As should be expected, the recent news regarding Buffett's stake prompted a rapid-fire release (11 articles) of Seeking Alpha coverage in the following 2 weeks (Nov 15 - Dec 1). Although I had a strong opinion on the deal (I was long XOM and bought my entire share this past summer/fall) I withheld from publishing a piece due to two primary reasons-a low "signal/noise" ratio due to the "buzz" of the event and a very hectic personal schedule.
Prior to this morning, the price of XOM had barely moved since from the previous 'post-Buffett' range ($93.50-$95.80), so I believe this article is still relevant to current and potential XOM investors. Another "don't follow Buffett" article was released on 16 December (albeit much better written and logically argued than previous bearish contributors), so I believe it's now time for another "Buffett is right!" view.
There has been a lot of distracting 'noise,' focusing on a mixture between "Buffett's folly" and XOM as a less attractive blue-chip value play. There have also been some ridiculous suggestions that XOM should alter its capital allocation structure by doubling the dividend and abandoning share repurchases. Additional bearish arguments regarding (the lack of) production growth and poor reserve replacement ratios are largely red herrings and/or FUD plays (fear, uncertainty, and doubt).
I firmly believe an XOM investment falls perfectly into the 'Warren Buffett Methodology.' I will cover this methodology and then examine each XOM-related argument (relative value, poorly positioned/XTO blunder, reserve replacement issues, and capital allocation strategy) point-by-point.
For additional reading, I firmly endorse Jim Sloan's coverage, "It's Not So Much Why Buffett Bought Exxon Mobil, It's Why He Bought It Now."
On November 14, as part of regular quarterly filings, Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) revealed a sizeable investment in Exxon Mobil (NYSE:XOM). The 40.09M shares, worth over $3.7B on 14 Nov and equivalent to a 1% stake in the company, are large enough to warrant a direct decision by Warren Buffett, as opposed to underling investment managers Todd Combs and Ted Weschler.
While adding the Exxon stake, Buffett also increased his Phillips 66 (NYSE:PSX) stake to 27.16M shares ($1.8B-4.5%) and trimmed his ConocoPhillips (NYSE:COP) stake to 13.53M shares ($997M - 1.1%). Additional information from Berkshire reveals confidential purchases during Q2 to avoid share price inflation.
The Buffett Methodology
Warren Buffett is often characterized as a genius value investor, and in his early days he made some phenomenal value picks for himself and his partners. However, in the past few decades at the helm of Berkshire Hathaway, his stock picking success has been less about finding 'amazing value opportunities' and instead finding companies that fit two key traits:
- Skilled management that is focused on the long-term picture for their company.
- Strong return of capital to shareholders.
The prevalent investment portfolio mixture since the 1980s has been massive blue chip companies at 'fair' prices like Coca Cola (NYSE:KO), Wal-Mart (NYSE:WMT), and IBM (NYSE:IBM) combined with special "lender of last resort" financing opportunities like General Electric (NYSE:GE), Bank of America (NYSE:BAC), and Goldman Sachs (NYSE:GS). Buffett has not recently dabbled in his roots as a Ben Graham style "cigar butt" investor, likely due to the combination of enormous allocatable capital and the availability of special investment opportunities such as with the Heinz deal.
Buffett is less of a skilled 'stock picker' and more of a genius 'capital allocator.' While there are a lot of similarities in these roles, there are times when stark differences arise. There are several phenomenal personal and hedge fund investors who wouldn't touch Exxon, and it is unlikely Buffett will ever buy Apple (NASDAQ:AAPL) at 'any price' despite its recent allure as a 'no-brainer' investment.
Exxon Mobil easily fits both of the aforementioned requirements, and it is selling at below what I (and clearly Mr. Buffett) consider to be a 'fair price.'
Exxon is an excellent business that is well positioned for the next century in the energy business. Even after the Buffett-purchase run-up (chart based on $95), XOM trades for an inexpensive multiple to 5-year average earnings (12.9x) and a fair multiple to 5-year average FCF (18.3x). While there are cheaper companies out there, there are hardly any companies with the rich operating history of Exxon. Compared to Coca-Cola , which trades at 22.3x (5y avg) earnings and 26.6x FCF, XOM is a bargain. XOM is also cheaper than the other US oil majors as shown below.
The only true peer competitor to XOM is Chevron (NYSE:CVX), as ConocoPhillips has pursued spinoffs in attempts to 'enhance value.' Buffett was already long both COP and PSX, so his deeper allocation choice was mainly between XOM and CVX. I believe he chose XOM because of their large natural gas holdings, their prioritization of share repurchases, and their overall value proposition.
Following the 1998 merger of BP and Amoco, Exxon merged with Mobil to establish the world's largest energy company. Over the past 14 years, Exxon has reduced their share count from 6.96B shares to 4.37B shares, a 37% (2.3% annualized) reduction despite the massive XTO purchase in 2009. Meanwhile during the past 13 years (1999 to 2012) underlying revenues have grown from $185.5B to $482.3B (160%/7.6% annualized), profits have grown from $7.91B to $44.88B (467%/14.3%), and EPS have grown from $1.13 to $9.70 (758%/18%).
Meanwhile CVX has reduced shares outstanding by 9% in the 10 years (2003-2013) post-Texaco merger, which only represents 0.95% annually. Over the past 9-years Chevron has boosted revenues by 92% ($120B to $230.6B / 7.5% annualized) and earnings per share by 91% ($6.96 to $13.32 / 7.5% annualized). This compares to XOM's revenue gains of 91% ($237B to $453B / 7.5%) and EPS gains of 200% ($3.23 to $9.70 / 13% annualized).
