Exxon Mobil And The Buffett Benchmark

Mar.12.14 | About: Exxon Mobil (XOM)

Summary

I look at historic data for sales, earnings, book value, dividends, and shares outstanding over the past fifteen years at Exxon Mobil.

This historic data is used as a basis to form a view on future expectations.

The future expectations are then valued to arrive at a view on whether the shares are priced to buy (or hold).

The future expectations are also assessed to quantify alpha potential.

Exxon's performance is also benchmarked using Warren Buffett's methodology, which compares the total return on the S&P 500 versus growth in book value.

Why look at Exxon Mobil (NYSE:XOM) now?

Firstly, Exxon is a mega cap stock. This gives it a defensive character, which appeals to me when I perceive the markets are expensive. Secondly, the stock has a low beta. This adds to the defensive characteristics and protects downside during weak markets. Thirdly, the stock delivers a yield of 2.7%, which is a premium to the market yield. This too adds defensive characteristics to the stock. Fourthly, I believe that we are now either in, or fast approaching the late or mature phase stage of the economic expansion. As I mentioned in a recent post, during such periods, the energy sector has displayed a historic tendency towards outperformance. Finally, Exxon as recently priced, includes potential alpha. Alpha is the difference between actual returns and risk adjusted returns an investor should expect from a stock. When a low beta stock includes potential alpha, downside protection is provided by the low beta, while upside total return potential is not compromised, because we earn returns from alpha in addition to the lower upside beta driven gains associated with low beta stocks.

Do I own, or plan to own Exxon Mobil?

I don't own and have no plans to own Exxon at present. The capital I allocate to the energy sector goes to Shell (NYSE:RDS.A), BP (NYSE:BP), Transocean (NYSE:RIG), and from time to time to Schlumberger (NYSE:SLB) and National Oilwell (NYSE:NOV). That provides me with my targeted mix of growth and dividend. This mix also provides an opportunity to profit from re-allocation of capital on volatility. But not owning Exxon does not stop me from admiring that bedrock of stability. For those of you who are looking for a view backed by a long position, stop reading now: there is nothing here for you.

Exxon and the Buffett Benchmark

The first page of Warren Buffett's annual letter to shareholders starts with a review of Berkshire's Corporate Performance versus the S&P 500. You can see his most recent letter here. This benchmark compares the growth in Berkshire's book value versus the total return (including dividends) on the S&P 500. While this is not a perfect benchmark, it has merit. Ultimately, the change in book value reflects growth in per-share investments and earnings, which growth in turn will ultimately reflect in market prices. What is a good top level measure of management performance at Berkshire is good enough as a top-level measure of management performance at Exxon.

How has Exxon done applying this benchmark?

This table below displays the growth in book value at Exxon, versus the growth in book value at Berkshire and the total return (including dividend) on the S&P 500. As you can see, Exxon has outperformed both Berkshire and the S&P 500. If you add the dividend paid out by Exxon, which having been paid out is not included in Exxon's book value, the level of outperformance rises considerably.

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Source: Berkshire Hathaway 2013 Annual letter, Value Line report for XOM, and my calculations.

Over the past five years, Exxon's book value has grown at an annualized growth rate of 12.08%. This compares with annualized growth in the annual average price of 1.89%. Over the past ten years, Exxon's book value has grown at an annualized growth rate of 11.36%. This compares with annualized growth in the annual average price of 9.65%. Over fifteen years, Exxon's book value has grown at an annualized growth rate of 10.49%. This compares with annualized growth in the annual average price of 6.61%. Since the growth in market prices rewarded is lower than the growth in book, it is possible that Exxon was expensive then, and is cheap now. Alternatively, there has been a dramatic change in forward expectations, which leaves the stock rightly valued now. Which is it?

What is Exxon worth?

Mathematically, the worth of Exxon is calculated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation - Long-term Growth Rate].

What is the Growth Rate?

