Every now and then the market gets really nervous about one aspect of a company's financial picture without weighing all the variables that will influence the future of the company. In the case of Chevron (NYSE:CVX), the market has been really nervous about management's decision to increase the debt of the company in the current pricing environment.
Source: Chevron June, 2016, Investor Presentation
On the one hand, the short-fall between the cash flow (click on the June, 2016 investor presentation) and the capital budget, in the first slide has gotten a lot of coverage. But the second slide gets severely discounted by the market. Sometimes, though Mr. Market has a hard time telling the difference between companies such as Energy XXI (EXXI) and this company when it comes to cash flow short-falls and what it means for their survivability.
Energy XXI had so much debt that any cash short-fall was fatal. The total debt service was a significant contributor to the operating cost of the company. In fact that debt service turned the company from an efficient competitor into a high cost competitor which is fatal in the current low commodity price environment.
Chevron on the other hand has a low debt level when compared to shareholder equity and the assets behind that debt. While cash flow fell precipitously in the first quarter, the company still had cash flow. In fact, despite borrowing nearly $4 billion, the long term debt remained at the same level of $33 billion from a year ago. While short term debt approximately doubled to $9 billion, the current ratio remained at a very reasonable 1:1 and the total debt of $42 billion also remained very reasonable when compared to shareholders equity. This company could borrow quite a bit more (probably $40 billion more or so) before having to worry about the consequences of the amount of the debt on the balance sheet. So the company is at least several years away from any kind of debt crisis.
Cash flow (when annualized) to long term debt was about a 1:8 in the first quarter which is not the greatest ratio and normally would be a cause for concern. However, the company has indicated some cost reduction initiatives in process as well the ending of some long term capital projects that is corresponding to the beginning of cash flow from these projects. Plus the company has had considerable success selling assets. There is a recognition that the assets cover the debt and any future foreseeable debt quite comfortably. The company continues to have a superior financial strength rating, and its debt remains quite low even among its peers. Such financial discipline is not likely to disappear quickly.
While the future capital budget is likely to dip below $20 billion a year if the current market conditions last into that future projection shown on the second slide, the market has fretted over the possible debt implications of such a move. But the market does not appear to have factored the impact of cash flow from completed major projects and the effect of cost reduction initiatives underway. The net result of this is a prediction of a debt explosion that is very unlikely to occur given the company's financial strength rating.
Source: Chevron June, 2016, Investor Presentation
The above slides show two of the many projects (click on the June, 2016, presentation) included in the capital budget. These two sizeable projects will soon be contributing to cash flow. There are many more projects in the pipeline for the investor to review. In each case the company retains options to either shut down the project or sell the project.
Source: Chevron, June, 2016, Investor Presentation
As shown in the slides above, the company (click on the June, 2016 presentation) is doing exactly what one would expect management to do in an environment such as this. First, the suitable assets are being sold. Of course that goal is flexible and can be increased or decreased as market conditions change. Second, the company is shifting its priorities to higher return and shorter cycle projects.
But this means if the remaining capital projects have a budget, and that budget means loaning money, then a management with a far above average track record believes that loaning the money to finish the project will be profitable. Depending upon the investor's viewpoint that could also mean that management is somewhat bullish on the future of the industry even though the capital budget has been cut.
The company has the alternative of selling any or all the capital projects or shutting them down and simply collecting the money from current production. Management could use the proceeds to pay off the debt and then gradually liquidate the company as the cash flow from current production arrived. The fact that management chose not to do this should inspire some hope for the future of the industry and not fear of the viability of the company.
In the meantime it is clearly early in the industry recovery, if indeed this is the start of the recovery. Cyclical stocks such as this tend to look expensive and indeed there could well be a pull back at which point it would be clear for investors to jump in for good return at very below average risk. However, this stock has gone nowhere for years and indeed dropped with the commodity price drop. But companies of this quality do not stay down long, so dollar cost averaging may be indicated (pullbacks are not guaranteed). A stock such as this should reward investors by doubling over the next five years as the cost cutting takes effect, cash flow increases as the capital projects come online, and the change in capital project investing takes effect. The stock will probably have a bright future until Mr. Market figures that above average profit margins will continue forever. At that point caution will be advised. But right now, Mr. Market is wondering if the company will ever make a profit again, so that is probably the time for investors to consider a position in one of the least risky stocks in the market.
Disclaimer: I am not an investment advisor and this is not a recommendation to buy or sell a security. Investors are recommended to read all of the company's filings and press releases as well as do their own research to determine if the company fits their own investment objectives and risk portfolios.
Disclosure: I am/we are long EXIXF.
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.