4 Undervalued Oil And Gas 'Strong' Buys

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 |  Includes: BP, COP, CVX, XOM
by: Takeover Analyst

With the Shiller PE multiple currently standing at 21.7x versus the 16.4x average, investors should consider looking for cheap companies with strong brand names and value. This is particularly recommended in light of job numbers being 20% below expectations. I continue to be bullish about oil & gas, which offers both high dividend yields and low multiples. And unlike most basic materials, energy sources are not volatile - an opinion reinforced by sub-1 betas.

BP (BP) is perhaps my favorite sector play for several reasons. First, I see the Macondo incident as "overblown", which will be come increasingly evident as more culpability falls on the service provides (which I also believe are substantially undervalued). Second, the company trades at just 5.2x past earnings despite a successful operating history. This makes the firm cheaper on a multiples basis than ConocoPhillips (COP), Chevron (CVX), and Exxon Mobil (XOM). Third, the firm is a free cash flow machine. Typically oil & gas producers are so overburdened by heavy capital acquisitions that they do not make up for present operating cash flow. But in just 2011 alone, BP generated $4.3B in free cash flow. With a singular exception in 2010, this strength has been consistent throughout the recent past. Fourth, safety with a dose of value is king in this market: BP offers a 4.8% dividend yield and has a price target of $50.57 according to FINVIZ.com.

Aside from BP, there are other safe investments. Conoco offers a similarly generous 4.8% dividend yield and has a low bar required for value creation. 2012 EPS is expected to be $6.23 and grow around 2.3% annually over the near-term. That means 2016 EPS of around $6.82, which, at a 11x multiple, translates to a future stock value north of $75. Discounting backwards by 8% yields a present value of $51 - slightly below the current market assessment. But the growth estimates are overly bearish and are thus likely to give way to "surprise" results. This, in turn, will generate strong short-term returns as the stock market possibly resides elsewhere. Equipped with a clean balance sheet and consistent shareholder-friendly capital allocation policy, Conoco has limited downside.

And then there are two other Standard Oil heirs, Chevron and Exxon. I remain more bullish on Chevron given its lower multiples and unreasonably low growth expectations against its larger competitor. When you consider that Chevron is almost just one-half of Exxon's $500B valuation, it is hard to conceive a rationale for the latter's 330 bps-greater expected 5-year annual growth. A market correction will send Chevron's PE multiple, which stands at only three-fourths Exxon's, surging. Here's why:

The company might have missed 4Q11 results by 9.8%, but near-term performance has generally been better-than-expected. Moreover, it doesn't even take excellent performance to generate double-digit appreciation. Chevron is expected to realize 2012 EPS of $12.90 and grow 5.3% over the near-term. That means 2016 EPS of around $15.86 and a future stock value of $174.46 at a 11x multiple. Chevron is one of the safest investments out there with a beta of 0.8, an excellent brand, and a 3.4% dividend yield, so a WACC of around 7% is reasonable. Present valuing $174.46 at that discount rate yields a $124.39 price target - in-line with consensus. Combined with the dividend yield, risk/reward is thus highly compelling.

Exxon may be the safest oil & gas play out of the four mentioned herein for several reasons: (1) it has the largest moat, (2) it has the strongest brand name, and (3) it has a consistently impressive track record. In fact, the company is approximately half as volatile as the broader market despite generating ROA, ROE, and ROI of 12.4%, 25.8%, and 16.5%, respectively. Exxon generates $57.8B worth of cash flow and has a $18.7B liquid position in its balance sheet for acquisitions. Accordingly, I recommend an investment for more risk-averse investors.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in BP over the next 72 hours. We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.