Notice the similar revenue increases, but vast EPS difference? There are two key drivers here: XOM's focus on higher-margin units and XOM's dedication to share repurchases. While past performance does not indicate future returns, I firmly believe that it is very suggestive, especially in huge corporations and large mutual funds.
I believe XOM will again trounce CVX over the next decade+ in terms of EPS and FCF growth, and clearly Mr. Buffett agrees.
Although the XTO purchase has been chided as a mistake due to poor market timing, and short-term results suggest it was a blunder based on natural gas prices, I believe it is far too early to judge XOM on this allocation.
Was the timing poor? Perhaps, but taken from a larger perspective (EIA-charts) of historical natural gas prices, the timing looks a whole lot better.
For a closer view of the same chart:
As you can see, the spot price of natural gas is roughly the same as when XOM completed the XTO purchase, so perhaps the 'timing' views are overblown, especially as massive LNG (liquid natural gas) export facilities are being built. The following chart, pulled from Oil & Gas Journal, lists the proposed export facilities, which could come on prior to 2020. As investors have seen through refinery profits based on the WTI-Brent spread, there are enormous profits to be made with North American natural gas and NGLs (natural gas liquids), and the worldwide spread will slowly reduce as transport facilities are constructed (as per basic economic common sense).
Fellow Seeking Alpha contributor Michael Fitzsimmons has been a vocal critic of XOM's prioritization of repurchases over dividends, including in his recent piece on the Buffett allocation. He is not alone, as many investors prefer the CVX yield of 3.24% or the COP yield of 3.92% compared to XOM's 2.63%.
However, as illustrated above, long-term EPS and FCF growth is all that really matters, as the dividend must be paid from these sources. Once again, a comparison of past performance is in order to see which companies have historically rewarded investors-- for COP I will include the PSX dividends to attempt a fair comparison. I will include the 10y period from 2003-2013 to highlight total and annualized dividend growth.
As shown above, the critics are certainly correct that XOM's dividend growth over the past decade has been dominated by ConocoPhillips. However, as the chart shows, COP's higher payouts are at a clear deterioration to the payout ratio, while XOM and CVX's ratios have actually improved. I believe that over the next decade, COP will fall behind due to its "one-off" maneuvers (spinoff, assets sales, and pipeline IPO) to boost returns coupled with a higher payout ratio.
This leaves XOM and CVX in a neck-to-neck race, with almost identical valuation multiples.
Production Growth and Reserve Replacement (FUD?)
However, the bears keep repeating how XOM's production growth and reserve replacement ratios are far inferior-as an example of the production growth issues, I have included a chart from Elliott Gue's recently published (16 Dec) article on XOM (originally sourced from Bloomberg).
The general thesis is that considerable equity appreciation requires organic production growth. While I agree this that statement, it ignores two critical facets-the underlying share count and the additional margin returns of production growth.
To compare production growth directly to share count I have included a comparison of 2003 production to 2013 production (9M extrapolated to full year projected) for both XOM and CVX. The chart is expressed in terms of thousands of barrels of oil equivalent (BOE) produced per day.
As clearly shown, XOM has dominated the production count as adjusted by shares-which is all that really matters to the long-term shareholder. In fact, even on an unadjusted basis, XOM has performed comparably to CVX.
The argument that XOM is a 'value trap' due to its inability to grow production, especially when compared to CVX, is completely baseless.
The one argument that does carry some ground is the (poor) reserve replacement ratio- again, demonstrated through a chart from Elliott Gue's article (originally from Bloomberg).
While the argument is factual (unlike the complete 'FUD' approach of "stagnant production levels"), as long as XOM stays above 100% I see no cause for concern.
It is more advantageous for long-term shareholders if XOM keeps a flat production at a higher margin and uses the excess cash to repurchase shares than if XOM pursues production growth at lower margins.
These high hurdle requirements keep XOM from many projects such as the recent Greenland licensing due to inadequate risk/reward projections, but as highlighted above, the per share production growth and ultimate EPS growth (which is all that ultimately matters for a rational shareholder) has been phenomenal.
Don't listen to the 'FUD' forecasters that pan XOM as an inferior investment to CVX. Exxon's performance over the past decade, including a rather 'disappointing' 2013, has been phenomenal and will likely continue. XOM doesn't show any signs of slowing their repurchase program, and as long as reserve replacements hover around 100%, there are no long-term production concerns.
Comparison to COP is a red herring due to their significantly higher (combined with PSX) payout ratios and multiple one-off type return schemes. In this market, separating refining operations makes sense, but this cycle could easily change in a few years. Refining is a very volatile business as long-term Tesoro (NYSE:TSO) and Valero (NYSE:VLO) shareholders can attest to, and the market may soon decide to stop rewarding pure-plays with higher multiples.
ExxonMobil is one of the best long-term "blue chip" plays I see on this market. Even at its current price, when compared to Chevron and especially the S&P 500, I believe it is an attractive buy. I have a position in my IRA and my charity fund that I plan to hold indefinitely (unless the multiples get way out of whack, in which case I'll book a sizeable profit).
However, at $98, the shares have appreciated significantly since I (and more importantly Warren Buffett) opened a position this summer/fall. Obviously higher current prices guarantee lower future rates of return, so all investors should temper their expectations accordingly. Those looking for a "record 1-year return" should probably steer clear of XOM, just as Mr. Buffett steers clear of stocks like Google (NASDAQ:GOOG) and Apple.