## Summary

My projections for future free cash flow and earnings payout level suggests that XOM can comfortably drive a 9%-10% annual growth in dividend per share.

However, current share price implies a growth rate of about 7%.

A 2-stage dividend discount model suggests the shares are 7% undervalued.

Owing to a recent pullback, shares of **Exxon Mobil** (NYSE:XOM) now trade at 6% below their 52-week high. I consider this a buying opportunity from a dividend investing perspective as I believe the 52-week high price of $104-$105 represents XOM's fair value and the current value gap should warrant a buy decision. In this article, I will elaborate on some cash flow and dividend forecast analyses that substantiate my buy thesis.

I first performed free cash flow projections between 2014 and 2016 to gauge XOM's capacity for future dividend growth. My analysis is based on current consensus EBITDA estimates which predict the figure to stay somewhat flat at around $77B from 2014 to 2016. XOM managed to maintain a fairly steady EBITDA to operating cash flow conversion rate in the past 5 years (except for 2010). To be conservative, I assumed a flat conversion rate of 72.0% through 2016, which is below its 3-year historical average of 74.8%. In terms of capital expenditure, I used management's $39.8B guidance for 2014 and incorporated management's view that the spending will land at around $37B over the next few years. Based on those assumptions, free cash flow was projected to increase by 6.5% CAGR from $16.0B in 2014 to $18.2B in 2016 (see chart below). As you may have noted, the free cash flow growth is primarily attributable to declining capex trend because of the flat EBITDA trend and the conservative cash flow conversion assumption that I used.

Given XOM's historical divestment trend and that the company has sold $3.7B assets in the first 6 months of 2014, I conservatively assumed annual divestment proceeds of $4.0B in 2014 and $1.5B in each of 2015 and 2016. Hence, XOM will have about $19B-$20B distributable cash flow in each forecast year (see the first chart).

XOM raised quarterly dividend by 9.5% from $0.63 to $0.69 per share in Q2 2014. As the next dividend hike is expected to take place in Q2 2015, total annual dividend in 2014 will be $2.70 per share. Based on my average share count estimate (discussed later), total dividend payment in the year will be approximately $11.7B. Assuming XOM will continue to maintain the same annual dividend per share growth rate at 9.5% over the next 3 years, total dividend payment will climb to $13.8B by 2016 (see the first chart).

Since my projected free cash flows are more than sufficient to cover the dividend commitment, I assumed 90% of any cash surplus after paying out dividends to be spent on share buybacks, and this is consistent with XOM's historical movement to return significant amount of capital to shareholders. Assuming average repurchase price of $102 for 2014 and a 10% annual price appreciation, the average share count will decline to approximately 4,250M by 2016 (see the first chart).

One way to test the sustainability of my 9.5% annual dividend per share growth scenario is to look at trend of implied earnings dividend payout ratio. As shown in the model, the implied earnings dividend payout ratio was projected to increase modestly from $35% in 2014 to 42% in 2016. While the 42% level exceeds XOM's average in the past few years, it is still below the trailing 12-month average of 49% for XOM's global integrated O&G peers (see chart below). Further, current consensus view calls for a long-term EPS growth potential of 13% for XOM. Even at a lower 10% long-term EPS growth rate, the earnings payout ratio will likely stabilize at slightly above 40% level beyond 2016 as the growth pace for both EPS and dividend per share will be similar.

Alternatively, the dividend growth sustainability can also be tested on the trend of free cash flow dividend payout ratio. My analysis has shown that the free cash flow payout ratio will rise slightly from 73% in 2014 to 77% in 2016, both of which are substantially below the 97% free cash flow payout experienced in 2013 and provide ample buffer for potential negative free cash flow performance (see the first chart).

Based on Gordon Growth Dividend Discount Model and a 10% cost of equity (CAPM suggests 8% cost of equity based on 3% risk-free rate, 6% equity risk premium, and XOM's 5-year beta of 0.85), XOM's current share price of $98.5 implies a perpetual dividend growth rate of about 7%, which is below my 9.5% expectation over the next few years (see chart below).

I used a 2-stage dividend discount model to estimate the stock's fair value. The first stage incorporates my view that XOM can sustain a 9%-10% annual dividend per share over the next 3 years through fiscal 2017, and the second stage reflects a perpetual growth state with the 7% perpetual growth rate implied by the current share price. Based on the 10% cost of equity, I arrived at a share price of $105, which represents almost 7% upside from the current price (see chart below).

In summary, XOM has the capacity to sustain a 9%-10% annual growth in dividend per share over the next few years. However, this potential is modestly underappreciated by the current valuation. As the value discount is somewhat notable (~7%) and the shares offer a 2.8% dividend yield, the potential return is sufficient to warrant a buy rating.

*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.*