Energy giant Chevron took a bit of a hit recently after it announced that second-quarter earnings and sales came well short of year-ago figures. Combine the quarterly results with longer-term concerns about the global economy and fracking-driven energy price declines, and a lot of people aren't too bullish on the world's second-largest energy company.
But such unloved stocks often present the best long-term opportunities. So when Chevron's shares dipped after its earnings announcement, my Guru Strategies -- quantitative models based on the approaches of Warren Buffett and other investing greats -- jumped at the chance to buy shares of a solid company on the cheap. They recently issued a Trade Alert for San Ramon, Calif.-based Chevron (CVX), the mega-cap ($237 billion) oil and gas power that also has a foot in alternative energy businesses. These Trade Alerts are issued when a stock's fundamentals earn it certain level of interest from one or more of my models. With Chevron, it was my Benjamin Graham-, Peter Lynch-, and James O'Shaughnessy-based models that triggered the alert, which started on Aug. 6 and runs through Nov. 5.
The second quarter certainly wasn't a great one for Chevron. Earnings per share declined 26% versus last year's second quarter, while revenues were down 8.4%. The declines were in part attributable to shorter-term factors. Its Richmond, Calif., refinery, for example, only recently began working at full capacity again -- its crude unit had been closed for a lengthy period following an explosion last August.
Some of the concerns, however, may run deeper. Operating margins, which have been quite high over the past few years thanks to a big spread between the price of U.S. crude oil and European crude, shrank from nearly 20% in the year-ago quarter to about 15%. Costs also increased, and many fear that the increasing difficulty of extracting finite resources from the earth and the increasing cost of securing ethanol credits to satisfy Environmental Protection Agency requirements could mean costs will keep rising. And then, of course, there are concerns about the global economy. Lingering debt woes in Europe, sluggish growth in the U.S., and a slowdown in China's massive growth engine have all impacted demand for oil and gas.
But while all of those are legitimate challenges going forward, the bullish story with Chevron has to do with fundamentals and valuation. First, the company is standing on solid financial footing. It has about $18 billion in debt, which is significantly less than its $22.7 billion in net current assets, passing a key test of my Graham-based model. Looked at another way, its debt/equity ratio is just 14%, which comes in well underneath my Lynch-based model's 80% upper limit. The company's return on total capital, meanwhile, is over 20%, a bit higher than that of its chief rival, Exxon Mobil.
As for valuation, there's a good deal of pessimism baked into Chevron's current price. Shares trade for just 10.1 times three-year average earnings and 1.66 times book value, which my Graham-based model likes. My O'Shaughnessy-based value model likes the stock's 1.02 price/sales ratio, which is a nice discount from the 1.3 average for the integrated oil and gas industry. And my Lynch-based model likes the stock's combination of a 9.9 trailing 12 month P/E ratio, 3.3% dividend yield, and 16% long-term EPS growth rate (using an average of the three-, four-, and five-year growth rates). All that makes for a stellar 0.51 P/E-to-Growth ratio, a metric Lynch used to gauge value.
One other non-quantitative note: If you're worried about the rise of alternative energy sources, and what that could mean for oil and gas companies, Chevron also dabbles in the geothermal, solar, and biofuels operations. Should any of these areas take off in popularity, who do you think has a better chance of seizing the opportunity: a small startup, or an established energy giant that has nearly $22 billion of cash and cash equivalents at its disposal?
All in all, Chevron and the other big oil companies have a lot of challenges ahead of them. But Chevron also has a huge stockpile of cash and valuable assets all over the world. Moreover, no one is expecting a whole lot from the company going forward. Earnings are expected to fall nearly 9% this year, and increase at a meager 4.5% pace over the long haul. Shares are trading for very reasonable values, whether you use earnings, sales, or book value as a gauge. In other words, it seems to have what Graham famously called a "margin of safety": Enough pessimism is baked into its prices that good news could have a powerful impact, while bad news shouldn't cause shares to fall too much. That's why my models like the stock for the next three months, and why Chevron may well be a good bet beyond then.