Chevron's Investment Considerations
• 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. Followers of our research were far ahead of the collapse in the energy-resource pricing markets.
• On an indexed basis (2007), Chevron tops peers BP (NYSE:BP), Shell (NYSE:SHLX), Total (NYSE:TOT), and Exxon (NYSE:XOM) 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. This has been on full display over the past 12-18 months, though junk has rallied quite a bit in the past few weeks.
• 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.
• 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.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. Chevron's 3-year historical return on invested capital (without goodwill) is 10.6%, which is above the estimate of its cost of capital of 9.9%. As such, we assign the firm a ValueCreation™ rating of GOOD.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Companies that have strong economic profit spreads are often also solid free cash flow generators, which also lends itself to dividend strength. Chevron's Dividend Cushion ratio, a forward-looking measure that takes into account our projections for future free cash flows along with net cash on the balance sheet and dividends expected to be paid, is negative 0.3 (anything above 1 is considered strong).
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cost. Chevron's free cash flow margin has averaged about 0% during the past 3 years. As such, we think the firm's cash flow generation is relatively WEAK.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Chevron, cash flow from operations decreased about 19% from levels registered two years ago, while capital expenditures expanded about 14% over the same time period.
In fiscal 2015, Chevron reported cash flow from operations of ~$19.5 billion and capital expenditures of ~$29.5 billion, resulting in negative free cash flow generation of just over $10 billion. This compares negatively to fiscal 2014's free cash flow generation of negative $4 billion.
This is the most important portion of our analysis. Below we outline our valuation assumptions and derive a fair value estimate for shares.
We think Chevron is worth $101 per share with a fair value range of $81-$121. Shares are currently trading at ~$102 per share, very close to our fair value estimate. This indicates that we feel there is a similar amount of downside risk and upside potential associated with shares at this time.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our long-term forecasts for energy resource pricing can be found here.
Our model reflects a compound annual revenue growth rate of -3.6% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -5.8%. Our model reflects a 5-year projected average operating margin of 10.5%, which is below Chevron's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 3.6% for the next 15 years and 3% in perpetuity. For Chevron, we use a 9.9% weighted average cost of capital to discount future free cash flows.
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $101 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
In the graph above, we show this probable range of fair values for Chevron. We think the firm is attractive below $81 per share (the green line), but quite expensive above $121 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Chevron's fair value at this point in time to be about $101 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Chevron's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $122 per share in Year 3 represents our existing fair value per share of $101 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Wrapping Things Up
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. 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 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. 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. All things considered, 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, and we're not interested in the firm at current price levels after considering its operating environment and financial situation.
Chevron currently registers a 6 on the Valuentum Buying Index. This isn't the worst rating but it's not the best either.
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.