This means that Chevron shares don't just trade in tandem with crude oil; there is a fundamental reason why this happens. Price movements in crude oil do in fact have significant impact on the profitability (and market value) of Chevron. Again, while this seems intuitive, it is instructive to understand the extent to which Chevron's value is dependent upon crude oil prices.

Finally, let's take a look at Chevron's return on equity in relation to the price of crude oil. The story is the same but I think it's important to point out that Chevron's management isn't able to affect the return the company has on its equity more than the price of the raw material they work with. This is somewhat striking in that management should ideally be able to soften the effects of raw material prices either through efficiencies in the exploration, production or distribution process, or by hedging out some or all of their exposure to price movements.

As we can see plainly from this chart, this is not the case. As a result, Chevron shareholders are at the mercy of swings in crude oil prices.

Crude Oil

Now that we have established that Chevron is dependent upon crude oil prices, what does it mean for shareholders? For the past year and a half, WTI crude has been range bound between about $80 and $110. As of this writing, it is trading at about $89. The question becomes, given Chevron's share appreciation over the past couple of years and where crude is trading, what does crude price movement mean for Chevron in 2013?

To produce a fair estimate of how CVX will perform next year, we first need to forecast WTI crude oil prices in 2013. Given the many variables that can move crude oil prices (geopolitical issues, supply and demand, inflation, US dollar strength or weakness, etc.), it can be quite challenging to accurately forecast crude oil prices for any given time period. However, the Energy Information Administration (EIA) produces forecasts for many energy products, including WTI crude. Since they are generally recognized to be the authority on such matters, I have elected to use their forecast for 2013 WTI crude prices.

As you can see below, the EIA expects WTI crude to be flat to down in 2013 (the red line). This, of course, means that Chevron will probably suffer some ROE erosion and as a result, net income and presumably, the stock price will suffer. These are assumptions, of course, but given the evidence presented above, I feel they are quite reasonable assumptions to make. We've demonstrated that Chevron's profitability and valuation are in large part due solely to movements in crude oil prices.

I am also aware that Chevron doesn't necessarily operate in markets that only use WTI crude but the chart for Brent crude looks almost identical, just with different prices, so the point stands.

(click to enlarge)

Discounted Cash Flow Analysis

Given the relationship between crude oil prices and CVX share performance, let's now take a look at Chevron's earnings prospects and attempt to assign a value to the company. First, a few assumptions were made for this analysis. The discount rate I used is 10%, which I believe is fair given that Chevron is relatively low risk and that we need to expect a fair return on our money while accounting for the fact that any capital we allocate to Chevron cannot be allocated elsewhere in the interim. Second, the earnings estimates for 2012 and 2013, as well as the growth estimates for the next five years are all derived from Yahoo! Finance analyst compilations. Dividend growth is assumed to be 5% for each year. One last assumption is the perpetual growth rate, which I estimated at 5%. You may disagree with some or all of my assumptions but I believe they are reasonable estimates of what may actually occur; all DCF analyses contain some subjectivity.

2012

2013

2014

2015

2016

2017

2018

Earnings Forecast

Reported earnings per share

$12.55

$12.18

$11.99

$11.79

$11.60

$11.42

x(1+Forecasted earnings growth)

