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Overview

At this time, we believe that Chevron is a Hold. The stock lacks reliable catalysts from current levels despite solid value as we continue to see weakness in major integrated gas and oil companies as they search for growth in an industry with diminishing supply. Our current price target highlights that the stock should be priced at around $115 for 2013.

Profile

Chevron (CVX) is an integrated oil and gas that operates both Upstream and Downstream segments. The company's Upstream business accounts for exploration, development, and production of crude oil and natural gas along with transportation. Downstream business engages in refining crude, marketing, and selling of products. The company has minor productions in coal, debt financing, insurance, and services.

Price Performance


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Value

Chevron scores very well on our value assessment. Historically, the stock has never had over a 16 price-to-earnings ratio in the past five years, so the scale for CVX is much lower than most companies, but even so, the company's current multiple and future multiple are at very low levels. Current PE sits at 9.3 and future PE at 9.8. While value is there in shares currently, we believe that current headwinds are causing this value to appear. Value investors interested in CVX may be attracted to it, but with earnings staying stagnant to slightly growing over the next several years, CVX lacks a catalyst to obtain a significantly higher multiple.

We can see this discrepancy in value due to a very high PEG ratio for the company at 5.5. PEG ratios can be misleading because they are based on projected growth levels. If those levels are too low, then PEG appears too high. For CVX, though, a ratio at 5.5 is very high and shows that the earnings growth for this company is stagnant right now due to cyclical weakness in oil and gas. The lack of growth for the company is causing them to not be able to see multiple increases.

CVX shows great value as well, though, in its debt-to-equity ratio and price-to-operating cash flow ratios - both score at our highest level at a 10. The low d-to-e ratio is a definite positive for CVX as it shows that high debt levels as well as the company are not negatively affecting share prices can adopt more debt without it being a big drag on valuations. At the end of the day, cash flow may be the most important factor for any company, and CVX is not valued strongly according to OCF.

For CVX, there is value in shares, but we do worry about their lack of growth as will be noted in that section to create multiple upside.

Growth

Growth is an issue in the major integrated oil/gas industry due to large size as well as lack of upside expected in oil and gas prices for the next two years. After 2014, though, oil/gas may start to see cyclical strength again. The company is currently working on some important projects: natural gas in Australia, offshore oil in the Gulf of Mexico, and continued growth of LNG. For us, a strong commitment to natural gas is crucial to the future for CVX.

The company is at the forefront of Australia's shale gas, where trillions of cubic feet of shale natural gas lie deep below the surface. The company is working with Beach Energy to get the shale gas, but there are a lot of question marks about the geology of Australia, developing the shale, and determine if it's even profitable. The costs are high to frack so deep for the gas, so counting on this project is still too much of a question mark. The advantages of Australia are that the shale is in unpopulated areas, and the shale can be turned into LNG and pushed to Asian markets. Pipelines still need to be built and demand still needs to grow in Australia for natural gas. There is, though, about 30-60 Tcf of natural gas that can be economically fracked in Beach Energy's basin. With current prices around $3.50 per thousand cubic feet, the potential in revenue is gigantic if all goes well - $20B -$40B.

The other growth area for the company is the Gulf of Mexico where CVX recently struck oil in the Gulf. The discovery, though, is 6 miles below the surface of the water. There is growth potential offshore as well, but the pattern we will notice with energy companies is that they have to continue to drill deeper, convert less attractive (shale) forms of energy into usable energy. The cost of doing business is on the rise, and growth seems to be harder to imagine for these companies even if demand is high.

For now, we believe that growth issues are a major negative for Chevron, and the value in shares is just not enough to outweigh the potential growth prospects that at this point are still question marks.

Profitability

Profitability is Chevron's most appealing indicator for investors at this time. The company ranks second out of the ten companies we cover in major oil/gas integrated marked by strength in their operating, net, and gross margin growth over the past five years. The company maintains pretty solid overall margins currently as well, but the question for investors is can they maintain these levels.

In the past five years, growth for operating, net, and gross margins have been 18%, 24%, and 444%, respectively. The company's current margin for each is 19%, 11%, and 42% as well. In the company's latest quarter, though, margins fell due to lower oil prices, but we do worry about rising costs of doing business. As we previously noted, oil companies continue to have to dig deeper for oil and move into harder geological areas to get natural gas. Costs of doing business have actually fallen in the past five years, so CVX is still doing an excellent job of managing this issue, which is one of the reasons we do like CVX. Yet, the future worries us.

