On January 9, 2013, I published research suggesting BP is undervalued and investors should accumulate shares of BP. The research included statistical analysis of BP's return series; also, there was some analysis of the valuation and historic financial performance. Since that research was published, the share price of BP declined.
In this report, we'll discuss BP in more depth than the prior research. We'll cover the financial position, discuss the oil spill, analyze the cash flows, develop a relative valuation, forecast the U.S. unemployment rate, conduct technical analysis, and make an investment recommendation. This report isn't meant to cover all aspects of BP's operations, but it does go into considerable depth relative to the prior research.
My goal as a professional investor is to generate alpha for myself and my clients. I generate alpha through information asymmetries and the timing of my investments. That said, I'm not managing money for the readers of this report. Hopefully, I'm providing you with some information that you don't already know and giving you a conceptual investment framework regarding common equity shares of BP.
Investors should remain long common equity shares of BP and accumulate shares in the $37.50 to $40/share price range. A continued decline in U.S. unemployment should put a floor under share price declines.
The decline in the unemployment rate will boost demand for energy related products and boost BP's revenue. Also, monetary policy in the U.S. continues to target a lower unemployment rate. The trend is towards an improving employment picture, and the FOMC is likely to keep monetary policy loose until the unemployment rate declines to roughly 6.5 percent.
The FOMC decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month. Expansionary monetary policy should lead to a lower unemployment rate; when the unemployment rate falls below the natural rate of unemployment and GDP is above potential GDP, the economy is operating in an inflationary gap.
The unemployment rate continues to decline. The unemployment rate reported in April 2013 was 7.6 percent. In April 2012, the unemployment rate was 8.2 percent, and in April 2011, the unemployment rate was 8.8 percent. The unemployment rate could decline to about 7 percent in April 2014, which means that monetary policy could remain accommodative until, at the earliest, late 2014.
The monetary policy outlook suggests remaining long common equity shares of BP. We can't time the investment perfectly: I consider it a 3-5 year project. There could be periods of relative outperformance, but I am targeting the end of the economic expansion cycle as an eliminate long-equity exposure time frame.
Gulf Oil Spill
A substantial portion of the oil spill payments have been made, in my opinion. The trust fund payments totaling $20 billion have been made. Additionally, another $20 billion of expenses have been recorded. We are seeing the magnitude of the payments decline and the financial performance impact has diminished.
The trust fund was fully funded at the end of calendar 2012; at the end of 2012, there was $10.5 billion remaining in the trust fund. That amount should cover 2013 expenses and possibly 2014 expenses. Between 2010 and 2012, including the trust fund, there were about $45 billion in payments. There were about $26 billion in litigation expenses and $14 billion in oil spill response expenses.
In terms of ongoing expenses, we are looking at litigation expenses that could be roughly $5 billion in 2013 and 2014. Regardless of what is the actual litigation expense, a substantial portion of the expenses have probably been paid. In other words, unless we see an unlikely $10b-$20b expense in 2013 and/or 2014, expect expenses in roughly the $5 billion range. Expenses related to the oil spill could reach $60 billion, or $15 billion more than the current cost.
Most of the expenses related to the Gulf Oil Spill have been paid; consequently, the credit risk to investors has substantially diminished.
BP is solvent and the credit risk is minimal. The industry is seeing the improved solvency and liquidity positions consistent with economic expansion. Further, I expect the liquidity and solvency positions to continue to improve.
BP's current ratio increased from 1.12 in 2010 to 1.43 in 2012; the cash ratio increased from 0.22 to 0.25. Exxon's current ratio increased from 0.94 to 1.01; the cash ratio increased from 0.13 to 0.15. Chevron's current ratio declined from 1.68 to 1.63; the cash ratio increased from 0.59 to 0.64. BP is well positioned amongst its peers in terms of liquidity.
During the same period, BP's long-term debt to equity ratio increased from 0.35 to 0.36; the financial leverage ratio declined from 2.84 to 2.52; the total debt ratio declined from 0.52 to 0.45. Exxon's long-term debt to equity ratio decreased from 0.08 to 0.05; the financial leverage ratio declined from 1.98 to 1.94; the total debt ratio declined from 0.10 to 0.07. Chevron's long-term debt to equity ratio decreased from 0.11 to 0.09; the financial leverage ratio declined from 1.75 to 1.69; the total debt ratio declined from 0.11 to 0.09. BP is less solvent than the other firms, but the trend is heading in the right direction.
