- Stabilized capex and completion of major LNG projects should help cash flow growth.
- Strong balance sheet allows for higher leverage to fund capital deployment.
- The company has sufficient resources to support 8%-10% annual dividend growth.
- Current valuation reflects 6%-7% dividend growth.
- The stock also trades favorably to its global peers.
The share price of Chevron (NYSE:CVX) has risen by almost 16% since dropping to its 52-week low of $109.27 in February. In my view, it is still not late for long-term dividend investors to accumulate the shares at the current level as the price upside remains large given the company's healthy cash flow prospects as well as its inexpensive stock valuation.
Chevron recently reported Q1 2014 results, which fell short of expectations. However, the miss was largely due to extraordinary items including write-downs and currency effects. The company indeed delivered a few positive messages, which I believe, would benefit dividend investors. At the Analyst Day early this year, management indicated that capital spending has reached its peak level. As promised, the spending in Q1 2014 was only up 4% from Q1 2013, compared to a 20% capex growth in Q1 2013. Annual capex in 2014 is expected to be around $35B and will remain flattish through 2016. In addition, the Gorgon LNG project has reached 80% completion and is on track to commence operation in 2015. As capital expenditure continues to cool off and a mega LNG project comes online, Chevron should see strong cash flow growth over the next few years.
I have performed a cash flow forecast to illustrate Chevron's capacity to cover its capital programs (i.e. capex, dividend, and share repurchase) over the coming 3 years. My analysis started with consensus revenue forecasts from 2014 to 2016. I noted that the company has been doing a great job in maintaining an operating cash flow ("OCF") margin of 16%-17% over the past 3 years. In this analysis, I assumed a 16.0% OCF margin through 2016, which is at the low end of the 3-year historical range. As a result, OCF would reach $39.9B by 2016 based on my assumption. It should be noted that this is a much more conservative forecast than management's long-term OCF guidance, which calls for $50B OCF by 2017. Based on the company's capex expectation (i.e. ~$35B through 2016), I assumed capex to decrease from $37B in 2014 to $36B. At the Analyst Day, management also noted a plan to divest approximately $10B non-core assets over the coming 3 years. As such, I assumed $3.3B annual proceeds from asset sale through 2016. Assuming Chevron continues to borrow $3.0B to $3.5B per year, the resulting distributable cash flow is able to support 8% to 10% annual dividend increase (see chart below). Given that both Chevron's net debt to EBITDA and total debt to capital ratios are way below the average levels of its global integrated oil peers (see chart below), the company should have ample capacity for higher leverage. Even with a total $9.5B borrowing in between 2014 and 2016 (what I have assumed), the pro forma total debt to capital ratio in 2016 will be just around 17%, which is still much lower than the peer average at 26%, meaning that Chevron can incur more debt than I have assumed to fund share repurchase.
In terms of valuation, I believe the shares are trading at a somewhat attractive level from both absolute and relative perspectives. The company recently announced a 7% increase in quarterly dividend from $1.00 per share to $1.07 per share. Based on an annualized dividend of $4.28 per share and 10% cost of equity (it is noted that CAPM model calls for a 9.4% cost of equity based on 3.0% risk-free rate, 6% equity risk premium, and Chevron's 5-year beta of 1.04), the Gordon growth dividend discount model suggests that the current share price of ~$126 implies a perpetual 6.5% dividend growth rate. Given my views that 1) Chevron should see continued cash flow improvement over the next few years due to stabilized capital spending trend and completion of major LNG projects and 2) the company also has ample borrowing capacity to support its capital deployment, I believe future dividend growth should be in the range from 7% to 10% over a medium term, suggesting that the current stock valuation has somewhat underestimated the dividend growth prospects. Based on the sensitivity table shown below, a combination of 10% cost of equity and just 7.0% dividend growth would result in a share value of $150.
From a relative perspective, Chevron trades at 8% to 15% discount to its peer average level based on various forward valuation multiples though its consensus long-term EPS growth estimate is only slightly below peer average, making the stock's PEG ratio below par (see chart below).
In conclusion, Chevron's solid dividend growth can be sustained over a medium term thanks to the company's healthy fundamentals and strong balance sheet. As the stock valuation remains inexpensive in a way that the future dividend potential is likely underappreciated, income investors 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.