By The Valuentum Team
Exxon Mobil's dividend is stronger than that of peers, but we can't lose sight of its Dividend Cushion ratio, which is near parity.
--> Exxon Mobil (NYSE:XOM) is involved in the exploration and production of crude oil/natural gas, and the manufacture of petroleum products as well as the transportation and sale of crude oil, natural gas and petroleum products. It also makes commodity petrochemicals. Exxon had 25.3 BOEB of total proved reserves at the end of 2014.
--> Though we don't think Exxon deserves its coveted, pristine AAA credit rating, its financial health is still rock-solid. The executive team continues to focus on fundamentals in a lower price environment while selectively investing in potential opportunities.
--> We were quite impressed with Exxon Mobil's recent performance. In 2014, return on capital employed was a solid ~16%, while the company's reserve replacement was north of 100%. The firm's ROCE performance is consistently better than that of its peers, and its upstream earnings-per-barrel trails only that of Chevron in its peer group. It has generated $100+ billion in free cash flow since 2009.
--> Exxon has a wonderful streak going. The energy giant has had 20 straight years of more than 100% reserve replacement. We find this to be a remarkable streak given its size and production capacity. The investments that it is making continue to position it for long-term success.
--> Exxon Mobil's dividend is better than that of peers, and we expect growth in it for many years to come. The energy giant's Dividend Cushion ratio is near parity. The company is best in class, in our view.
Note: Exxon Mobil's dividend yield is above average, offering a ~3.9% yield at recent price levels. Exxon Mobil boasts a solid yield, but we think the company is one for the watch list, if only because its Dividend Cushion ratio could be better. Let's walk through several of its key investing merits.
Exxon Mobil is our favorite dividend growth idea out of the oil and gas majors, by a long shot -- yes, better than Chevron (NYSE:CVX) and ConocoPhillips (NYSE:COP). We're huge fans of Exxon Mobil's integrated model, and we point to resiliency of the company's downstream and chemicals operations as a reason to be optimistic even in the face of collapsing energy resource pricing. A relentless focus on cost management will be par for the course in coming years, even as capital and exploration expenditure declines pad free cash flow. For a firm of Exxon Mobil's size, the company is handling the current commodity malaise incredibly well. Its pristine AAA credit rating speaks of strength, and its Dividend Cushion ratio, while not fantastic, is much better than that of peers.
Exxon Mobil's dividend is much stronger than that of its peers, but the Dividend Cushion ratio is still picking up long-term risk, particularly in the event of a prolonged downturn in energy resource prices. We encourage readers to focus more on the ratio itself than any qualifier such as POOR or VERY POOR, for example, but we wouldn't be doing our job if we said that there's nothing that could derail the energy behemoth's dividend strength. With a AAA rating from the credit rating agencies and positive free cash flow generating capacity even during these difficult times though, we don't think income investors have too much to worry about. We're watching its debt load closely in any case.
From the Comments Section: How to Interpret the Dividend Cushion Ratio -- A Ranking of Risk
As for how to interpret the Dividend Cushion ratio, itself, it is a measure of financial risk to the dividend, much like a credit rating is a measure of the default risk of the entity. Said differently, a poor Dividend Cushion ratio of below 1 or negative doesn't imply the company will cut the dividend tomorrow, no more than a junk credit rating implies a company will default tomorrow. That said, the Dividend Cushion ratio does punish companies for outsize debt loads because in times of adverse conditions, entities often need to shore up cash, and that means the dividend becomes increasingly more risky.
We think investors should look at a variety of different metrics in assessing the sustainability of the dividend. Because the Dividend Cushion ratio is systematically applied across our coverage, it can be used to compare entities on an apples-to-apples basis. Dividend payers with significant free cash flow generation and substantial net cash on the balance sheet often register the highest Dividend Cushion ratios, as they should. These companies have substantial financial flexibility to keep raising the dividend.
We think the safety of Exxon Mobil's dividend is poor. The breakpoints below explain how we arrive at that assessment:
Breakpoints: Dividend Safety. We measure the safety of a firm's dividend by adding its net cash to our forecast of its future cash flows and divide that sum by our forecast of its future dividend payments. This process results in a ratio called the Dividend Cushion. Scale: Above 2.75 = EXCELLENT; Between 1.25 and 2.75 = GOOD; Between 0.5 and 1.25 = POOR; Below 0.5 = VERY POOR.
Analyst note: Due to the punitive nature of a Dividend Cushion ratio of 1, for example, in qualifying it as POOR, Valuentum is considering changing the qualitative description of POOR to NEUTRAL and VERY POOR to POOR. We continue to evaluate performance across our coverage universe and plan to update readers when this study is completed.
