## Summary

8%-9% annual dividend per share growth is achievable due to continued free cash flow recovery, healthy EBITDA and EPS growth potential, and stable leverage trend.

Current valuation implies a perpetual dividend growth rate of about 6.5%.

Share price would be 8% higher if the company can realize my 8%-9% dividend growth expectation over the next few years.

The share price of **Chevron** (NYSE:CVX) has recently dropped by almost 6% since reaching its 52-week high of $135 in late July. The pullback was driven by the company's lowered 2014 production guidance due to reasons including the shutdown of Angola LNG project, divestitures, and weather impact. From a long-term dividend investing perspective, I recommend income investors accumulating shares during this hiccup. In this article, I will elaborate on some cash flow and dividend analyses that support my thesis.

My free cash flow model is based on current consensus revenue estimates that predict the top line to grow by 1.5% CAGR from $235.4B in 2014 to $242.4B in 2016. Chevron's operating cash flow margin averaged at 16.0% in the past 5 years. The figure has been trending very steadily over the past few years. As such, I used the average operating cash flow margin (16%) for my 2014 projection. In the next 2 years, I modeled a 1% margin expansion to reflect the current consensus view that Chevron's EBITDA margin may rise by almost 200 bps over the period. For capital expenditure, management guided a flat spending trend at around $35B over the next few years. To be conservative, I assumed the spending to gradually decline to $36B by 2016. Given the improving profitability and declining capex trend, free cash flow was therefore projected to grow substantially from $371M in 2014 to $5.2B in 2016 (see chart below).

Earlier this year, management also announced a plan to divest approximately $10B non-core assets in the current and next 2 years. As such, I forecasted the divestiture proceeds to be $3.0B, $3.5B, and $3.5B respectively.

Chevron's dividend payment in 2013 was approximately $7.5B. In order to maintain the recent dividend growth rate of about 7%, the company will need to incur similar or higher dividend payment in 2014 (assuming a modest share repurchase). Apparently, my forecasted free cash flow and divestiture proceeds are not sufficient to cover this amount. Hence, a significant portion of the dividend commitment has to be funded by debt borrowing.

For modeling purpose, I assumed net debt issuance to fill the dividend funding shortfall. It should be noted that this method of funding is consistent with management's strategy to improve balance sheet efficiency through undertaking additional borrowing. Based on my dividend spending projections ranging from $8.0B to $9.4B between 2014 and 2016 (discussed later), Chevron's reliance on net debt issuance will subside considerably in the period thanks to the significant free cash flow growth (see the first chart).

Total net debt issuance between 2014 and 2016 was forecasted to be $9.6B. While the amount seems quite significant, from a net debt to EBITDA perspective, the company's leverage may not increase at all. As of Q2 2013, Chevron had $23.5B debt with a LTM EBITDA of $40.5B, representing a debt to EBITDA multiple of 0.6x. Adding the net debt issuance of $9.9B to the debt level, the leverage multiple will still be 0.6x based on consensus estimated EBITDA of $56.9B for 2016.

For dividend per share trend, I assumed a scenario of 9% growth in Q2 of fiscal 2015 and 2016. Given that Chevron paid quarterly dividend of $1.07 per share in Q1 2015, the annualized dividend per share for the current and next 2 fiscal years would be $4.21, $4.57, and $4.98, respectively (discussed later). As mentioned earlier, Chevron will require debt borrowing to finance its dividend payout. Hence, I only modeled year-to-date value of share repurchase and assumed no further buybacks over the forecast period. This means that the company's average share count will not change from the current level. Based on my average share count estimate at 1.9B and the dividend per share forecasts, I projected total dividend spending to increase from $8.0B in 2014 to $9.4B in 2016. Accordingly, net debt issuance is forecasted to decrease considerably from $6.6B in 2014 to $0.7B in 2016 primarily due to significant growth of free cash flow (see the first chart).

One can look at implied earnings payout ratio to test the reasonability of my dividend per share forecasts. Based on current consensus EPS estimates, my dividend projections suggest that the earnings payout ratio will stay fairly flat over the forecast period at about 40%-41%. This means that my dividend growth forecast is within a sustainable range (see the first chart).

On the valuation front, based on Gordon Growth Dividend Discount Model and a 10% cost of equity, Chevron's current share price of $128 implies a perpetual dividend growth rate that is close to 6.5%, which is slightly below the actual dividend growth in recent years as well as my forecasted potential (see chart below).

To illustrate the impact of the 9% dividend per share growth scenario on Chevron's valuation, I established a 2-stage dividend discount model. The first stage incorporates my 9% dividend per share growth forecast through fiscal 2017. The second stage reflects a perpetual growth stage based on the current implied perpetual growth rate of 6.5%. Using the 10% cost of equity, I arrived at a stock value of $139, which is 8% above the current market price (see chart below).

In conclusion, Chevron's current valuation implies a dividend growth rate that is lower than what the company can achieve over the next few years. Given the expected strong free cash flow growth, solid balance sheet, as well as healthy EBITDA and EPS growth, Chevron is believed to have a sufficient capacity to maintain the current dividend growth pace or even accelerate the growth to 8%-9% level. As the shares are trading at a value that underestimates this potential, the stock warrants a buy rating now.

*All charts are created by the author, and historical data used in the article and the charts is sourced from S&P Capital IQ, unless otherwise specified.*