Chevron Still In Investment-Grade Territory - Does That Equal Worthy Investment?

| About: Chevron Corporation (CVX)


Chevron’s balance sheet is firmly in investment grade territory, but its financial health has deteriorated in recent quarters.

Chevron has a large debt position, and while scaling back investment in these uncertain times will help shore up flexibility, it also means the growth outlook is not as rosy.

Management's target for free cash flow covering the dividend by 2017 may be too optimistic if commodity prices do not recover.

Let's take a look at the firm's investment considerations as we attempt to uncover the drivers behind its Dividend Cushion ratio.

By The Valuentum Team

Chevron may need to cut capital spending more to free up additional cash. The company's dividend strength isn't as strong as it once was.

--> Chevron (NYSE:CVX) is engaged in integrated petroleum operations, chemicals operations, mining activities, power generation and energy services. The upstream and downstream activities of the company are widely dispersed geographically. The company was founded in 1879 and is headquartered in California.

--> Chevron is a fantastic company and one that we have included in the Dividend Growth portfolio in the past. However, its Dividend Cushion ratio has soured as of late and so have our views on the pace of dividend expansion.

--> On an indexed basis (2007), Chevron tops peers BP, Shell, Total, and Exxon in average capital employed. Against that same peer group, the firm's adjusted return on capital employed, which approximates our ROIC measure, has been consistently second (behind Exxon). Cash flow per share has been at the top of this peer group, however, allowing it to buy back $40+ billion worth of shares since 2004.

--> Chevron's balance sheet is firmly in investment grade territory, but its financial health has deteriorated in recent quarters. The firm's primary competitors all boast a larger net debt position, however. A strong balance sheet is crucial in a commodity-producing business to withstand cyclical troughs and to sustain dividend growth.

--> Chevron's downstream performance should help buoy earnings that have suffered as a result of crude-oil price declines. Deliberate actions to lower its cost structure in the face of potentially permanently lower energy prices have become the norm.

Note: Chevron's annual dividend yield is above average, offering a ~5.1% yield at recent price levels. Though we prefer yields above 3%, other factors keep us from considering adding Chevron to our dividend growth portfolio. This article explains why.

Dividend Strengths

Chevron had once been our favorite dividend growth idea among the major oil and gas producers. Not only were its economic returns strong, but the company had a strong net cash position on the balance sheet, something that was lacking at its peers. All of that changed with the recent collapse in energy resource pricing, however. Now the company reveals a large net debt position, and while scaling back investment in these uncertain times will help shore up flexibility, it also means the growth outlook is not as
rosy. It has recently expanded its asset sales program and is optimistically targeting free cash flow to cover the dividend by 2017. Chevron's downstream operations will help, and capital spending could dip as low as $20-$24 billion in 2017-2018.

Dividend Weaknesses

Chevron has a nice dividend growth track record, nearly 30 consecutive annual dividend increases through 2015, amounting to a compound annual growth rate of ~11% since 2004. Its financial priorities remain unchanged: grow the dividend and maintain a AA credit rating, while returning excess cash to shareholders. The collapse in energy resource pricing won't make achieving such priorities easy, however, and management's target for free cash flow covering the dividend by 2017 may be too optimistic if commodity prices do not recover. Asset sales will help, but those only bring cash flow forward. A Dividend Cushion ratio below 1 speaks of risk to the payout; more costs must be cut.

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.

Dividend Safety

We think the safety of Chevron's dividend is very poor. Please let us explain.

First, 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 Chevron, this ratio is 0, revealing that on its current path the firm would have difficulty being able to cover its future dividends and growth in them with net cash on hand and future free cash flow (over this discrete forecast horizon).

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. Chevron'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 less 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, Chevron's numerator is smaller than its denominator suggesting weak 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."

Dividend Growth

Now on to the potential growth of Chevron'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. However, this is not the case for Chevron, which is categorized as very poor.

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 Chevron '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

The deterioration of Chevron's financial health may be cause for concern, but the firm's credit rating remains firmly in investment grade territory. Unlike many of its peers, the firm did not find itself on Moody's list of energy companies on review for potential credit rating downgrade. However, we continue to prefer firms that have strong balance sheets and can cover dividend payments with free cash flow, which is not the case for Chevron. Based on the company's poor Dividend Cushion ratio, we think there are better dividend growth ideas available.

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.

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.

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