Exxon Mobil: Agreeing To A 7%-Plus Yield

| About: Exxon Mobil (XOM)

Summary

Exxon Mobil has demonstrated a strong and profitable history in good times or bad.

If shares were purchased today, the "current" dividend yield would be just below 4%.

This article details a way to increase this cash flow.

exxon Exxon Mobil (NYSE:XOM) is a profit-making machine. This can get lost in the everyday share price fluctuations and commodity price slump as of late. In the best of times the company was earning over $40 billion in profits. Just to give you some context, last year Coca-Cola (NYSE:KO), PepsiCo (NYSE:PEP) and Dr. Pepper (NYSE:DPS) made a bit over $16 billion combined. Even with oil prices materially lower, Exxon Mobil is still on pace to earn as much as these three beverage and snack food giants.

This sort of profitability is what has allowed the company to pay dividends for a century and increase its payment for 33 consecutive years. It's that sort of consistency (although perhaps a bit more erratic than you would originally suspect) that draws many investors to become a partner in the business.

Of course there are always reasons to doubt the future of a company. Perhaps you believe that oil will remain at current levels for a good deal of time or that this time it's simply too much and the giant firms in the industry will ultimately prove unprofitable - there's always a reason. In this sort of scenario you likely would not be interested in owning a piece of the business.

Yet if you believe that a massively profitable company might still be around in the coming years (after all it still is making billions in very bad times) then now could be an opportunity for the long-term owner. Uncertainty is usually what drives opportunity, not a future that everyone agrees with. So let's think about this second scenario: you think that Exxon Mobil might be around in the future, and you would like to partner with the company.

This is a straightforward process: you set aside funds, use a brokerage and add shares of XOM to your account. In doing so, you now own a portion of the business and have a proportional claim on the underlying earnings power of the firm and dividend cash flow. Your return in a classical sense is equal to your dividend payment along with the price (bids) others are willing to pay. If you don't have an intention to sell this part becomes a bit less central, but this is the theoretical framework.

Presently this means collecting a $0.73 quarterly dividend ($2.92 on an annualized basis) to go along with whatever happens to the share price. This is what a great deal of investors experience. Yet I would like to bring up a supplemental option (literally).

If you're happy to own shares anyway, you could own the shares and also sell a covered call. In doing so you make an agreement to sell your shares at a future price. The buyer gets the opportunity to buy at a set price and you get a premium for providing this option. Let's walk through an example.

At last glance the January 20, 2017, call option with a $87.50 strike price had a bid of about $3. This means that if you were to agree to sell your shares at a price of $87.50 within the next year you would get $3 upfront (less fees). With transaction costs, we'll call it $2.75 - the actual cost could be less, but this bakes in a bit of fluctuation as well. Note that options trade in "round lots" of 100 shares, so this means agreeing to sell 100 shares at $8,750 and receiving ~$275 upfront for doing so.

Now one of two basic things happens in this situation: either the option is exercised or it is not. If the option is not exercised, likely the case with a future share price below $87.50, you hold your shares of Exxon Mobil just as you had planned. You still receive your quarterly dividend payment and whatever happens to the share price. In addition, you also received the option premium upfront. Now it's true that dividends are "qualified" while option premiums can be ordinary income, but it's clear that your cash flow would increase in this scenario. You'd go from a dividend yield under 4% to a cash flow yield of over 7%.

The second thing that could happen is that the option might be exercised - as it becomes much more likely to be the case if the share price was above $87.50. In this scenario, at a minimum, you receive the upfront premium along with $8,750 (minus frictional costs). Based on today's share price, this represents a return of about 16.3%.

Here is what those scenarios look like in table form:

From the above table we can learn a variety of information. The first column illustrates hypothetical share prices in the future. The middle column shows your return if you just owned shares. And the third column demonstrates the potential return spectrum if you sold the covered call described above. I think it's important to take a look at the "lesser" scenarios from an annual return point of view. (If you have a truly long-term time horizon lower intermediate share prices can actually be helpful, but that's a different story.) A lot of people like to bring up the idea that selling a covered call does not protect you from the downside - which is true. Yet I would like to make a point.

If you're going to own shares anyway, selling a covered call provides a higher comparative return for lower share prices. You get the upfront premium, plus whatever happens to the security. You can see this with hypothetical share prices ranging from $50 to $75 above. In every instance selling the call provided a higher return. That doesn't mean it was positive, it just means that it was better than what you would have done had you simply owned shares.

Indeed this trend continues even once you start looking at positive returns - up until about 16% to 20% annual gains. Once (or if) the $87.50 share price is reached, the call is likely to be exercised, leaving you "stuck" at selling at this price, even if the actual price is much higher. This is the real risk in my view - being forced to sell a security you're happy to hold at a below market price. However, I would contend that there are at least three mitigating factors at play.

First, once the $87.50 mark was reach I assumed that no dividends would be received. In reality you might still receive one or even all four payments, resulting in a total return closer to 20%. Second, you get the option premium upfront - giving you immediate funds to reinvest or spend as you choose. And third, you have to be happy with the agreement. If the share price were to shoot up to $100 next month, you likely wouldn't be pleased. Yet this isn't as if you're now losing money - far from it. Instead, you're agreeing to a 16% to 20% annual gain. That sort of return will quickly build your wealth even if a few people get rich faster.

In short, Exxon Mobil has demonstrated its excellent profitability and strong dividend history - in good times or bad - for decades now. That doesn't mean it will continue, but the current environment allows for an interesting opportunity. For many investors that means simply buying and owning shares, which could work out quite well. Yet I'd contend that it can also be useful to at least be aware of different options - in this case literally. Presently, for agreeing to sell your shares at a 13% higher price, you could be looking at a 7%-plus yield or else a 16% to 20% annualized return. These sort of things don't get talked about as often, but that doesn't mean that interesting situations are not being offered.

Disclosure: I am/we are long KO, PEP, XOM.

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.