Exxon Mobil: A Safe Long-Term Bet

May.25.12 | About: Exxon Mobil (XOM)

Exxon Mobil (NYSE:XOM) is an integrated oil and gas company, with $486 billion in revenue in 2011. Exxon is one of the world's largest companies with a market capitalization of nearly $400 billion. Its main competitors are Chevron (NYSE:CVX), British Petroleum (NYSE:BP), and Royal Dutch Shell (NYSE:RDS.A),(NYSE:RDS.B).

Click to enlargeClick to enlarge

Exxon stock has risen substantially from the mid-50s in the middle of 2010 to the mid-80s today, currently trading at $82.61. Here's Exxon's recent financial data.

(In Million $) 2007 2008 2009 2010 2011
Revenue $404,552 $477,359 $310,586 $383,221 $486,429
Operating Cash Flow $52,002 $59,725 $28,438 $48,413 $55,345
Capital Expenditure $-15,387 $-19,318 $-22,491 $-26,871 $-30,975
Free Cash Flow $36,615 $40,407 $5,947 $21,542 $24,370
Click to enlarge

Capital expenditures have doubled since 2007, while operating cash flow has increased much more modestly. The company has guided for capital expenditures of about $37 billion annually going forward.

Owner Earnings

Owner Earnings is a better measure for valuation purposes than free cash flow. Warren Buffett defines Owner Earnings as follows:

These represent (1) reported earnings plus (2) depreciation, depletion, amortization, and certain other non-cash charges... less (3) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume... Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (3) must be a guess - and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes.

I'll calculate Owner earnings by taking the Net Income and adding back various non-cash items, such as depreciation, and then subtracting the 2-year average Capital Expenditures. I'll also add interest payments adjusted for taxes since interest is tax deductible.

(In Million $) 2007 2008 2009 2010 2011
Net income $40,610 $46,867 $19,658 $31,398 $42,206
Depreciation & amortization $12,250 $12,379 $11,917 $14,760 $15,583
Investment/asset impairment charges $0 $-63 $0 $0 $0
Other non-cash items $-2,121 $-2,289 $-1,978 $-455 $-1,574
Interest Payments $400 $673 $548 $259 $247
Avg Capital Expenditure $-29,000 $-29,000 $-29,000 $-29,000 $-29,000
Owner Earnings $21,969 $28,272 $906 $16,856 $27,357
Click to enlarge

Owner earnings smooth out capital expenditures and provide a clearer picture of the profitability of the company. Let's use the Owner Earnings figures to determine Exxon's Cash Return on Invested Capital, or CROIC. This is the cash return generated by the company on invested capital, and is simply the Owner Earnings divided by the total invested capital. This is a better measure than ROIC because ROIC relies on earnings, which is a poor measure of profitability.

(In Million $) 2007 2008 2009 2010 2011
Owner Earnings $21,969 $28,272 $906 $16,856 $27,357
Invested Capital $242,082 $228,052 $233,323 $302,510 $331,052
CROIC 9.08% 12.4% 0.39% 5.57% 8.26%
Click to enlarge

Exxon's CROIC has recovered since 2009, but large increases in capital expenditures puts into doubt the companies ability to reach pre-recession efficiency. Here is Exxon's latest balance sheet:

Cash and Cash Equivalents $12,664
Investments $34,333
Debt $38,140
Pension Obligations $24,994
Minority Interest $6,348
Net Cash (Debt) $-22,485
Diluted Float 4,843
Cash/Share $-4.64
Click to enlarge

Exxon has $47 billion in cash and investments compared to $38 billion in debt. I also include pension obligations of $24 billion and minority interest of $6.3 billion as liabilities, leaving $4.64 in net debt per share. With Exxon's interest payments being a minute fraction of their free cash flow, the balance sheet looks fairly strong.

Valuation

I use a discounted cash flow analysis to estimate the fair value of a company. I will use a discount rate of both 12% and 15% and use these two values to define a fair value range. You can read about my view on discount rates here. I will assume that owner earnings will grow at 9% next year and that the growth rate will decay over 20 years to a perpetual value of 3%, as per the growth table below.

Year 1 2 3 4 5 6 7 8 9 10
% 9% 8.7% 8.4% 8.1% 7.8% 7.5% 7.2% 6.9% 6.6% 6.3%
Year 11 12 13 14 15 16 17 18 19 20
% 6% 5.7% 5.4% 5.1% 4.8% 4.5% 4.2% 3.9% 3.6% 3.3%
Click to enlarge

Using the above parameters, I arrive at a fair value range of $64.50 - $91.52 for a share of Exxon.

Conclusion

With Exxon currently trading at $82.61, the stock falls towards the upper end of my fair value range. The big concern going forward is whether the massive increases in capital expenditures will lead to comparable increases in cash flow. With capex taking up a larger and larger portion of revenue, it remains to be seen whether this behemoth of a company can deliver sufficient growth going forward. But given that demand for energy will continue to grow into the future and Exxon's enormous size and dominate position in the oil and natural gas markets, Exxon Mobil is probably the safest long-term bet in the energy industry.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.