Sales Growth

I use history as a guide to the future on growth expectations. Let's look at growth in sales per share first. Sales growth has been volatile: this we know from the high standard deviation in the annual sales growth. Yet growth over the long term has been strong, with sales growing at median levels at an annualized rate of 13.92% (average 11.84%) in the years since 1998. Energy is a cyclical sector, with earnings and sales being very sensitive to the economic cycle. Thus, I also look at a cyclically adjusted sales figure. Six years is the average duration of an economic cycle. Thus, I look at six-year median sales per share as an estimate of cyclically adjusted sales. Cyclically adjusted sales per share (SPS 6) have grown at an annualized rate of 10.99% at median levels (average 12.70%) and as expected the growth over the course of an economic cycle comes with a far lower standard deviation of 7.71%.

Looking at annualized growth in sales over ten and fifteen years, we see annualized growth rates of 10.88% and 10.33% respectively.

What is somewhat worrying is that sales per share over the past five years has been a mere 1.11%. And it is worse when you consider that total sales has actually decreased: we see the growth in sales per share only because share count reduced from 4,976 million shares outstanding at the end of 2008 to 4,335 million shares outstanding at the end of 2013. We must remember that 2008 was a unique year, with oil prices peaking at $145 in July, before collapsing to near $30 by December. There is a high base effect impacting the low 1.11% five-year annualized growth rate. As we roll into 2014, we expect sales per share of $96.95 with five-year growth in sales since 2009 returning to an annualized rate of 10.70%.

Source: Value Line report for XOM, and my calculations.

Now that oil prices are at a level slightly above the marginal cost of new production, the price growth at 10% plus is unlikely. Production growth during 2013 fell. But in the coming few years, production growth is expected to rise at a 2% to 2.5% rate. In forward years, I would look for nominal growth of 7%. That is 2% to 2.5% in production growth, plus price growth driven by global inflation rates estimated at 3.8% and a little bit more on pricing gains driven by supply constraints and rising marginal costs of new production. In my view, the cyclical nature will remain preserved with annual growth rates varying from negative 2% to positive 14% from year-to-year.

Earnings Growth

I use history as a guide to the future on growth expectations. Let's look at growth in earnings per share first. Earnings growth has been volatile: this we know from the high standard deviation in the annual earnings growth. Yet growth over the long term has been strong, with earnings growing at median levels at an annualized rate of 19.37% (average 18.92%) in the years since 1998. Energy is a cyclical sector, a sector very sensitive to the economic cycle. Thus, I also look at a cyclically adjusted earnings figure. Six years is the average duration of an economic cycle. Thus, I look at six-year median earnings per share as an estimate of cyclically adjusted earnings. Cyclically adjusted earnings per share (EPS6) have grown at an annualized rate of 9.72% at median levels (average 15.85%) and as expected the growth over the course of an economic cycle comes with a far lower standard deviation of 14.27%.

Looking at annualized growth in earnings over ten and fifteen years, we see annualized growth rates of 11.15% and 12.21% respectively.

That per share earnings over the past five years has shrunk at an annualized rate of 3.24% is worrying. And it is worse when you consider that total earnings has actually decreased: we see the growth in earnings per share only because share count reduced from 4,976 million shares outstanding at the end of 2008 to 4,335 million shares outstanding at the end of 2013. We must remember that 2008 was a unique year, with oil prices peaking at $145 in July, before collapsing to near $30 by December. There is a high base effect impacting the negative five-year annualized growth rate. As we roll into 2014, we expect earnings per share of $7.80 with five-year growth in sales since 2009 returning to an annualized rate of 14.40%.

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Source: Value Line report for XOM, and my calculations.

Now that oil prices are at a level slightly above the marginal cost of new production, the earnings growth at 10% plus is unlikely. Production growth during 2013 fell. But in the coming few years, production growth is expected to rise at a 2% to 2.5% rate. Earnings growth of 7% is likely. That is 2% to 2.5% in production growth, plus price growth driven by global inflation rates estimated at 3.8%, and a little bit more on pricing gains driven by supply constraints and rising marginal costs of new production. In my view, the cyclical nature will remain preserved with annual growth rates varying from negative 7% to positive 21% from year-to-year.

