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Back to Part V

By Mark Bern, CPA CFA

Part V provided an overview of my views on the oil industry and why I believe that oil will continue to be a great long-term investment, especially for those seeking both total return and a rising stream of income. I also revealed my top picks from the integrated oil industry and explained how I rated those companies superior to their peers. This article is intended to explain why other widely-held companies in the industry did not make the cut. If you wonder what measures I use to select the quality companies from each industry please refer back to the first article in this series.

Since a reader asked specifically about Total (NYSE:TOT) I will begin there. Another reader (chowder) who had previously owned TOT explained why he sold the stock in favor of CVX and COP. I am paraphrasing to cut down on length: Over the last ten years he held CVX, COP, EOM (I believe this is XOM), RDS.B, and TOT. The annual returns ranged from a high of 12.6 percent from CVX to a low of 7.0 percent from TOT. TOT was the worst performer of the lot. In addition, foreign stocks like TOT withhold taxes from dividends and it is impossible to recoup the taxes if the stock is held in a retirement account.

But that is only part of the story. Next let's take a look at how TOT stands up when measured against my metrics.

Metrics

Total

Industry Averages

Grade

Dividend Yield

6.1%

3.9%

Pass

Debt-to-Capital Ratio

25.0%

14.8%

Neutral

Payout Ratio

44.0%

27.0%

Fail

5-Yr Average Annual Dividend Growth

7.3%

N/A

Neutral

Free Cash Flow per Share

-$4.21

N/A

Fail

Net Profit Margin

6.9%

7.4%

Neutral

5-Yr Average Annual Growth in EPS

.7%

3.0%

Fail

5-Yr Average Annual Growth in Revenue

10.3%

-.02%

Pass

Return on Total Capital

14.0%

17.5%

Fail

S&P Credit Rating

AA-

N/A

Pass

This is not a favorable report card; four fails, three neutrals and three passes. The dividend is great, but when a company has to borrow money every year to pay its dividend it is not really an ideal situation; far from it. Revenue growth is good but it needs to lead to similar or higher growth in earnings and TOT has not demonstrated that its cost structure allows this. I do not expect TOT's total returns to continue to be so woeful, but neither do I expect the company to perform as well as its peers.

I want to take a look at Suncor (NYSE:SU) next because even though I really like several things about the company it could not make the master list cut. SU has great assets and superior potential, but the company needs to become more consistent in the future to make the grade.

Metrics

Suncor

Industry Averages

Grade

Dividend Yield

1.4%

3.9%

Fail

Debt-to-Capital Ratio

21.0%

14.8%

Neutral

Payout Ratio

15%

27.0%

Pass

5-Yr Average Annual Dividend Growth

23.9%

N/A

Pass

Free Cash Flow per Share

$0.03

N/A

Pass

Net Profit Margin

10.8%

7.4%

Pass

5-Yr Average Annual Growth in EPS

1.2%

3.0%

Fail

5-Yr Average Annual Growth in Revenue

8.2%

-.02%

Pass

Return on Total Capital

8.9%

17.5%

Fail

S&P Credit Rating

BBB+

N/A

Pass

With one neutral three fail ratings I could not, in good conscience, put SU on my master list. The dividend is too low. The return on capital is lower than I like and the EPS growth needs to improve. I believe that EPS growth will improve as will the return on capital. The EPS problem is really one of consistency rather than growth. The company's EPS fell more than 50 percent in 2009. But the future holds tremendous potential growth, in my opinion, and I estimate total return could exceed 20 percent on average over the next five years.

Petrobras (NYSE:PBR) is another foreign oil giant with huge potential. The company has huge oil finds in deep water that will require very significant investment to produce. There are some technical hurdles to be overcome, but I suspect that the company has the experience and expertise to do so. This one has more risk due to potential spills in the ultra-deep water environment, but once the company has achieved production it could be a very interesting investment for long-term investors. Let's see how the company fares against the metrics.

Metrics

PBR

Industry Averages

Grade

Dividend Yield

5.8%

3.9%

Pass

Debt-to-Capital Ratio

28.0%

14.8%

Neutral

Payout Ratio

5.0%

27.0%

Pass

5-Yr Average Annual Dividend Growth

-14.7%

N/A

Fail

Free Cash Flow per Share

-$5.08

N/A

Fail

Net Profit Margin

13.6%

7.4%

Pass

5-Yr Average Annual Growth in EPS

2.4%

3.0%

Neutral

5-Yr Average Annual Growth in Revenue

6.7%

-.02%

Pass

Return on Total Capital

8.5%

17.5%

Fail

S&P Credit Rating

BBB

N/A

Pass

PBR has a lot of potential with a reserves-to-production ratio of 14.5 years, but carries higher than normal risks due to the dependence on deep-water reserves yet to be developed. But a company that fails on three metrics, and especially when one of those is cash flow, it just harbors too much risk to qualify for my master list.

Royal Dutch Shell (NYSE:RDS.A) is another foreign major integrated oil company. It is, as noted in the comment by chowder above under the first paragraph on Total, not a good choice for a tax advantaged account. One reason is that the company does not allow reinvestment of shares into the B shares and the other reason is that the A shares have the taxes withheld and investors will not be able to retrieve taxes withheld from an investment through a tax advantaged account. The company is a stalwart in the industry but does not measure up for inclusion to my master list.

Metrics

RDS-A

Industry Averages

Grade

Dividend Yield

4.7%

3.9%

Pass

Debt-to-Capital Ratio

15.0%

14.8%

Pass

Payout Ratio

27.0%

27.0%

Pass

5-Yr Average Annual Dividend Growth

8.5%

N/A

Pass

Free Cash Flow per Share

-$0.39

N/A

Fail

Net Profit Margin

5.7%

7.4%

Fail

5-Yr Average Annual Growth in EPS

7.9%

3.0%

Pass

5-Yr Average Annual Growth in Revenue

2.3%

-.02%

Pass

Return on Total Capital

13.7%

17.5%

Fail

S&P Credit Rating

AA

N/A

Pass

The company gets seven passes and three fails on my report card. The dividend is great, but having a negative cash flow and a net profit margin that is below average for the industry are big concerns. Cash flow isn't negative by a large amount on a per share basis, but represents over $1 billion. The low profit margin is a reflection of management's ability to control the cost structure of the company. This isn't a bad company, and if held in a taxable account I would hold on for the dividend. I expect the average annual return to be close to 10 percent over the next five years.

This concludes my assessment of the integrated oil industry. The next industry I intend to write about is the beverages industry. If you are would like to enhance the income from your portfolio please consider my other series based upon the strategies explained in "My Long-Term, Enhanced Income Investing Strategy." Thanks for reading and, as always I enjoy your comments so keep them coming. Only through sharing our ideas, experiences and perspectives can we all learn to be better investors together. I wish you all a successful investing future!

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

Source: The Dividend Investors' Guide - Part VI: Integrated Oil Also Rans