Chevron: An Inexpensive Mega Cap Energy Stock With An Economic Moat

Jun.21.12 | About: Chevron Corporation (CVX)

Chevron (NYSE:CVX) is the second largest U.S.-based oil company behind Exxon Mobil Corp. and offers investors broad-based exposure to the energy sector.

CVX manages investments in various subsidiaries that are involved in oil, chemical, and mining operations, and in power generation and energy services. The company's upstream operations consist of the exploration and production of oil and natural gas, liquefied natural gas processing and transportation, transportation of oil via pipelines, transportation and storage of natural gas, and a gas-to-liquids project.

The company's downstream operations consist of the refining of oil into petroleum products, the marketing of oil and refined products, and transporting of oil and refined products by pipeline, by sea, and by rail, and the manufacturing and marketing of petrochemicals, plastics and additives. The company is based in San Ramon, CA, and employs approximately 61,000, with roughly half of those based in the U.S.

CVX's EBIT yield on EV is 19.06%, which is at the breakpoint for the bottom quartile of our universe of cheap stocks that consists of the top 10% of the cheapest stocks in the market (please see our Appendix for additional discussion of the construction of this universe). While it is not among the very cheapest stocks within our screen, two factors distinguish CVX; it has an extremely large market capitalization, and achieves among the very best on our statistical quality scores.

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It is very difficult to build sustainable competitive advantages in the energy industry where oil's commodity nature inhibits pricing power within the industry. Market participants are constantly required to invest capital to maintain cash flows and market share. Nevertheless, CVX appears to have succeeded in assembling the elements of a durable economic moat. In particular, the two interrelated factors of scale and capital requirements serve to discourage competitors, as does the complex network of government approvals and licenses CVX has created that enable it to do business around the world.

The sheer scale of CVX creates several barriers to entry. Over a long time frame, the company has successfully developed and fully integrated upstream production and development with downstream refining, transportation and marketing capabilities, which enable it to optimize across the oil value chain, and tightly manage a variety of costs, which can be spread over a large base. CVX's size also gives it significant bargaining power with suppliers, allowing it to influence the setting of price. Finally, its scale and diversified lines of business allow it to manage cyclical lows better than its smaller competitors.

Another area related to the company's scale is that of the capital required for many aspects of CVX's business. For example, the company is investing in two large liquefied natural gas (LNG) projects in Australia, the Gorgon and Wheatstone Projects, and is also focused on additional LNG projects in Angola and Europe. LNG projects are highly capital intensive, requiring the investment of tens of billions of dollars. CVX has invested in a series of such large-scale, multi-year projects, including a gas-to-liquids plant, refineries, cracker plants, additive facilities, deepwater exploration and development projects, and oil sands projects. These projects and markets have extremely high entry costs, which discourage competitors.

CVX is a truly global company, with operations in 180 countries. In order to conduct business around the world, the company has obtained government regulatory approvals, permits and licenses from such far-flung and diverse nations as Kazakhstan, Cambodia, Indonesia, Philippines, and Bulgaria. These agreements are complex, and require CVX to negotiate wide-ranging issues such as profit sharing, and safety and environmental terms, and assess the economic impact of projects and investments. These governments do not hand out approvals to just anyone. Only large, well-capitalized companies with demonstrated credibility and a significant presence in the country or the region can hope to succeed in obtaining such approvals. The difficulty of obtaining these approvals forms a barrier to entry for new competitors.

It appears CVX's statistical profile is consistent with the presence of an economic moat. CVX's normalized (8-year, geometric mean) return on assets of 12.0% ranks highly within our universe, within the 92nd percentile, and the company's normalized (8-year, geometric mean) return on capital is also very strong at 19.7%, which is in the 94th percentile of our universe. Long term free cash flow (8-year cumulative FCF) / assets is 34.4%, which places the company in the 67th percentile, another respectable outcome.

CVX's margins have also grown at an average rate of 2.7% per year over the past eight years, which places the company in the 75th percentile of our universe. Increasing gross margins can indicate that a company is successful in controlling costs or passing them on to customers. When we take an average of these franchise-related percentile scores, we find that CVX's average is 82%, which is at the very top of our universe of cheap stocks.