-2.95%

-1.60%

-1.60%

-1.60%

-1.60%

-1.60%

=Forecasted earnings per share

$12.18

$11.99

$11.79

$11.60

$11.42

$11.24

Equity Book Value Forecasts

Equity book value at beginning of year

$67.93

$76.33

$84.35

$91.97

$99.20

$106.03

Earnings per share

$12.18

$11.99

$11.79

$11.60

$11.42

$11.24

-Dividends per share

$3.60

$3.78

$3.97

$4.17

$4.38

$4.59

$4.82

=Equity book value at end of year

$67.93

$76.33

$84.35

$91.97

$99.20

$106.03

$112.44

Abnormal earnings

Equity book value at begin of year

$67.93

$76.33

$84.35

$91.97

$99.20

$106.03

x Equity cost of capital

10.00%

10.00%

10.00%

10.00%

10.00%

10.00%

10.00%

=Normal earnings

$6.79

$7.63

$8.43

$9.20

$9.92

$10.60

Forecasted EPS

$12.18

$11.99

$11.79

$11.60

$11.42

$11.24

-Normal earnings

$6.79

$7.63

$8.43

$9.20

$9.92

$10.60

=Abnormal earnings

$5.39

$4.35

$3.36

$2.41

$1.50

$0.63

Valuation

Future abnormal earnings

$5.39

$4.35

$3.36

$2.41

$1.50

$0.63

x discount factor (10%)

0.909

0.826

0.751

0.683

0.621

0.564

=Abnormal earnings disc to present

$4.90

$3.60

$2.52

$1.64

$0.93

$0.36

Abnormal earnings in year +6

$0.63

Assumed long-term growth rate

5.00%

Value of terminal year

$12.68

Estimated share price

Sum of discounted AE over horizon

$13.59

+PV of terminal year AE

$7.15

=PV of all AE

$20.75

+Current equity book value

$67.93

=Estimated current share price

$88.68

What we see is that, given my set of assumptions (some of which are quite generous), Chevron is currently worth only about $89 per share. Given that it is trading near $107, that would imply CVX is highly overvalued and due for a pullback on a fundamental basis. In addition, given the risk to crude oil prices in the future (softening demand, increased supply, etc.) and the correlation CVX's price has to crude oil, my personal feeling is that Chevron is not a great place for you to invest your capital in the coming year. The dividend would be the only reason I could see allocating your capital to Chevron at this point.

Speaking of the dividend, this is where Chevron management really shines. They are extremely shareholder friendly, as evidenced by the chart below depicting CVX's dividend over the past 10 years. What you see is a steady, almost constant increase in the size of the dividend and this is no doubt serving to buoy the stock.

Also on the bulls' side, growth in shareholders' equity has been relentless for the past decade, reflecting Chevron's continued immense profitability. Even though the point stands regarding Chevron's valuation in relation to crude oil prices, it seems that at virtually any realistic crude oil price, Chevron can make money. It just makes a lot more when the price of the raw material goes up. Regardless, this is an impressive chart and should help sustain the valuation of the company if crude oil prices falter again.

Lastly, Chevron's price to earnings multiple is currently about 9, which is right in line with past years. As can be expected with a mega-cap stock like Chevron, multiple expansion is unlikely and if multiple expansion did occur it would probably only move marginally, perhaps up to 10. However, given that Chevron is expected to have negative earnings growth over the next five years, I would argue that a multiple of 9 is in fact too high. We can see from the chart below that 9 is certainly not the floor of Chevron's PE and we could certainly revisit the days of CVX trading for 7 times earnings. I suggest that this is not only probable but necessary given that Chevron is expected to make less money over the next five years than they have over the past five years. Any business that is contracting does not deserve a premium multiple and I believe Chevron shares haven't yet reflected this reality.

Conclusion

Given Chevron's near complete dependence upon the price of crude oil and management's inability to affect profitability meaningfully, I expect Chevron shares will trade down 2013. Chevron's business is slowly deteriorating and as such, the shares don't warrant a multiple even as high as 9 times earnings. I suspect we will see Chevron trading for 6 or 7 times earnings in the medium term and current shareholders will suffer as a result.

The only reason I could see buying Chevron at these levels is the hefty dividend. Chevron is yielding twice the 10 year Treasury and is a great source of income for a retiree's portfolio. However, given that earnings are contracting and expected to do so for a long time, I will certainly be staying away from the shares for now. If you must buy Chevron, even just for the dividend, you could do worse than to wait for a pullback into my fair value range, perhaps $85 to $90, before entering your position. At that point, the stock would be yielding a solid and steady 4%. Coupled with stable dividend growth, Chevron could be an instrumental part of an income portfolio, but wait for the valuation to catch up with the fundamentals.

Source: Why Chevron Is Going Lower In 2013