Chevron: How Safe Is The Dividend?

| About: Chevron Corporation (CVX)

Chevron (NYSE:CVX) looks enticing when taking a cursory look at the historical dividend statistics.

The stock currently yields around 4.3% and has provided highly reliable dividend growth over the years.

Chevron's dividend has increased by 7.8% per year over the last 20 years and by 8.5% annually over the last five years.

The company is also a dividend aristocrat, having raised its dividend for over 28 straight years. Investors can learn more about dividend aristocrats and download their data here.

Despite Chevron's appealing historical dividend growth, income investors have been burned over the past year with a number of high profile dividend cuts in the oil and gas industry.

While Chevron has been a favorite blue-chip dividend stock that has padded dividend investors' portfolios for years, we think it is prudent to analyze the business to determine if Chevron could be the next one to cut their dividend in this historic oil and gas downturn.

Business Analysis

Chevron is a global integrated oil and gas company.

Their upstream operations (~26% of 2015 revenue) consist of exploring for, developing, and producing crude oil and natural gas; processing, liquefaction, transportation and regasification associated with liquefied natural gas; and transporting the crude and natural gas.

The downstream operations (~73% of 2015 revenue) consist of refining crude oil into petroleum products; marketing of crude and refined products; transporting crude oil and refined products by pipeline, marine vessel, and rail car; and manufacturing and marketing of commodity petrochemicals, plastics, fuel additives, and lubricants.

As of the end of 2015, Chevron had significant net proved reserves in their upstream business. These net proved reserves totaled an estimated 6.26 billion barrels of oil and 29.4 billion cubic feet of natural gas.

Their reserves do have some geographic concentrations with 21% of the net proved reserved located in Kazakhstan and 19% located in the United States.

During 2015 Chevron continued to expand production with oil-equivalent production of 2.62 million barrels per day, which was up 2% year-over-year from 2014 levels.

For 2016 the company estimates that worldwide oil-equivalent production will be flat to up 4% compared to 2015.

The business has struggled since the dramatic collapse in oil prices. Revenue in the upstream segment was down 47% from 2013 to 2015, and the downstream business was down nearly 43% over the same time period.

Clearly the largest driver of revenue and profits for the business is the price of oil. We are not experts at forecasting the price, nor do we believe there are many people who can consistently, accurately forecast the price.

According to the Energy Information Agency's Annual Energy Outlook 2016 report, which is probably as good as any, the price for West Texas Intermediate (WTI) is expected to increase 4% per year from 2015-2040 while Brent is expected to increase at 3.9% over the same timeframe.

It is anybody's guess as to what the future holds for energy prices, but it is unlikely that energy prices will remain at depressed levels for decades into the future.

While the current environment is not good for Chevron and could get worse, it is unlikely to stay this bad for an extended period of time.

Let's take a look at how much longer Chevron can potentially maintain its dividend in today's environment.

Dividend Safety Analysis: Chevron

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. Chevron's dividend and fundamental data charts can all be seen by clicking here.

Our Dividend Safety Score answers the question, "Is the current dividend payment safe?" We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

Click to enlarge

Chevron's Dividend Safety Score is 25, which indicates that the dividend is risky based solely on the company's fundamentals. When Conoco Phillips cut its dividend earlier this year, it had a Safety Score of 17.

However, Chevron's management team publicly remains very committed to the dividend. Here is Patricia Yarrington, the CFO, on the Q2 2016 earnings call:

"Our financial priorities remain unchanged. We're committed to growing the dividend as earnings and cash flow permit. We recognize the value our shareholders place on dividends and the value they place on our long term annual dividend payment increases."

Source: Seeking Alpha

She further elaborated on the importance of the dividend:

"…we've had the same financial priorities for a long time. Dividend return to shareholders being first, and then reinvestment in the business second, and then having a prudent financial structure being third. And I don't see those priorities changing going forward."

Source: Seeking Alpha

Chevron's quarterly dividend has remained frozen at $1.07 per share for 10 quarters, highlighting the pressure the business is under.

Let's investigate some of the key ratios and drivers of the Dividend Safety Score to determine if the dividend is at risk of a cut.

Currently, analysts expect Chevron to generate EPS of $1.29 for Fiscal Year 2016, and we expect the company to pay out about $4.28 per share in dividends this fiscal year (assuming no dividend increase or cut from 2015 levels).

This implies a payout ratio of about 232%. Clearly that is unsustainable. Even looking out to next year when analysts expect Chevron to earn $5.24 per share, a stable dividend would imply a payout ratio of 82%, which is well above the historical levels.

Chevron CVX Dividend Safe

Source: Simply Safe Dividends

The company did not generate positive free cash flow in 2015 and is not generating positive free cash flow year-to-date in 2016 either.

So far this year, Chevron has used $14 billion of cash on capital expenditures ($10 billion) and dividends ($4 billion) while only generating $3.7 billion in cash from operations.

These payout ratios are not healthy for a cyclical oil and gas business and could indicate a dividend cut is on the horizon if the company cannot continue raising funds in other ways.

As of the end of Q2 2016, the Chevron had about $9 billion in cash and marketable securities on its balance sheet. This cash position was offset by $5.53 billion in short term debt and about $39.5 billion in long-term debt.

On an annualized basis, the company will spend about $8 billion dollars on dividend payments. Therefore, Chevron only has enough cash to fund about half a year's worth of dividend payments.

For the company to maintain the dividend when it is not generating positive free cash flow and doesn't have the cash balance, they need to drastically improve the cash position on the balance sheet. They are doing this through asset sales, capital expenditure cuts, SG&A and operating expense reductions, and borrowing money.

