There is one thing for certain in the energy markets: crude oil and natural gas prices are not only volatile but they are also extremely cyclical. We think having an iron-clad balance sheet is paramount to getting comfortable with a dividend-growth firm in a commodity-producing industry. After all, we want to see continuous dividend hikes regardless of the broader economic environment. Out of the oil majors, we think Chevron (CVX) is best-positioned to do so. Let's find out why.
Chevron's Investment Considerations
Energy-Specific Multiple Analysis
Evaluating Chevron's Dividend
Before we get to far ahead, please select the front page of our dividend report above, which supplements our 16-page report on Chevron on our website. You'll see on the bottom right, we're expecting some strong dividend increases in the future at Chevron. This is important to note, as our analysis below considers the coverage of the firm's dividend, incorporating this growth.
On the surface, Chevron's dividend yield is excellent, offering a 3.2% annual payout at recent price levels. We prefer yields above 3% and don't include firms with yields below 2% in our dividend growth portfolio. So Chevron fits the bill thus far.
But What About the Safety of Chevron's Dividend?
As you can probably gather from our expectations for future growth in the dividend, we think the safety of Chevron's dividend is good (please see our definitions at the bottom of this article). We measure the safety of the dividend in a unique but very straightforward fashion via the forward-looking Dividend Cushion ™. The measure is a ratio that sums the existing net cash a company has on hand (on its balance sheet) plus its expected future free cash flows (cash from operations less capital expenditures) over the next five years and divides that sum by future expected cash dividends paid over the same time period.
Basically, if the score is above 1, the company has the capacity to pay out its expected future dividends. As income investors, however, we'd like to see a score much larger than 1 for a couple of reasons: 1) the higher the ratio, the more "cushion" the company has against unexpected earnings shortfalls, and 2) the higher the ratio, the greater capacity a dividend-payer has in boosting the dividend in the future. For Chevron, this score is 2.1, revealing that on its current path the firm should be able to cover its future dividends with net cash on hand and future free cash flow.
To get a feel for just how good this 2.1 measure is, let's compare it to that of peer ConocoPhillips (COP), which has a higher yield (but a -0.2 Dividend Cushion score). The first graph is the composition of the Dividend Cushion for Chevron, while the second graph is the composition for ConocoPhillips. We do this for all companies in our coverage universe to assess the strength and coverage of their respective dividends.
Chevron's Cash Flow Breakdown and Derivation of Dividend Cushion
ConocoPhillips' Cash Flow Breakdown and Derivation of Dividend Cushion
After looking at the above two charts, you'll see that both Chevron and ConocoPhillips are excellent cash-flow generators (cash from operations). However, the make-up of ConocoPhillips' capital expendutures and balance-sheet obligations are much more punitive than Chevron's. In fact, over the next five years, it is highly likely that ConocoPhillips will have to engage in financing or asset sales to sustain its dividend at current levels (we were a bit puzzled that the board recently raised it).
On the other hand, Chevron has a more measured capital program during the next five years, and a net cash position (the only one in the majors at the end of the first quarter)--the data above reflects end-of-2012 data. Further, its dividend obligations don't come anywhere close to absorbing its financial strength, unlike that of ConocoPhillips. This affords Chevron much greater flexibility to raise the dividend. Just how important is the balance sheet to dividend strength? Click here.
Also, dividend growth investors should think about the financial flexibility a firm with a strong balance sheet has. But of course, you have to be careful -- every company out there says they have a strong balance sheet -- even ConocoPhillips (despite its huge net debt position). Humor this scenario for a momentum, as to why we might prefer Chevron as the top dividend-growth oil major:
ConocoPhillips $3.9 billion ending cash balance in its second quarter compares to a $21.2 billion long-term debt load. If Chevron levered up to the equivalent of ConocoPhillips on an absolute basis, such that both had a $17.3 billion net debt position, the firm could issue a one-time $17.9 billion dividend ($9.26 per share based on second-quarter diluted shares outstanding). We think Chevron's financial flexibility will come in handy to the dividend growth investor during tough economic times (from our recent earnigns note on the firm).
Okay...Chevron Has a Strong Dividend, But How Do We Determine Growth?
As we mentioned above, we think the larger the "cushion" the larger capacity it has to raise the dividend. However, such dividend growth analysis is not complete until after considering management's willingness to increase the dividend. To do so, we evaluate the company's historical dividend track record (see our front page report above). If there have been no dividend cuts in 10 years, the company has a nice growth rate, and a nice dividend cushion, its future potential dividend growth would be excellent, which is the case for Chevron. We use the board's historical growth pace to inform what we think the company's dividend will grow at in the future (assuming its Dividend Cushion is healthy).
Wrapping It Up
And because capital preservation is also an important consideration, we assess the risk associated with the potential for capital loss (offering investors a complete picture). In Chevron's case, we currently think the shares are fairly valued, so the risk of capital loss medium. If we thought the shares were undervalued, the risk of capital loss would be low. Our fair value estimate process is the primary reason why we choose Chevron over Exxon (XOM)--Exxon is trading at a much fuller discounted cash-flow valuation.
All things considered, Chevron stands out to us as one of the better income plays on the market today. We include it in the portfolio of our Dividend Growth Newsletter.
Additional disclosure: CVX is included in the portfolio of our Dividend Growth Newsletter.