One of the most important profitability ratios for companies is ROIC, which is the return a company is making for shareholders after dividends are removed. It is the true measure of cash-on-cash yield and shows how much money a company is making on investments. The company has an ROIC at 18%, which is very solid. One important indicator is to see ROIC increasing as it shows increasing profitability of a company's core operations. ROIC has dropped since 2008, when ROIC sat at 26%, which shows us a truer indicator of the issue we noted about risk to profitability in CVX's core operations.

CVX is a strong profitable company, but margins may be hindered to grow by rising costs and lack of growth catalysts.

Cash Flow/Efficiency

Cash flow is like the blood of an organization - without the company cannot survive. Along with ROIC, we look at FCF and its growth as one of the most important indicators for the health and future of a company. FCF can be used for new projects, share buybacks, dividend expansion, and acquisitions. For CVX, the company has concerning FCF growth and FCF/Sales. FCF has declined over 70% in the past five years and FCF/sales is at 1%. We look for 10% to see a positive ratio. What does a weak FCF/Sales ratio mean for CVX?

FCF to Sales is a truer indicator of how much of a company's revenue is being transformed into cash. FCF is a much more true version of looking at a company's business than EPS. Much like ROIC, we are not seeing the same strength in CVX as margins, which tends to continue to suggest our issue with CVX in that costs of doing business are growing and cash flow is weakening.

The positive for CVX, though, is that the company has strong inventory turnover, cash conversion cycle, and operating cash flow. Inventory turnover is important for oil/gas companies because it's important that supply is being bought - with such large overhead and investment into wells and fracking, the companies need to keep inventory sold. The company has a high inventory turnover at 20. Further, the company has a negative cash conversion cycle, which is a major positive. CVX is making money before products are even sold, which happens due to receiving payments for energy before the company supplies it. It's important to track CCC and see it declining, which has occurred over the past five years (1.0 to -6.8).

Finally, we do see strong operating cash flow for CVX. Why strong OCF but not FCF? Capital expenditures. Capex is not included against OCF, but it is against FCF. The continued rise of capital expenditures further points to a common theme that is developing for CVX in that it needs to continue to increase expenditures to maintain its demand, causing an uncertain, potentially rocky road for the company.

Financial Health

Chevron ranks at the top of oil/gas companies when it comes to financial health in our research, and that is a plus, especially in an industry that has some definite issues with rising expenses and potential debt increases. CVX ranked well in its growth of its current ratio over the past five years, debt/equity ratio, and gross profit to current liabilities.

Current ratio is a key indicator when looking at financial health as it takes current assets / current liabilities. The ratio allows us to see the company's ability to pay back its short-term liabilities with assets. A ratio above 1 is considered decent. Over 1.5 is considered very solid for financial health. Another sign that CVX has good control of its debt is its gross profit to current liabilities. The company makes 3x as much of its liabilities in gross profit, which is a very solid ratio as well.

What does financial health mean for investing? For most companies, it is more a matter of making sure that financial health is just not a red flag. If it is not, then most companies are not to be of worry. Companies with the strongest levels of financial health can more easily take on debt without it being impactful, but too high of some ratios suggests the company is not correctly using debt.

For CVX, we see them as fairly positive in most of the crucial categories, and that is good because we believe more debt and liabilities are in the future for oil/gas. We worry about companies like Ecopetrol (EC) where they have very weak financial health indicators in a market that is becoming increasingly more difficult.

One area to be wary of CVX is its financial leverage as well as cash to liabilities ratios. Financial leverage over 2 is a red flag because it means that debt doubles equity, which is a negative capital balance. That issue is further revealed by very low cash to liabilities ratio at 0.2. With high capital expenditures, weakening FCF, and some cash-to-liabilities issues, we do see a lower positive rating for CVX. The company, though, is still strong in this sector.