On a forward-looking basis, BP's solvency and liquidity ratios should improve. The improvement in financial position is contingent on cash flows.
Cash Is King
BP's cash flows should improve relative to its peers. The firm is lagging in some of the key metrics. Some of the poor standing can be attributed to the oil spill. Deleveraging would improve BP's relative cash flow metric standing. We'll take a look at funds from operations, discretionary cash flows to total debt, operating cash flows, and investing cash flows. Exxon (XOM), BP, Chevron (CVX), and Total (TOT) will be used for peer company comparisons.
Between 2010 and 2012, BP's funds from operations ratio increased from 0.30 to 0.42; Exxon's ratio went from 3.22 to 4.85; Chevron's ratio went from 2.80 to 3.21; Total's ratio went from 0.61 to 0.67. BP can improve on its funds from operations ratio: BP lags its peers.
During the same period, BP's discretionary cash flows to total debt ratio went from -0.17 to -0.31; Exxon's went from 0.87 to 1.02; Chevron's went from 0.54 to 0.09; Total's went from -0.02 to -0.08. Overall the trend was towards lower discretionary cash flows to total debt. Also, BP lags its peers in this metric.
In terms of operating cash flows, BP's operating cash flow rebounded in 2012 back to the $25 billion zone; we could see operating cash flow increase from $25 billion to $30 billion. Exxon's operating cash flow is trending higher; we could see an increase to $60 billion. Chevron's operating cash flow is trending higher and could increase from $38 billion to over $40 billion. Total's operating cash flow could increase to about $25 billion. The other firms in the industry are seeing operating cash flows trend higher; thus, BP's operating cash flows could trend higher in the coming year or two.
BP's investing cash flow has been trending higher, but investments declined in 2012 compared to 2011; BP is generating enough cash from operating activities to cover cash used in investing activities. Exxon's cash used in investing activities is trending higher; also, it is covering the investing activities with operating cash flow. Chevron's cash used in investing activities is trending higher; also, it is covering the investing activities with operating cash flow.
I would say that BP's cash flows is the firm's weakness. We won't use cash flow to value the firm; we'll use the price-sales and price-earnings ratios.
BP is undervalued relative to its peers on a multiplier model basis. Also, the firm is undervalued relative to its recent trading history, on a time-series basis.
On a price-sales basis, BP is currently valued at 0.20 and the forward valuation is between 0.19 and 0.20; Exxon is currently valued at 0.83 and the forward valuation is between 0.71 and 0.76; Chevron is currently valued at 1. On a price-sales basis, compared to its peers, BP is substantially undervalued.
On a price-earnings basis, BP is currently valued at 6.50 and the forward valuation is between 3.83 and 5.11; Exxon is currently valued at 8.42 and the forward valuation is between 6.99 and 7.51. On a price-earnings basis, relative to Exxon, BP is substantially undervalued. On a time-series and absolute basis, BP is undervalued.
BP is undervalued with a tremendous amount of upside potential and huge margin of safety. Shares of BP are trading near support.
Shares of BP are trading near an accumulation zone. Also, shares of the firm are trading in a similar consolidation formation to that of crude oil. Both, assets are poised for a advance of primary degree.
BP is trading in a triangle of primary degree. Triangles are typically continuation formations; thus, I expect the share price of BP to advance in 2013 through most if not all of 2014.
The declining unemployment rate suggests being bullish on shares of BP. Additionally, the oil spill expenses are priced into the market. The firm remains solvent, is undervalued, and the technicals suggest accumulating shares. BP should improve on its cash flows.
Investors should remain long common equity shares of BP and accumulate shares in the $37.50 to $40/share price range.
Additional research should continue to add depth to the industry and company analysis.
Disclaimer: This article is not meant to establish or continue an investment advisory relationship. Before investing, readers should consult their financial advisor. Christopher Grosvenor does not know your financial situation and ability to bear risk and thus his opinions may not be suitable for all investors.