If you noticed, I have indicated a 7% growth rate for both sales and earnings. This is somewhat unusual because normally as sales rises, earnings rise at a faster rate as fall-through rates rise. Fall-through rate is that part of the increase in sales that falls through to the bottom line. Normally, rising sales coupled with benefits from learning while doing, technological innovation, and better absorption of fixed costs, would result in earnings rising at a faster rate. It could very well happen. But for now, because of the high costs of new production, I am assuming that in the coming years these gains will be eaten away by rising supplier costs.

What are sustainable earnings?

Earnings in the energy sector are volatile from year-to-year. When I speak of sustainable earnings, I mean the level of earnings that can be expected to occur over the course of an economic cycle, which can be grown at estimated growth rates over time. I will use the cyclically adjusted earnings per share (EPS6) of $7.73 as an estimate of sustainable earnings.

What is the adjusted payout ratio?

The adjusted payout potential is that part of sustainable earnings that we can expect the company to return to shareholders via dividends and buybacks, net of dilution.

Over the past several years, dividend per share growth has been at median rates of 7.03% (average 7.69%). Over the past five, ten and fifteen years, it has grown at annualized rates of 9.68%, 9.65% and 7.6% respectively. The median payout ratio is 28%.

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Source: Value Line report for XOM, and my calculations.

In addition to the payout via dividends, Exxon has been returning capital via buybacks. In the table below, you will see how the share count has reduced in recent times. Share count is declining at median levels of 3.98% (average 3.27%). Over the past five, ten and thirteen years, share count has declined at an annualized rate of 2.72%, 4.07% and 3.54% respectively. The Buyback $ column in the table below represents the value of shares bought back during a year, at the average price during the year. I divide the Buyback $ by shares outstanding at the end of the year to arrive at a buyback cost per share. The buyback cost per share is divided by earnings per share to arrive at that part of earnings per share paid out to owners via buybacks - the result is in the column labeled Payout. Thus, in addition to payout via dividends, the median payout ratio for buybacks is 8.91%. Thus, the historic adjusted payout ratio for Exxon is 37% (28% via dividends and 9% via buybacks).

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Source: Value Line report for XOM, and my calculations.

I do not expect major changes in the adjusted payout ratio of 37%. However, I will reduce this adjusted payout ratio to 33.67% for future years. I am lowering the payout ratio, because over the last several years, capex per share has eaten away 52% of cash flow per share and 77% of earnings per share. To maintain balance sheet quality, I expect the dividend payout ratio to stay stable, while the payback payout ratio should contract.

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Source: Value Line report for XOM, and my calculations.

What return should investors in Exxon expect?

Exxon has a beta based on a five-year regression, adjusted for beta's tendency to converge to 1, of 0.90. Based on a long-term risk free rate of 4.5%, and a long-term equity risk premium of 5.75%, we arrive in an expected market return of 9.68%: this is what investors should demand. The capital asset pricing model, which adjusts market returns for risk as measured by beta, suggests that investors should expect a long-term return of 9.68% [Risk Free Rate + Beta * (Market Return - Risk Free Rate)] from the stock.

Valuation

Mathematically, the value of Exxon is calculated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation - Long-term Growth Rate].

Working with $7.73 in sustainable earnings, a 7% long-term growth rate, an adjusted payout ratio of 33.67% and an investor return expectation of 9.68%, we value Exxon at $103.91. Exxon traded at $94.01 recently. Thus, we have $9.90 in potential alpha: buying at $94.01 adds 28 basis points of long-term alpha.

I will end with my usual caution: I have looked at Exxon and liked what I saw. I do not own Exxon. I have no intention of initiating a long position in Exxon, and as a long only investor, I do not short stocks. This post is not a recommendation of any sort. Nor is it research. Nor can it be considered due diligence. It is merely an idea, or an investment thought-piece: if you like, it is a penny for my thoughts! I'd be delighted if you enjoyed it and it got you thinking, but if you buy, or if you sell, be sure to do your homework, research and due diligence first. If you did not like the post, or the thought that Exxon does not represent an interesting buy pick - that is fine too. There are two sides to every trade. We need a seller and buyer for two parties to walk away satisfied: if you are a seller of Exxon, be glad that there are buyers available.

Disclosure: I am long RIG, BP & RDS-B. 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.