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Retail investor, long/short equity, dividend investing, medium-term horizon
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Successful trades are boring - I keep notes in ACT! (a contact manager) for each buy/sell decision I make on stocks in my portfolio, two or three paragraphs to track what I was thinking at the time. My best trades don't make good reading – an opening entry summarizing my initial impression and valuation, followed by two entries saying I bought it because it was cheap and sold it because it was fairly priced. In the meantime, there might be notes on analyst upgrades/downgrades or material events of one kind or another.

But my losing trades sometimes accumulate voluminous notes - repetitious analyses, observations of minutiae about market action, quarter after quarter of conference calls, strategic revisions in an effort to find a way to make money on the case, etc. Perhaps I should just set a cut-off figure, once I get over 7 (maybe 10) entries to just close the case out and go on to something else.

Exxon Mobil (XOM), which closed yesterday at 66.79, is starting to accumulate notes – it started off as a no brainer and is now turning into a puzzler. In point of fact, this is my third effort at an article since the XTO deal was announced.

Valuation

The company is cheap on 5 year average EPS, share count adjusted. Using projected 2010 plus 4 years actual, I arrive at a figure of 7.18, and a P/E of 9.25 on that metric. Ben Graham counseled investors not to pay more than 15 X 5 year average EPS, so this situation is very firmly in value territory, based on historical performance.

Using historical 5 year average EPS and P/Es on that basis, a midpoint price for XOM is 90 per share. Allowing two years to reach target, the annualized return would be 16%, not too shabby, and in the meantime there is the dividend, 2.58% and secure. That is the no brainer case for XOM.

XTO

After taking up a position in XOM in August last year, things developed as expected until the December announcement of an agreement to acquire XTO in an all-stock deal. Mr. Market did not like the deal: the shares plummeted. I concluded that it was an over-reaction and enlarged my position. So here I sit, with a small loss ($2 per share controlled) instead of a medium sized gain.

Exxon did not participate meaningfully in the early development of unconventional natural gas – shale formations. Advances in horizontal drilling and hydro-fracturing have resulted in a bonanza of low cost natural gas, to which the markets are still adjusting. XTO has been a major player in this game. The use of leverage has been key in developing shale gas, bringing with it the use of hedging to provide protection against declining prices. XTO is leveraged and hedged.

Hydro-fracturing is environmentally questionable as it involves the forceful injection of chemical-laced water into formations from which it may reach groundwater or aquifers. The EPA, after securing agreements from major players to keep benzene (a known carcinogen) out of the mix, gracefully bowed out of regulating the process under the CDWA (Clean Drinking Water Act), leaving it to the states.

XOM prudently made the XTO deal contingent on regulatory certitude. That is still playing out. My take: shale gas is too big to ignore and hydro-fracturing will continue on economically feasible terms. The resulting natural gas is sufficiently low cost that the process could pay for a lot of clean-up and regulation and still make sense.

Valuing XOM Post-Acquisition

XTO trades at a higher multiple to historical earnings than XOM does. Valuing the combined entity based on historical earnings and XOM's multiple, the company is worth 3% less after the deal than it was before. The more than 10% drop since the deal was announced is an over-reaction.

Valuing XTO vs Peers

Here is a snip from my valuation spreadsheet:



As can be seen, XTO seems relatively cheap compared to other natural gas players. There is nothing here to support the idea that XOM has overpaid.

Strategic Sense

XOM needed an increased presence in North American shale gas. The XTO acquisition, if consummated, will fulfill that need. The deal is not expected to be immediately accretive to earnings, but is expected to add to cash flow.

XOM uses the word “hedge” three times in its last 10-K, vs. more than one hundred occurrences for XTO. Seriously, use word search on the documents, XOM doesn't talk too much about hedging. XTO's stable GAAP earnings look somewhat erratic when examined in light of accumulated AOCI. XOM has the financial muscle to carry shale gas operations through to where they reach an economic equilibrium, without some kind of a tight-rope balancing act between capex, hedges and borrowing.

Paradigm Shift

For decades, or indeed generations, US based International oil companies made huge profits from natural resources belonging to the citizens of foreign countries, profits difficult to justify in the face of the poverty of the countries involved. That rich vein appears to be played out, to where the balance of power is shifting in favor of local ownership of natural resources.

On the other hand, the development of infrastructure to harvest these resources requires increasing amounts of capital, enterprise scale, and expertise – all of which XOM has in abundance. Browsing XOM's website, their operational principles include a concern for local content, by which mean hiring, training and developing employees locally, sharing the wealth.

Lenny Dykstra

Now for a digression. The former Mets center fielder, renowned for his toughness on the field, for a time made a stir in investment circles, advocating a strategy of using in the money calls, often LEAPS, for leverage, and tenaciously doubling down on all losing trades. Astute observers at the time noted that doubling down and leverage do not mix well. Somewhere in there Lenny crashed and burned, eventually winding up in bankruptcy.

While I am nowhere near as tough as Lenny, I too advocate the use of LEAPS for leverage – specifically including a long diagonal call spread on XOM in an article I wrote in August last year. Having since enlarged the position when it moved against me, I am now in good company with my investment approach.

Risk/Reward

XOM Jan 22 2011 55 calls, recently attracting a bid of 12.85, will be worth 20 if the stock gets to 75 by expiration. It was trading in the 75 area when the XTO deal was announced. The attraction is, XOM has a low beta and while it seems more likely to go up than to go down, the movements may not be large. However, by applying leverage, the situation has some pop, very suitable for an old man in a hurry.

XOM has not closed below 60 during the past three years. It touched an intra-day low of 56.51 during the meltdown. It closed below 65 18 days out of 760, or 2.37% over the same time period. An investor who has sufficient tenacity to avoid liquidating a position in the stock at a price of less than 65 is unlikely to suffer a lot of permanent harm from Tuesday's close of 66.79.

The company has traded above 75 a little more than 50% of the time during the past three years. Taking all of this together, the risk/reward of a LEAPS position in XOM is attractive.

Strategy

The difference between my approach and what Dykstra was advocating is to roll down rather than double down, to carefully examine downside risk and salvage strategies ahead of involvement, and to maintain sufficient back-up resources to avoid forced liquidation of positions. Buying long-term in the money calls, and selling short-term out of the money calls, time is on my side.

Plus, I have been known to give up on positions, take my ball and go home. Sometimes I even leave the ball behind, after all, if I get home with my glove I can still play the game tomorrow.

This is a less aggressive strategy, more like rope-a-dope, just hang in there and wait for mean-reversion. Acquisitions, hedges, leverage, hydro-fracturing, Congress, the EPA, benzene, CDWA, paradigm shifts, commodity prices...let's see what happens. Ben Graham suggested giving value cases about two years for a catalyst to turn up, that would leave another 18 months to wait on this case.

Disclosure: Author holds a long position in XOM as described, and holds no other positions

Source: ExxonMobil: No Brainer or Puzzler?