So far this year, Chevron has sold assets worth about $1.4 billion dollars and is targeting asset sales of $5-10 billion dollars for 2016-2017. While this could incrementally help fund the dividend, it is not and cannot be a multi-year solution.

Another focus area for management is reducing capital expenditures and expenses.

Capital expenditures are trending lower so far this year with spending down to $10 billion versus the 2015 level of $15.2 billion through the first six months.

Furthermore, for 2017-2018 management is guiding for capital expenditures to be in the range of $17 billion-$22 billion. This is a huge step down from the $29.5 billion, $35.4 billion, and $38 billion spent in 2015, 2014, and 2013, respectively.

While not as drastic as the capital expenditure cuts, management has been reducing SG&A and operating expenses as another way to preserve cash. Through the first six months of 2016, SG&A is down about $100 million to $2 billion dollars, and operating expenses are down about $1 billion to $10.5 billion.

Patricia Yarrington, the CFO, spoke about this cost line-item on the most recent earnings conference call:

"Year-to-date operating expense is also down, down 8% when compared to 2015. And we expect a downward quarterly trend to continue in the second half of this year, as we realize the full-year run rate of organization actions and supply chain initiatives."

Source: Seeking Alpha

These initiatives by management are not enough to get the company cash flow positive in the near term, so the way management plans to fund the dividend while generating negative free cash flow is through additional borrowings.

Chevron is certainly in a much better financial position than other companies in the oil and gas industry and could continue to increase debt levels higher for a considerable amount of time.

However, this is our least preferred method for funding the dividend because it lowers the equity value of the business, increases balance sheet risk, and makes the company even more dependent on fickle financial markets.

Earlier this year Moody's downgraded the senior unsecured ratings of Chevron from Aa2 to Aa1. The basis of the downgrade was their expectations for continued negative free cash flow and rising debt levels through 2016 and 2017 due to low oil prices.

Our best guess is that as long as debt capital markets continue to be available and the dividend is management's #1 priority, Chevron can continue to fund it.

However, if capital markets freeze and the oil and gas environment remains challenging beyond the next year or so, management will have to cut the dividend to preserve the company.

Dividend Growth Analysis

Our Growth Score answers the question, "How fast is the dividend likely to grow?" It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

Chevron's Dividend Growth Score is 3, which indicates that the dividend has very poor growth potential.

The company has raised its dividend for 28 straight years, but an increase this year would mean that Chevron has to borrow even more money to fund the increase rather than boosting the payout due to rising cash flow.

Chevron CVX Dividend Safe

Source: Simply Safe Dividends

Chevron's CFO commented on how they are thinking about keeping the dividend growth streak alive:

"What I can say is that we're fully aware of the 28-year annual dividend payment increase. We're also fully aware that an increase needs to occur in 2016 if we are to keep that pattern alive. The board fully understands the value of the dividend increase and they understand the value of growing the dividend over time. So the board will be looking at cash generation and our ability from a sustainability sense to support a higher dividend going forward."

Source: Seeking Alpha

She continued:

"I guess I would just reiterate. We do see our cash flow circumstance improving over time here. We've got the confidence in our future growth, in production. We've got confidence in our future cash generation. I'll take you back to the $2 per barrel margin increase that we showed at the Security Analyst Day on the portfolio. Assuming flat commodity prices, that's the margin accretion that we get out of these LNG projects predominantly. It raises the cash margin on the entire portfolio. And we also believe that we can compete very successfully and sustainably over time here with a much lower capital program because we've got assets, for example, like the Permian and other unconventionals. So we feel very comfortable about what our future holds."

Source: Seeking Alpha

Simply put, if oil prices increase, then Chevron can probably continue to increase the dividend at a low rate. However, if oil prices are stable to declining, it will be very difficult to sustainably increase the dividend without just borrowing more to fund the increase. We believe this to be a risky capital allocation decision and puts the value of the company at risk.

Investors should not count on substantial future dividend increases unless the price of oil moves substantially higher.

Valuation

Chevron currently trades at over 70x 2016 expected earnings and roughly 19x 2017 estimates.

Future profits for the company are very difficult to forecast because they are not only predicated on management executing on their strategy of production growth and lowering the cost structure, but most important is the price of oil.

Control of the global oil market is somewhat up for grabs over the next five years, and it's not out of the question that prices remain below $55 per barrel for at least the next 1-2 years.

Since we don't believe we can accurately forecast the most important driver for the company, we cannot predict a normalized earnings growth rate.

All we can say is that an investor must have a positive viewpoint on oil prices, Chevron's capital allocation decisions, and the company's financial strength in order to make an investment in the stock.

Conclusion

Chevron is one of the largest integrated oil and gas companies in the world with a great history of 28 consecutive years of dividend increases, a 20-year dividend CAGR (compound annual growth rate) of nearly 8%, and a current yield near 4.3%.

These are some of the dividend statistics we love to see when looking at prospective investments.

However, Chevron's low Dividend Safety Score indicates the real financial pressure the company faces. There is certainly a reason why investors haven't received a quarterly dividend increase in more than two years.

Chevron's management team is doing everything they can to preserve cash, including selling assets, cutting capital expenditures, and reducing SG&A and operating expense spend.

Even with all of these actions, they are still currently free cash flow negative and must fund the dividend through additional borrowings.

While this strategy of funding the dividend will work in the short-term, this is not a sustainable solution if oil prices remain at lower levels and the debt capital market environment becomes less friendly.

As a result, we are not adding Chevron to any of our portfolios despite the seemingly attractive 4.3% yield.

Ultra-conservative income investors might want to consider companies that score higher for Dividend Safety. They can learn more about how Dividend Safety Scores are calculated and how they can help find safer dividend stocks here.