It's not everyday, or even every year, that you find an true undervaluing in the large cap space. We believe that the oil and gas giant, Occidental Petroleum (OXY), is just that. The company recently underwent a management shakeup and has outlined a plan to unlock shareholder value. This includes looking to refocus operations on North America, by selling off various international and domestic assets.
What gets us excited is that during our due diligence, we found that the stock is undervalued by as much as 20% irrespective of the breakup, by looking at its cash flow generating capabilities and net asset value.
Unlike some of the typical oil and gas Supermajors, Exxon (XOM) and Chevron (CVX), Occidental is a pure play on oil and gas production. The firm doesn't own refinery assets, and it doesn't own gas stations. But in many ways, that's a good thing; downstream components of the business for integrated Supermajors are generally lower margin.
OXY operates via three segments, including (1) oil and gas (2) chemical and (3) midstream.
Its oil and gas segment explores and develops oil, natural gas and natural gas liquids. The chemical segment (OxyChem) manufactures and markets basic chemicals and vinyls. The midstream and marketing segment gathers, processes, transports and stores oil, NGLs and natural.
Occidental doesn't participate in the downstream operations and as a result, Occidental enjoys much higher margins than some of the conventional oil and gas companies.
Big news of late includes the fact that Ray Irani is checking out as Chairman of the company. Now CEO Steve Chazen will be able focus on improving costs at the company and unlocking value for shareholders.
Irani took over as CEO in 1990 and transformed an oil, movies and meatpacking business into the fourth largest oil producer in the U.S. Irani also pushed OXY into the international market, with drilling contracts in the Middle East and North Africa.
Now with Chazen now at the helm, he plans to change the company's focus to a North American oil producer, pushing for a breakup of the company.
A breakup is where we see the most upside for the company. New CEO Chazen has outlined a plan to spinoff its California. The other big plan is to monetize its Middle East & North Africa assets. This will lead to a smaller, higher growth domestic-focused exploration and production company.
The current pro forma 2013 production profile is around 45% for the Americas (non-California), 35% Middle East & North Africa, and 20% California.
California: The California assets appear to be high yielding, making up 20% of production, but only 16% of capital expenditures, and generating some $1 billion in free cash flow.
Its California portfolio, which at 160 Mboe/d of estimated 2013 production, is a rival to even the largest domestic resource-focused exploration and production companies.
Analysts put estimates of California's assets at worth between $13 billion and $15 billion, which would be 30% to 50% premium from our current net asset value.
Middle East & North Africa: As for OXY's plan for Middle East & North Africa, the segment makes up some 35% of production, with around 75% liquids and 25% gas. International assets provide close to 33% of OXY's cash flow. Based on current production, unbooked resource potential and potential of the Al Hosn Sour Gas project, analysts put the segment value at upwards of $25 billion.
International: The other possible breakup could be a full-blown spinoff of its international operations. Analysts believe the international segment could go for upwards of $35 billion, which would unlock some 20% of value for shareholders given the premium paid.
Now let's get to what we see as the underlying, intrinsic, value of the company.
Occidental derives some 75% of sales from oil and gas wells, with the rest coming from a hodgepodge of chemicals and pipeline revenues. As a result, the company trades at a discount, since its not an integrated oil/gas company such as Exxon and Chevron, while it's also not a pure-play energy producer such as Apache.
Rising costs at the California oil fields and high capital expenditures has pressured the stock of late. As a result, Chazen has implemented plans to save the company upwards of $450 million in 2013. This helps support our case for a solid rebound in operating cash flow.
We believe that OXY will enjoy modest revenue growth, with EBITDA margin expansion thanks to cost reduction due to drilling efficiency initiatives.
The company has managed to grow operating cash flow at a 15.6% CAGR since 2003, but the drastic rise in capital expenditures has pressured free cash flow. OXY has seen its free cash flow taken from a 2010 high of nearly $6B to near $1B in 2012.
The real driver for a return to strong free cash flow will be reduced costs. OXY plans to reduce production costs back to 2011 levels.
Back in 2011, EBT margin was an impressive 43.4%. The company is already running ahead of its plan to reduce drilling costs; the total cost per barrel for its domestic segment dropped nearly 20%, being only $14.06 during the first quarter.
Now let's look at how all this translates into shareholder value.
Price to cash flow. Let's look at how OXY trades from a price to operating cash flow standpoint. Based on our 2015 numbers (from above), OXY will be trading near all-time lows come 2015, and well below its long-term average (excluding 2007 to 2010).
We believe that OXY should trade closer to its 10-year average of 7x -- this P/OCF is also closer to other major oil and gas companies, such as Exxon Mobil and Chevron. Putting a 7x P/OCF multiple on our 2015 operating cash flow number yields a target price of over $107.
Net asset value. In looking at OXY's proved and unproved reserves, as well as accounting for the company's other segments (chemical and midstream), we found OXY's NAV to be upwards of $107.
Subpar decisions by management have pressured the stock. The P/OCF and NAV valuations are very similar, suggesting an intrinsic value of the stock at $107. We believe the stock is undervalued and should be trading 19% higher than current levels.
We use the intrinsic value (based on P/OCF and NAV), coupled with its 2.8% dividend yield, as a margin of safety. The best case is a spinoff of assets, whether it be the international, California or MENA segments. Analysts believe the company could ultimately be worth $125 if it re-focuses as a pure U.S. oil/gas company.