I recently discussed Statoil's (NYSE:STO) growth prospects and valuation in a recent article that was posted to this site. One of the comments to this article, made by francobolo, brought up an interesting point: that the high tax rate that Statoil has to pay to the respective governments of the nations in which it operates could be a major contributing factor regarding the company's cheap valuation when compared to Exxon Mobil (NYSE:XOM), Chevron (NYSE:CVX), and even its European peers Total (NYSE:TOT) and Eni (NYSE:E). Most academic financial literature recommends that investors ignore taxation as a factor when evaluating or comparing two different investors. However, taxes are a very real factor that needs to be considered by investors as the more money that a government takes out of the company's profits the less that is available to the common stockholders in the company.
In some of my previous articles on Statoil, I showed how the company is significantly cheaper than its peers when they are compared using the EV/EBITDA ratio.
As the chart shows, Statoil is currently trading at an EV/EBITDA multiple of approximately half that of its peers. That would normally indicate that the company is significantly undervalued (and in my opinion, it is). However, it is important to remember that the company's EBITDA represents pre-tax income.
In the third quarter of 2013, Statoil reported a net income before tax of NOK 38.9 billion. Out of this, the company paid total taxes of NOK 25.2 billion. This gives the company a tax rate of 64.78%, far in excess of what its peer companies such as Exxon Mobil pay. This very high tax rate significantly reduces the money that is available to be distributed to investors. Statoil reported a net income of NOK 13.7 billion in the quarter. This much more closely represents the actual money that is available to investors after the government takes its cut. Let us compare the after tax revenues of these same companies to their market capitalizations to see how they compare:
As a company's market capitalization is calculated by multiplying the number of shares of stock outstanding by the current stock price and the earnings per share is calculated by dividing net income by the total number of shares outstanding, the "market capitalization to net income" column in the chart above is mathematically identical to the P/E ratio. As you can see, Statoil no longer appears to be the cheapest company out of its peers, although it is also not the most expensive, when we look at its market capitalization versus its after tax income. Unfortunately, market capitalization has the disadvantage of being influenced by a company's capital structure. For example, a company could use a copious amount of debt to finance its operations and thus have equity as a comparably small component of its financing. This results in the company having a small market capitalization compared to its net income. This company would thus have a much smaller P/E ratio than an identical company that finances its operations with 100% equity. An investor who is simply comparing P/E ratios might then be misled that this first company is ridiculously cheap compared to the second. However, an investor that is looking to buy the first company outright will have to not only buy all the outstanding stock but would also have to either assume or pay off all of its outstanding debt. It may therefore cost the same amount of money to buy either company outright. The enterprise value considers this and gives us the theoretical cost of acquiring the company outright including the assumption of all debt. It is thus capital-structure neutral.
This chart shows compares the after-tax income of each of the five companies that was in the previous two charts with their enterprise value to remove the effects of any given company's capital structure:
As the chart shows, Statoil is not ludicrously undervalued compared to its peers when we consider the company's after tax income compared to its theoretical buyout price. Therefore, it does appear that the tax rate that the company has to pay is indeed a major reason why it is selling at an enormous EV/EBITDA discount to its peers.
However, this analysis only considers the past performance of the company and does not consider its future potential. As I have discussed several times in the past, Statoil retains the ambition to increase its average daily production to 2,500 mboe by 2020. This gives the company relatively strong forward growth. In the third quarter, Statoil had average daily equity production of 1,852 mboe. Therefore, growing its average daily production to 2,500 mboe would represent an increase of 35.00% over its current levels. This is undoubtedly going to result in growing revenues, net income and cash flow barring a significant future decline in oil prices (which seems unlikely).
Disclosure: I am long STO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long several mutual funds which may have long positions in XOM, TOT, E, and CVX. However, I do not have any direct investments in any of these four companies.