Why Whitney Tilson Is Wrong About BP

| About: BP p.l.c. (BP)

Even famous investors can’t afford to ignore the obvious. In this week’s Barron’s, Whitney Tilson of T2 Partners justifies buying British Petroleum (NYSE:BP) for his clients with two arguments:

  1. By paying 5x earnings, he bought a great company at a cheap price.
  2. Spill liabilities will be comparable in their order of magnitude to previous oil spills. (Citing the 1979 failure of Ixtoc I, the world’s second largest spill, which Pemex settled for $100M and Exxon-Valdez (NYSE:XOM), for which the company paid only $500M after the Supreme Court knocked down a $5B judgment.)

True spill costs are already a spirited debate. My assertion here is more basic: Tilson did not buy BP when it was objectively cheap.

Tilson paid 14x Free Cash Flow for BP

Tilson states in Barron’s that BP was “extraordinarily cheap” at 5x earnings, meaning net income.

As a founder of the Value Investing Congress, Tilson is an investor seeking to emulate Warren Buffett’s approach. A basic point of Buffett’s is that it makes much more sense to value companies in terms of their “owner earnings” – primarily free cash flow.

While BP earned $20B in net income last year, the company’s high capital expenditures meant it only generated $7B in free cash. While it is hard to prove what part of such cap-ex is “optional,” the company has spent $15B+ in cap-ex every year since 2006 without meaningful growth in earnings.

Given the fast-changing technologies and site developments required for a modern major oil E&P, it is likely the cap-ex must be spent to tread water competitively. Even in the face of its $20B escrow requirement, the company only aims to try and lower cap-ex a mere 10%.

On Buffett’s free cash flow basis, Tilson paid 14x earnings. That means he accepted a 7.1% yield for a company that conceivably might not be around next year.

BP’s interest expense won’t stay this low

According to its filings, BP pays a weighted average interest expense of only 1-3% depending on the currency in which it is borrowing. If BP’s interest expense rose, it would further decrease the company’s earnings, compounding Tilson’s valuation error.

Generally, companies facing internationally-covered crises develop skittish lenders. All three ratings agencies have recently downgraded BP’s debt.

If the company is to make the cash payments required of the Obama escrow, it is likely to try and borrow more. In addition to whatever new loans it demands, BP must roll over $10B of existing debt in the next two years. (Additional leverage itself tends to raise interest expense.)

Also of concern to lenders is that nearly half of BP’s tangible assets are in illiquid PP&E, whose value might be questionable to a non-oil producer. The company has already begun the process of trying to divest some of these. Without a doubt, bondholders will closely watch what level of compensation they will command in this fire sale.

A related issue is the company’s hedges. BP lists approximately $10B on both sides of its balance sheet. Traders worried about the company’s continuing solvency are already vocalizing concerns about BP’s counterparty risk. If the company’s effective cost of capital is raised from its book of derivatives, it would also erode the normalized earnings power Tilson is betting on.

Management’s poor reputation catalyzes the risks of BP’s crisis

Buffett quips there is usually more than one roach in a motel. A fundamental precept of value investing is to know not just what assets you are buying but who is responsible for them. Since all public companies inherently have information asymmetry between principals and owners, management that is hard to trust during good times will kill you in bad ones.

This decade, BP:

A lifelong devotee of Graham, Buffett, and Munger, Whitney Tilson must see a margin of safety in the price he paid for BP. For the moment, it escapes me.

Disclosure: No positions