Thesis & Catalyst For Imperial Oil
The market is very pessimistic about Imperial Oil's (IMO) ability to grow its earnings. If you believe that these fears are unfounded (which we do) then Imperial Oil offers patient investors a Gross IRR in the range of 15.2% to 24.9% over the next 5 years.
The market is forecasting zero to negative earnings growth over the next 5 years. We are anticipating average annual earnings per share growth of 13.0% over the next 5 years. Once Imperial Oil starts to deliver, investors should expect to receive 13.0% annual average earnings per share growth, a 1.1% current dividend yield and possible multiple expansion.
In addition we have analyzed Imperial's valuation relative to its peer group and conclude that it is 17.9% undervalued relative to Exxon (XOM).
In Chart A below, you can see how Imperial has steadily grown both its net income and cashflows over the last ten years. We believe Imperial Oil is the highest quality and most well run company in its sector and offers quality earnings and growth at a fair price.
In figure 2 below, we have calculated the 5 Year Average Return On Invested Capital for Imperial's peer group. The average is 10.7% compared to 19.7% for Imperial. The average Price To Book Ratio for Imperial's peers is 1.3 compared to 2.3 for Imperial. From this we can estimate a fair value for Imperial's Price To Book Ratio of 2.4x (19.7% / 10.7% * 1.3). This implies 6.2% relative undervaluation. What particularly stands out here is that Exxon trades on a higher Price To Book Ratio than Imperial (2.4x) and has a 5 Year Average Return On Invested Capital of 17.1% (lower than Imperial). This implies that Imperial is 17.9% undervalued relative to Exxon, which we think is a great Relative Value trade given that Exxon owns 69.6% of Imperial.
|Company||Ticker||Average ROIC||Price To Book Ratio||Fair Value Price To Book||Over (Under)Valuation|
|Royal Dutch Shell||(RDS.A)||12.4%||1.1||1.54||-28.1%|
|Canadian Natural Resources||(CNQ)||6.8%||1.4||0.84||71.6%|
Calculation Of Expected Returns
Earnings Per Share Estimate
There are 4 building blocks to our earnings per share estimate, Implied Growth In Earnings derived from Invested Capital, Organic Growth, Earnings Per Share Uplift from Share Buybacks and Earnings Per Share Dilution from stock compensation.
1. Implied Growth Earnings Per Share
Firstly we took a look at Imperial Oil's cash flows to see how much cash it is generating and how it has historically deployed that cash (Table 1 below). We use our own Adjusted Operating Cashflow number that includes proceeds from employee stock options.
Table 2 below breaks down how Adjusted Operating Cashflows are deployed. Over the last 10 years, the company has invested on average 32.8% of its Adjusted Operating Cashflows back into its business either in the form of Acquisitions or Growth Capex, 22.9% of Adjusted Operating Cashflows were required to maintain its assets (otherwise known as Maintenance Capex), 9.7% was paid out in Dividends and 30.1% went into Share Buybacks. In the last 5 years the company has spent 55.8% of Adjusted Operating Cashflows on Growth Capex and Acquisitions, 9.6% was paid out in Dividends and 15.3% was spent on Share Buybacks. Going forward, we estimate that spending 14.2% of Adjusted Operating Cashflows on Share Buybacks is sustainable without changing the capital structure of the company.
Implied Growth Earnings Per Share represents the increase in earnings we expect to see from Invested Capital. The stock has a 10-year average Return On Invested Capital of 19.7% as can be seen in Chart 1 below. If we multiply the 10 Year Average Return On Invested Capital of 19.7% by the 55.8% of Adjusted Operating Cashflow spent on Growth Capex and Acquisitions, we get 11.0%, which is what we expect to be the Growth Earnings Per Share over the next five years.
Chart 2 below shows the quarterly Return On Invested Capital since 2007. We can see that returns have been extremely stable over the last few years and there is no reason to assume that this situation will change.
2. Organic Earnings Per Share
Imperial Oil has three segments, Oil and Gas Exploration and Production (Upstream), Refining (Downstream) and Chemicals. In 2012, 50% of Net Income was derived from Upstream, 47% from Downstream and 4% from Chemicals.
It is problematic to calculate the trend growth of the existing business excluding the effect of Invested Capital (Acquisitions and Growth Capex), as this is very reliant on the market prices of Oil, Gas & Gasoline. We have taken a prudent view and assumed stable Oil, Gas & Gasoline prices going forward given the offsetting variables of growing global supply and increasing population. This is what we refer to as Organic Earnings Per Share. Extrapolating the sales trend forward, we assume a compound annual growth rate of 0% over the next 5 years.
3. Earnings Per Share Uplift from Buybacks
In Table 4 below we have estimated how much we anticipate Earnings Per Share to grow based on the % of Adjusted Operating Cashflow used for Share Buybacks. Based on the current market capitalization, we estimate the company can sustain buying back 14.2% of its stock every year.
4. Dilution from Stock Compensation
In Table 5 below we have estimated the dilutive effect on earnings of the company's stock compensation plans. Over the last 5 years, the average annualized dilution to the basic share count was -0.2%
Table 6 below pulls together the four drivers of our Earnings Per Share estimate. We calculate 13.0% expected Earnings Per Share growth over the next 5 years. This assumes stable margins throughout that period.
Our next step is to identify the assumptions we will use to calculate the Internal Rate Of Return for the stock. Table 7 below shows the current P/E ratio of the company of 10.1, which is calculated based on a time weighting of the trailing 12 month P/E and the forward P/E. In addition we identified that over the last 5 years, the company's P/E has traded at 0.96x the S&P 500's P/E, which would imply a P/E of 14.62. The current trailing 12 month P/E of the S&P 500 is 15.3.
In Table 8 below we calculate the 5 year Internal Rate Of Return of holding Imperial Oil stock based on 3 scenarios. Scenario 1 assumes that in 5 years, the stock still trades on its current P/E ratio of 10.1. Scenario 2 assumes that in 5 years, the stock trades based on its average relative P/E to the S&P 500 of 0.96 which would be 14.6x. Scenario 3 assumes that in 5 years, the stock trades on a market multiple currently 15.3x (for the S&P 500).
In conclusion, we believe that for patient investors, a minimum gross return of 15.2% will be realized. Once Imperial Oil starts to deliver these earnings, we could see an earlier re-rating of the stock resulting in shorter-term gains for the more speculative investor.
Imperial Oil is exposed to Oil, Gas, Chemical and Gasoline Prices. Price volatility in these asset classes can have a significant effect on Imperial's earnings.