ExxonMobil (NYSE:XOM) has been facing a deteriorating business environment along with every one of its peers. Exxon has a culture of continuous improvement and operating expertise that is second to none. Its focus on industry-leading returns, safety, and great employees has brought it to the forefront of many dividend portfolios. Perhaps then, it is strange that I recommend selling the stock.
An analysis of any business should focus on the sum of all future cash flows discounted to today. Throughout the commodity cycle, this allows investors to gain from both stock price appreciation and dividend payments. Consequently, for the last 40 years, it has been a viable strategy to buy ExxonMobil during a bear cycle, and either hold onto it forever or sell at the top (easier said than done). When I look at ExxonMobil today, I see a company that does not have the positive economic outlook that has fed it for many years. Indeed, any oil company could represent value at $30 oil, even $20 oil, but that all depends on the value ascribed by the share price.
For ExxonMobil, the optimism and lack of risk analysis represented in the stock price are staggering. And, while not alone in this situation, is one of the most prominent to analyze - specifically due to their aforementioned industry leading practices.
Free Cash Flow
It is important to ask the question. How important is free cash flow to a company like Exxon? One thing that I often see discounted when analyzing oil companies is the degradation of their assets.
Oil (or gas) in the ground has value. It can arguably be ascribed the value that it can be sold for minus the extraction costs at a future point in time. It follows that if we expect oil to be worth $100 in two years, then there is a clear economic case for tailing production back, and preserving assets without executing the exercise to calculate NPV. In practice this doesn't work, companies have debt payments to make, quarterly earning forecasts to hit, and dividends to pay.
When we look at free cash flow, dividend payments and Capex for ExxonMobil, we see the incredulous scenario. To pay dividends and just maintain production rates, XOM is footing a bill in excess of $7 billion over free cash flow quarterly.
XOM Free Cash Flow (Quarterly) data by YCharts
I could buy the idea that ExxonMobil is owned by investors that have expectations of a dividend. I also can understand the hope to continue to pay those dividends through the bear cycle, as before the company has come out the other end and paid down the debt used to fund dividends during the bottom. What I don't understand is why a company must do this into perpetuity. Eventually, the market must know that the balancing act is longer than normal - Perhaps, as this author proposes, this time is different. It is hard to disprove the argument that as oil prices rise, shale will come back online. This belief has the compounded effect of drawing an OPEC response, thus guaranteeing the one thing that was feared. However, that is a point for already written articles.
Onto the idea of asset degradation - something I think is severely misunderstood. In an oil field, nearly every day is worse than the day before it (barring an intervention such as drilling, secondary and tertiary techniques, etc.). In effect, you are wasting the best days of the oil fields life when either little or no profit is made. There is a cost involved with idling or shutting down an area, but for new fields and expansions, the argument is much simpler.
This is not typically done due to all those promises of cash flow at the quarterly, dividend payments, and well commitments. Something has to pay for it. Therefore, on go the oil companies spending money to increase production despite the internal hurdle rates not being met (except at some assumed future price). We should not view ExxonMobil's capital expense program from the eye of "getting ready for the next bull market", but instead of maintaining asset values at the lowest cost. I have little doubt that Exxon will continue to spend capital to this effect, but it is less clear whether the returns justify the price.
If The Market Turns Around
If the market turns around for ExxonMobil, they will not be bigger than they were before entering the bear market. This was typical of bear markets past. Few major takeovers have occurred, and so many companies are now betting on the turnaround that asset sales have been limited (and at questionable prices). This is why I find it so strange that ExxonMobil's price has sat close to all-time highs as recently as last week.
As a result of this style of financing Exxon's debt has ballooned higher than anything seen before. There is safety in the weakness of interest rates, but this tells an interesting story of the company.
XOM Total Long Term Debt (Quarterly) data by YCharts
To maintain production levels from cratering, which have dropped by 8.5% this quarter alone, ExxonMobil has been betting increasingly on debt financing. Free cash flow has been on a downward trajectory since its peak before the GFC. This spells concern for shareholders counting on the dividend.
XOM Free Cash Flow (Quarterly) data by YCharts
Will The Dividend Be Cut?
The last time I predicted a company cutting the dividend, it took the company several months. It was BHP (NYSE:BHP), and I certainly can say BHP was in a much tighter corner than XOM is at present. What I do expect is that at some point, major shareholders will push ExxonMobil to slash the dividend and cut capital expense to buy assets. Those assets can then be left in the ground until the oil price appreciates. However, this comes with the caveat that prices rise - something I doubt will happen in earnest before 2018.
For now, I see ExxonMobil as a company that will be around for many years. It is always the best that survive- However, it is not always the best that thrive. Just because Exxon operates well, does not mean that the actions being taken are in the long-term best interests of shareholders. I continue to see Exxon as vastly overpriced. And, while I don't recommend shorting the stock, I recommend current holders and prospective buyers to take a second look at the numbers to understand where all that money is heading.
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.