As our readers may know, we measure the safety of the dividend in a unique but very straightforward fashion. As many know, earnings can fluctuate, so using the payout ratio in any given year has some limitations. Plus, companies can often encounter unforeseen charges, which makes earnings an even less-than-predictable measure of the safety of the dividend. We know that companies won't cut the dividend just because earnings have declined or they had a restructuring charge that put them in the red for the quarter (year). As such, we think that assessing the cash flows of a business allows us to determine whether it has the capacity to continue paying dividends well into the future.
That has led us to develop the forward-looking Dividend Cushion ratio, which we make available on our website. The measure is a ratio that sums the existing net cash a company has on hand (on its balance sheet) plus its expected future free cash flows (cash flow from operations less capital expenditures) over the next five years and divides that sum by future expected cash dividends over the same time period. Basically, if the score is above 1, the company has the capacity to pay out its expected future dividends and the expected growth in them.
As income investors, however, we'd like to see a ratio much larger than 1 for a couple of reasons: 1) the higher the ratio, the more "cushion" the company has against unexpected earnings shortfalls, and 2) the higher the ratio, the greater capacity a dividend-payer has in boosting the dividend in the future. For Exxon Mobil, this ratio is 1, revealing that on its current path the firm should be able to cover its future dividends and growth in them with net cash on hand and future free cash flow. It's quite close -- we call a ratio of 1, parity.
Dividend Cushion Ratio Cash Flow Bridge
The Dividend Cushion Cash Flow Bridge, shown in the graph below, illustrates the components of the Dividend Cushion ratio and highlights in detail the many drivers behind it. Exxon Mobil's Dividend Cushion Cash Flow Bridge reveals that the sum of the company's 5-year cumulative free cash flow generation, as measured by cash flow from operations less all capital spending, plus its net cash/debt position on the balance sheet, as of the last fiscal year, is greater than the sum of the next 5 years of expected cash dividends paid.
Because the Dividend Cushion ratio is forward-looking and captures the trajectory of the company's free cash flow generation and dividend growth, it reveals whether there will be a cash surplus or a cash shortfall at the end of the 5-year period, taking into consideration the leverage on the balance sheet, a key source of risk. On a fundamental basis, we believe companies that have a strong net cash position on the balance sheet and are generating a significant amount of free cash flow are better able to pay and grow their dividend over time.
Firms that are buried under a mountain of debt and do not sufficiently cover their dividend with free cash flow are more at risk of a dividend cut or a suspension of growth, all else equal, in our opinion. Generally speaking, the greater the 'blue bar' to the right is in the positive, the more durable a company's dividend, and the greater the 'blue bar' to the right is in the negative, the less durable a company's dividend.
Dividend Cushion Ratio Deconstruction
The Dividend Cushion Ratio Deconstruction, shown in the graph below, reveals the numerator and denominator of the Dividend Cushion ratio. At the core, the larger the numerator, or the healthier a company's balance sheet and future free cash flow generation, relative to the denominator, or a company's cash dividend obligations, the more durable the dividend. In the context of the Dividend Cushion ratio, Exxon Mobil's numerator is larger than its denominator suggesting strong dividend coverage in the future. The Dividend Cushion Ratio Deconstruction image puts sources of free cash in the context of financial obligations next to expected cash dividend payments over the next 5 years on a side-by-side comparison. Because the Dividend Cushion ratio and many of its components are forward-looking, our dividend evaluation may change upon subsequent updates as future forecasts are altered to reflect new information.
Please note that to arrive at the Dividend Cushion ratio, divide the numerator by the denominator in the graph below. The difference between the numerator and denominator is the firm's "total cumulative 5-year forecasted distributable excess cash after dividends paid, ex buybacks."
Now on to the potential growth of Exxon Mobil's dividend. As we mentioned above, we think the larger the "cushion" the larger capacity the company has to raise the dividend. However, such dividend growth analysis is not complete until after considering management's willingness to increase the dividend. To do so, we evaluate the company's historical dividend track record. If there have been no dividend cuts in the past 10 years, the company has a nice dividend growth rate, and a solid Dividend Cushion ratio, we characterize its future potential dividend growth as excellent. This is not the case for Exxon Mobil in light of its Dividend Cushion ratio, which is roughly at parity.
Because capital preservation is also an important consideration to any income strategy, we use our estimate of the company's fair value range to assess the risk associated with the potential for capital loss. In Exxon Mobil's case, we currently think shares are fairly valued, meaning the share price falls within our estimate of the fair value range, so the risk of capital loss is medium (our valuation analysis can be found by downloading the 16-page report on our website). If we thought the shares were undervalued, the risk of capital loss would be low.
Wrapping Things Up
Exxon Mobil has recently become our favorite oil and gas major thanks to the resiliency of the company's downstream and chemicals operations. We think the firm is handling its current operating environment incredibly well for an entity of its size, and its AAA credit rating speaks of its strength. However, we would be remiss not to highlight to high potential downside that exists in any company as exposed to the price of oil as Exxon is. We will continue closely watching the company's debt load and free cash flow generation as they relate to its dividend health.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.