Background and Thesis
We published an article last month on Imperial Oil. We have decided to update our readers for two reasons; the stock has fallen a further 5% since then and Imperial's principle upstream project Kearl is about to start production. We have re-crunched our numbers and are very excited about the prospects of the stock at these levels.
The purpose of this article is to calculate the returns one can reasonably expect by buying Imperial Oil (IMO). We believe the stock offers excellent growth prospects in relation to price (9.2x trailing 12 month earnings).
Imperial Oil in which US-based Exxon Mobil (XOM) holds a 69.6 percent stake, is Canada's second-largest integrated oil company (by market capitalization).
The stock has been investing significant amounts of capital in its Kearl Oil Sands Project which is now finally starting production.
We believe the stock has fallen out of favor with investors because of the long term nature of its CAPEX projects and a misleading slowing in growth.
As production from Kearl will now start to come on stream, growth will reappear and Returns On Invested Capital (ROIC) will start to grow. This should result in a re-rating of the stock and eps growth.
In the chart below you can see Imperial Oil's historical Upstream production levels. We have added to the right our estimates for 2013, 2014 and 2015 based on increasing contributions from Imperial's Nabiye and Kearl projects.
Strong historical cash flow generation….
As Kearl starts to kick out cash, we expect an increased focus on returning excess cash to shareholders (buybacks and dividends) like in 2005 - 2008….
Below one can see how cash is deployed. The key observation is the significant growth capex over the last 5 years….
Naturally significant growth in the levels of invested capital….
Revenues/Invested Capital have been falling as the Kearl Project had yet to start production….
Margins have been expanding as the downstream business has been very strong recently….
ROIC is below its historical averages as the CAPEX going into Kearl has been growing without a commensurate increase in revenues feeding through. This is about to change....
Using maximum, minimum and average historical Returns On Invested Capital in the previous chart, we have calculated based on the historical levels of invested capital possible ranges for where NOPAT could be (see below). Right now, NOPAT is slightly below average ROIC levels. We believe that as Kearl begins production, ROIC will break up through the average and NOPAT will follow. Please note that this is based on current levels of invested capital and we expect invested capital to continue to grow going forward that should result in an even higher NOPAT.
Historically, Imperial Oil has traded on an average relative p/e of 0.95 to the S&P 500. Applying this to the current multiple of 15.47 gives us 14.75x earnings. We have multiplied the current P/E of 9.16 by the historical NOPAT levels (derived from minimum, average and maximum ROIC levels) to get a sense of where the market cap for the company can trade. In the chart below you can see the actual market cap of Imperial plotted against the market capitalisation calculated using NOPAT derived from the minimum, average and maximum historical ROIC. We can see that right now the market cap of Imperial is 15% below its fair value level. We believe that as ROIC expands, the market cap has significant upside potential.
Our annualized average EPS estimate for the next 5 years is 17.3%. The various components can be seen below.
Assuming Imperial will trade on its average relative P/E of 0.95 x S&P 500 which would equate to 14.75x trailing earnings, then we are looking at an 29.8% IRR over the next 5 years with a CAD$143.72 price target. In the event that multiples stay at the current level (9.17x trailing earnings), then the IRR would be 18.5% with a CAD$89.80 price target. Please note, we are long Imperial Oil through its primary listing on the TSE not the US listing.
Oil price volatility and North American refining capacity could have a significant impact on the earnings of the stock.