Chevron's Dividend Growth Coming Back?

| About: Chevron Corporation (CVX)

Summary

Chevron had once been our favorite dividend growth idea among the major oil and gas producers.

While Chevron scaling back investment in these uncertain times will help shore up flexibility, it also means the growth outlook is not as rosy.

Chevron's financial priorities remain unchanged: grow the dividend and maintain a AA credit rating, while returning excess cash to shareholders.

Let's take a look at the firm's investment considerations as we walk through the valuation process and derive a fair value estimate for shares.

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By The Valuentum Team

Chevron (NYSE:CVX) had once been our favorite dividend growth idea among the major oil and gas producers. Not only were its economic returns strong, but years ago, the energy resource giant had a strong net cash position on the balance sheet, something that was lacking at its peers. Chevron even had a nice dividend growth track record of nearly 30 consecutive annual dividend increases through 2015, amounting to a compound annual growth rate of ~11% since 2004.

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 $17-$22 billion in 2017-2018. Still, Chevron failed to raise its dividend during 2015, snapping its long annual consecutive growth streak.

Chevron's financial priorities remain unchanged: grow the dividend (shares currently yield nearly 4%) 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. Depending on how good those divested assets are, for example, it may turn out to be a bad deal over the long haul.

The company's Dividend Cushion ratio has begun to improve (it now sits at 1.1), but we must note our forward-looking assumptions include a relatively optimistic outlook for oil prices in 2017.

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In any case, Chevron is breathing a sigh of relief with crude oil prices nearly doubling from the depths of the mid-$20s per barrel only a few short months ago. Let's talk more about our investment thesis in Chevron.

Chevron's Investment Considerations

For the definition of terms in this article, please access Valuentum's glossary here.

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Investment Highlights

• Chevron 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 majority of the firm's primary competitors boast larger net debt positions, 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.

Business Quality

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Economic Profit Analysis

In our view, 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 4.3%, which is below the estimate of its cost of capital of 9.7%. As such, we assign the firm a ValueCreation™ rating of POOR.

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.

Image source: Valuentum

Image source: Valuentum

Cash Flow Analysis

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Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Chevron's free cash flow margin has averaged about -3.5% 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 44% from levels registered two years ago, while capital expenditures fell about 22% over the same time period.

Valuation Analysis

We think Chevron is worth $107 per share with a fair value range of $69-$145.

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 model reflects a compound annual revenue growth rate of 9.7% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -17%.

Our model reflects a 5-year projected average operating margin of 9.4%, which is above Chevron's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3% for the next 15 years and 3% in perpetuity. For Chevron, we use a 9.7% weighted average cost of capital to discount future free cash flows.

Image source: Valuentum

Image source: Valuentum

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Image source: Valuentum

Margin of Safety Analysis

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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 $107 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.

Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Chevron. We think the firm is attractive below $69 per share (the green line), but quite expensive above $145 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

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We estimate Chevron's fair value at this point in time to be about $107 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 $130 per share in Year 3 represents our existing fair value per share of $107 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.

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.