- As reorganization is approaching an end, BP will soon see improved cash flow generation.
- BP's discounted valuation is exaggerated given its cash flow profile, sustainable dividend yield, and well-contained exposure to Macondo litigation.
- BP is able to grow dividend by 5% per annum through 2018, while current valuation only implies 3-4%.
The share price of BP plc (NYSE:BP) has risen by 16% over the past 12 years, which is almost in line with the performance from the S&P 500 Index. Looking forward, I expect a gradual price appreciation to be supported by inexpensive valuation, as well as healthy free cash flow and dividend growth.
Recent development indicating promising prospects
BP's Upstream division has experienced significant reorganization over the past few years. The company divested approximately $30B of upstream assets and now carries less than half of the assets, which existed back then. A promising point is that a few of new start-up projects are expected to generate considerably higher free cash flow margins (e.g. projects coming online between 2014 and 2015 are estimated to generate cash flow per unit approximately twice of the 2013 actual level). As such, management now expects notable operating cash flow improvement from the more focused Upstream businesses. On the other hand, BP has almost completed reorganizing its Downstream division, as more than 10 refineries were sold in the past few years. During the refinery sale process, BP also made significant investments (e.g. modernization and capacity expansion) in its more advanced refinery facilities that the company decided to keep. With the sale and capital investment phase approaching an end, BP is about to see improved cash flow return from the downstream operations. Overall, owing to the firm-wide reshuffle effort, the retained high-quality assets are expected to improve cash flow efficiency and growth in capital expenditure (i.e. 34% capex growth from 2011 to 2013) will slow down.
Valuation looks cheap and signals a long-term entry point…
At $47.54, BP trades at 4.3x consensus estimated 2015 EBITDA and 9.3x consensus estimated 2015 EPS, both of which are at double-digit discount to peer average valuation levels (see chart below).
In my view, BP's 10% to 20% valuation gap relative to peer average should present a buy signal because 1) BP has an above-average cash flow profile in terms of both free cash flow margin and operating cash flow growth (discussed later); 2) the stock's dividend yield is in line with its European peers and exceeds North American peer average and its dividend growth is believed to be sustainable in my view (discussed later); and 3) BP is able to generate decent return on equity and the metric is likely to remain strong as the company is set to benefit from better efficiency from higher quality and more focused assets. I understand that BP's discounted valuation is largely owing to the Macondo litigation. However, I believe the results may not be as bad as the market currently expects. Through a significant transformation effort, I believe BP has strengthened both its balance sheet and operating model such that the company should have sufficient liquidity flexibility to afford the potential liability (illustrated later). Further, should the results turn out to be unfavorable, I believe BP would initiate an appeal process, which may take additional years, such that management can have sufficient time to review and update their strategic and liquidity planning.
Healthy dividend growth is expected to drive upside
I have performed a cash flow analysis to gauge BP's capacity to grow dividend over the next 5 years and my conclusion is very positive. Management announced an operating cash flow target of $30-$31B for 2014, which is then expected to grow by 3-4% and reach $34-$38B by 2018. To be conservative, my calculation assumed an operating cash flow of $30B for 2014 and an annual growth rate of 3.0% through 2018. These assumptions suggest operating cash flow would reach $33.8B by 2018, which is even below the low end of management's guidance. Management also expects capex to be within the range from $24B to $26B through 2018. Again, I assumed a capex growth rate of 2.5% through 2018 for conservatism, and this resulted in a capex range between $25B and $27B over the forecast period. The higher capex range is aimed to account for cost overrun risk. Before arriving at distributable cash flows, I factored in proceeds from divestiture. I modeled $5B proceeds in each of 2014 and 2015, which is in line with management's plan to incur a $10B asset sale in the coming two years. I then modeled $1B annual divestiture in subsequent years. Based on these conservative assumptions, BP is able to grow dividend by 5% per annum through 2018 and still has cash surplus. The company can also make a cumulative $7B share repurchase in 2014 and 2015 (see chart below).
I have performed an analysis to estimate the implied dividend growth rate that is baked in the current share price. Based on a risk-free rate of 2.6%, 6.0% equity risk premium, and BP's 5-year beta of 0.98, I estimated the stock's cost of equity to be in the range between 8.0% and 9.0%. By using a Gordon growth dividend discount model, the implied perpetual dividend growth rate at the current share price of $47.5 and 8.5% cost of equity is approximately 3.5%. According to the sensitivity table shown below, BP's share price would rise to $68 if dividend growth accelerates to 5.0% at 8.5% cost of equity, indicating that the share price is quite sensitive to dividend growth rate. The analysis also suggests that BP's dividend growth prospects have been underappreciated.
In conclusion, BP's fundamentals are much better than what is being reflected in its current stock valuation. As the valuation remains cheap and dividend growth potential has not been reflected, income investors seeking energy exposure are recommended to buy the shares now.
All charts are created by the author, and data used in the article and the charts is sourced from S&P Capital IQ, unless otherwise specified.
Disclosure: I am long BP. 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.