- $34.6 billion of deferred tax liabilities is a low-cost, non-perilous source of leverage.
- $30 billion of equity company investments.
- $14 billion of income from equity affiliates.
- ROCE (return on capital employed) of 17% for 2013, consistently higher than peers.
- Cost of debt is 48 bps above 10 year treasuries: cost of equity is irrelevant.
Deferred Tax Liability as Float
Warren Buffett's fascination with free float is well-known, in the context of the insurance business, where the loss reserves can be invested for years before they are paid out to claimants.
Less widely known, he regards deferred tax liabilities in a similar light. From the Berkshire-Hathaway Owner's Manual:
Besides, Berkshire has access to two low-cost, non-perilous sources of leverage that allow us to safely own far more assets than our equity capital alone would permit: deferred taxes and "float," the funds of others that our insurance business holds because it receives premiums before needing to pay out losses. Both of these funding sources have grown rapidly and now total about $117 billion. (emphasis added)
Exxon incurs taxes at a 42% rate, but the deferred tax liability is huge, and growing. The company pays plenty of taxes, but the amount owed keeps increasing. Here's the relevant material from the 2013 annual report:
So, we have found the "low-cost, non-perilous source of leverage." Now, what is Exxon doing with it?
Just scanning the asset side of the balance sheet for similar size numbers, here is information on equity investments:
The amounts are pretty similar to the deferred tax liabilities.
So, we have found out what they're doing with the deferred taxes. Now, how are they making out?
I see after tax income of $14 billion, on an investment of $30 billion, with zero cost of funds.
What's it worth?
When asked, Buffett will respond in an orthodox manner - he advocates the use of a DCF model:
Buffett: The appropriate multiple for a business compared to the S&P 500 depends on its return on equity and return on incremental invested capital. I wouldn't look at a single valuation metric like relative P/E ratio. I don't think price-to-earnings, price-to-book or price-to-sales ratios tell you very much. People want a formula, but it's not that easy. To value something, you simply have to take its free cash flows from now until kingdom come and then discount them back to the present using an appropriate discount rate. All cash is equal. You just need to evaluate a business's economic characteristics.
Source: BRK Annual Meeting 2002 Tilson Notes
Beyond that, he's not very specific. Keep "until kingdom come" in mind. Here's a link to a collection of his comments on the subject.
Before doing a DCF, I will detour into a discussion of buybacks, and a paradox associated with buybacks as a value creation mechanism.
XOM does a lot of buybacks. For 2013, the company repurchased 177 million shares, at a cost of $16 billion, or $93.39 per share. It was a 3.7% reduction in share count, at prices less than the current market. Future EPS will increase accordingly.
Buybacks are beneficial only if they are done for less than intrinsic value. Intrinsic value is heavily influenced by future growth assumptions. The paradox is, that if the market recognizes potential growth from buybacks by raising share prices, the buybacks will no longer create value.
This effect is more pronounced in cyclical businesses, because share prices go up and down far more than the long term average earnings.
Thinking outside the box on DCF
Leaving aside the academic paraphernalia relating to the preparation of a discounted cash flow valuation, let's just resort to common sense.
As an owner of Exxon Mobil, the investor's concern should be: 1) what is their cost of capital, 2) what is their return on capital employed, and 3) what is the difference between 1) and 2)?
Item 2) is easily answered, it's 17%.
To answer item 1) requires a little more thought. Let's start by noting that XOM is buying back its shares on the open market. It has no need ever to access equity markets as a source of capital. The cost of equity capital isn't relevant here.
Deferred tax liability increased by $3 billion, that's free capital. $14 billion of capital was added by the profit from equity affiliates, a nice source as demonstrated above. Exxon does have publicly traded debt, and is rated AAA. The ten year treasury has been yielding 2.75%: Exxon is able to borrow 48 bps higher. From Bloomberg:
Exxon sold $1 billion of 10-year, 3.176 percent coupon bonds that yield 48 basis points more than similar-maturity Treasuries, $1.75 billion of five-year debt with a 1.819 percent coupon and a yield spread of 25 basis points and $1.5 billion of three-year, 0.921 percent debt that pays 15 basis points more than benchmarks. A basis point is 0.01 percentage point.
Those are the economic characteristics of this company. It can borrow at approximately 0.5% above the risk free rate and earn 17% on the capital employed. Some of the capital employed comes in the form deferred tax liabilities that can remain on the books indefinitely, and are essentially a free source of funds.
Free Cash Flow vs. Return on Investment
The market has been voting in favor of reduced capex for Oil & Gas companies. The underlying assets consist of oil and gas in the ground, but somehow the market balks at the cost of bringing them up for consumption. There is still some low-hanging fruit, in areas where the cost of production is quite low.
Exxon has an excellent record of profitable investment. Their recently announced reduction in capex argues that it's better to leave the oil and gas in the ground until the price goes up sufficiently to warrant the cost of extraction.
The market will react with predictable negativity to flat production caused by lack of investment. It's more germane to follow reserve replacement and verify an increase in proved reserves on a regular basis.
Reserve and Resource Increases
The company issues a Press Release in February each year, covering their reserve replacement ratio, and documented on an 8-K available at the SEC website. Here is ten years' worth of data:
Reserves are figured according to SEC definitions in effect for the year involved. Resources is a broader figure, provided by the company. In any event, Exxon has historically been able to add 1% or 2% to the total reserves/resources on an average basis.
The economic characteristics of this business are that the company can increase reserves while pumping, refining and distributing oil and natural gas at a profit, meanwhile paying a dividend that increases on a regular basis, due to the ability to buy back approximately 4.3% of shares per year. The investor owns a steadily increasing asset base while receiving a steadily increasing payout.
This can't go on forever, but it could go on for a long time.
I'm long XOM. ROCE is far in excess of the cost of capital. Arguably, the company has access to zero cost capital in the form of deferred tax liabilities. Growth consists of 1% or 2% reserve increases plus buybacks that have averaged 4.3% over the past eight years.
Energy price inflation has been impacted by the advent of low cost natural gas from fracking. Over the very long term, energy prices will increase due to the increased cost of bringing more difficult sources on line, and will increase in cycles, operating as a choke chain on the global economy. I leave this factor out of my computations, for the fact that it's imponderable.
Plugging their 3.25% cost of debt into a DCF produces a valuation in excess of the current market price, and substantially so, depending on the terminal growth rate assumption. Bear in mind, if growth is higher than the cost of capital, a DCF goes haywire and develops an infinite valuation.
I see a very slow moving stock with a very strong upward bias, due to the factors enumerated in this article. I'm applying considerable leverage, as my position is taken with low cost, deep-in-the-money LEAPS.
A Digression on Buffettology
The disclosure of Berkshire Hathaway's (NYSE:BRK.A) large investment in Exxon Mobil was a field day for the punditry. Numerous articles appeared, wherein the authors purported to replicate the Oracle's thought process, and included his name in the article's title, to garner clicks. I've had this article on the back burner, until the company's recent debt offering provided insight into their cost of capital, and a basis for preparing a valuation.
I decided to leave Buffett's name out of the title, as an experiment, to compare the clicks to what I've received in the past on articles referencing the Oracle. "A View Of Economic Characteristics" sounds sort of dry and academic, not that enticing, compared to "Why Billionaire Buffett Loves Exxon."
While I admire and respect Warren Buffett, I question the utility of investment articles that are merchandized by the use of his name. By all means, those who utilize his insights should acknowledge the source, but applying his brand to low-grade commentary seems like an exercise in futility.