In general, it appears that the company's normalized return on assets and normalized return on capital are both exceptionally strong, falling within the top decile of our universe, and indicating significant franchise value. Also, the company generates significant free cash flows over time relative to its assets, and gross margins have grown steadily, which is unusual in a commodity business. All of these features suggest the presence of an economic moat.

CVX is currently profitable, generating a 13.0% return on assets, slightly above its long run average (see Franchise Power above), and FCF / assets is also positive at 4.4%. CVX's net income, however, exceeded its free cash flow, indicating that the company is using accruals, which are a statistical red flag. Overall, we give the company two out of a possible three points with respect to our profitability metrics.

Turning to our stability measures, our next component of financial strength, CVX's leverage, scaled by its assets, is decreasing. This decrease indicates a lower likelihood of financial distress, which earns the company a point. Additionally, CVX's current ratio increased by 5.8%, which signals increased liquidity and ability to meet creditor demands, which also earns a point. CVS is also a net repurchaser of equity, when equity is scaled by assets. This shareholder friendly statistical feature of CVX's financial profile garners another point. Overall, we award CVX a perfect three out of a possible three points for stability.

Next we review the company's recent operating improvements across several key statistical metrics. Return on assets increased slightly versus a year ago, which is a positive sign and worth a point. Return of FCF on assets decreased 2.5% versus a year ago, which fails to earn the company a point, as smaller free cash flow per unit of assets is statistically undesirable. Gross margins increased by 2.2% YoY, which earns the company another financial strength point. CVX's asset turnover increased versus the prior year, indicating a more efficient use of the company's assets. Overall, the company scores three out of a possible four points in connection with its recent operating improvements, a solid showing.

On our various Financial Strength metrics, CVX scores 8 out of a possible 10 points overall. Statistically, CVX appears to be profitable, very stable, and is also showing several statistically important recent operating improvements. One area that may deserve some additional scrutiny is that of accruals, and an analyst could review some of CVX's accruals policies in more depth.

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CVX is cheap company, with a 19.06% EBIT yield on its enterprise value and a single digit P/E. On this basis, the stock is statistically inexpensive, but it also exhibits numerous additional quantitative quality factors that also indicate undervaluation.

The company appears to have strong franchise power. CVX is a mega cap company that through its scale has integrated upstream and downstream operations enabling it to manage costs across the oil value chain. CVX also invests in capital intensive projects that require allocating large amounts of capital for extended periods of time, which serves as a deterrent against market entry by less well capitalized competitors.

CVX does business in countries around the world, and the company's many projects require a variety of government licenses and permits. Obtaining these government approvals is a time-consuming and complex process, and this serves as a deterrent to competitors, who would be faced with lengthy, expensive and complex challenges in any attempt to duplicate this network of approvals.

Consistent with these qualitative indications of an economic moat, the company scores well on our franchise power metrics. In particular, CVX's normalized return on assets of 12.0% and normalized return on capital of 19.7%, place in the 92nd and 94th percentiles, respectively, of our universe. These are very high returns that are rarely seen in companies of this size. It is also noteworthy that company has been able to grow its gross margins over longer time frames in a commodity industry. These factors are strong statistical indicators of the existence of an economic moat.

The company is showing numerous signs of financial strength. The company has good profitability, scoring a 2/3 on our profitability measures, although an analyst could review the company's use of accruals. The company appears to be extremely stable, as it is a mega cap company that scores a 3/3 on our stability measures. Additionally, the company shows several signs of recent operating improvements.

The company passed our screens for manipulation and financial distress, scoring a 3/3 for safety. The numbers are suggesting that statistically the company does not appear to be showing obvious signs that its equity is overvalued. Please refer to our Appendix for additional discussion of these metrics.

CVX scores in the 82nd percentile for Franchise Power, and scores 80% (8/10) for Financial Strength; thus its overall quality score (average of these two metrics) is 81%, which is an exceptional score, and at the very top of our universe, which consists of our top decile of cheap stocks.

In summary, CVS appears to be an inexpensive, safe, high quality, mega-capitalization stock with significant franchise power, and can provide investors a good way to get exposure to the oil sector.

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