Catalyst

We judge catalyst on a scale of 1 - 10, and for Chevron, we believe that the company has some definite positive catalysts moving forward that we noted in our Growth section, but we have some worries about the potential of new developments. The company expects to increase production 20% by 2017. In the company's latest shareholder meeting, they commented this:

Chevron is on track to deliver on its commitment to produce 3.3 million barrels of oil-equivalent per day by 2017, more than 98 percent of which will come from fields that are online today or from projects under construction or in detailed design. Over the next five years, 50 projects with a Chevron investment of more than $250 million each are scheduled to start production, 16 of which have a net Chevron investment exceeding $1 billion. Construction on the Gorgon liquefied natural gas (LNG) project in Western Australia is over 60 percent complete, with startup expected in late 2014. Start up of the Wheatstone LNG project, also in Western Australia, is planned for 2016.

The company notes that 98% of its 2017 production is planned, but a significant amount of this production is predicated by the success of Australia. As we have previously noted, there is tons of potential for natural gas here that could be liquefied and sent to Southeast Asia. Yet, we are still a year and a half from the Gorgon project and three years away from Wheatstone. To expect that these two projects will go completely as planned is expecting a lot, but at the same time, CVX is not priced too expensively at this time. We believe, though, that the company will unlikely see a lot more upside in the near-term with these issues existing and expectation of Gorgon not producing anything until late next year.

For now, it's a waiting game with Chevron for most of its major developments. What we want to see from CVX is that the company does acquire and develop other energy sources from natural gas and oil. It is not getting any easier to mine for oil and natural gas, and the company will continue to have to invest at higher and higher levels. Why not invest in energy sources that can produce profits with much lower overhead?

The company does have solar, geothermal, biofuels, and more renewable sources and alternative sources. These sources are a sliver of the company's current revenue, which has a lot to do with demand and consistent demand (we understand that). At the same time, energy companies that can make the plunge into renewable sources with effectiveness and success could be a winner in the energy market.

Overall, though, there is no near-term catalyst. The company has a five-year plan that is known, and it's now about executing that plan effectively. If things go well with Australia, shares of CVX are very cheap right now. If issues occur, the company is unlikely to meet its 2017 goals, which would cause disappointment. The answer to this will take another year to determine, and that is one of the main reasons we see a lack of near-term upside as well as downside.

Price Target Analysis

Step 1.

Project operating income, taxes, depreciation, capex, and working capital for five years. Calculate cash flow available by taking operating income - taxes + depreciation - capital expenditures - working capital.

2013 Projections

2014 Projections

2015 Projections

2016 Projections

2017 Projections

Operating Income

45750

46210

48500

51000

54850

Taxes

17843

18022

18915

19890

21392

Depreciation

13900

14200

14450

14700

15000

Capital Expendit.

-35000

-30000

-27500

-30000

-30000

Working Capital

2160

2160

2160

2160

2160

Available Cash Flow

4648

10228

14375

13650

16299

Step 2.

Calculate present value of available cash flow (PV factor of WACC * available cash flow). You can calculate WACC, but we have given this number to you. The PV factor of WACC is calculated by taking 1 / [(1 + WACC)^# of FY years away from current]. For example, 2016 would be 1 / [(1 + WACC)^4 (2016-2012). WACC for CVX: 8.56%

2013

2014

2015

2016

2017

PV Factor of WACC

0.9211

0.8485

0.7816

0.7200

*

PV of Available Cash Flow

4281

8679

11236

9828

*

Step 3.

For the fifth year, we calculate a residual calculation. Taking the fifth year available cash flow and dividing by the cap rate, which is calculated by WACC subtracting out residual growth rate, calculate this number. Companies with high levels of growth have higher residual growth, while companies with lower growth levels have lower residual growth. Cap Rate for BUD: 6.56%

2017

Available Cash Flow

16299

Divided by Cap Rate

6.56%

Residual Value

248453

Multiply by 20167PV Factor

0.7200

PV of Residual Value

178881

Step 4.

Calculate Equity Value - add PV of residual value, available cash flow PVs, current cash, and subtract debt:

Sum of Available Cash Flows

34023

PV of Residual Value

178881

Cash/Cash Equivalents

21647

Interest Bearing Debt

12093

Equity Value

222458

Step 5.

Divide equity value by shares outstanding:

Equity Value

222458

Shares Outstanding

1940

Price Target

$115

Chevron, therefore, is a Hold right now. We need to see a correction of around 15% to become interested in shares.

Source: Chevron Lacks Near Term Catalyst, Needs 15% Correction