2 Deeply Undervalued Oil And Gas Stocks That Are A Strong Buy, 1 With Huge Downside

by: Global Value Investor

Given the weak performance of equities that already stretches on for months, investors are looking for companies that can achieve growth even in scenarios of uncertainty.

I was always convinced, that buying equities is most profitable when nobody pursues equity investments - which is usually the case when uncertainties about the future economic outlook increase. Currently, recession fears are being purported in newspapers resulting from the European debt situation, unrest in Syria and a weak kick-off earnings season. It is my belief, that cheap companies with strong growth perspectives will do reasonably well over the long-term and can overcome any temporary setbacks as long as they keep their balance sheets in check. In the energy field, I found two undervalued energy plays with low P/E ratios and strong EPS growth prospects. Investors can find attractive energy plays which are even more attractive than big name oil companies such as Exxon (XOM), Chevron (CVX), Chesapeake (CHK), ConocoPhilips (COP) or BP (BP).

Valero Energy Corporation (VLO) is the United States' largest independent refiner and marketer of petroleum products and trades at only 5.92x earnings while increasing EPS about 127% this year.

EPS is expected to come in at $4.36 per share in 2013. With an earnings multiple of 15, Valero's intrinsic value stands at $65.4 which gives investors about 153% upside potential. The stock is deeply undervalued: Despite having a 17% earnings yield and a 2.3% dividend, the market, including analysts, underestimate margin improvements that come from plant restructurings. Also, based on extraordinarily high capex in the last year, I expect higher free cash flow levels going forward that could be used to fund a higher dividend.

Occidental Petroleum Corp. (OXY) has a P/E ratio of 10.5 and PEG ratio of only 0.88 showing that the market continues to discount growth prospects across the oil & gas spectrum. This mis-pricing becomes particularly apparent with OXY:

EPS growth this year stood at over 45%. Analysts expect Occidental to grow its earnings at an average annual rate of 5.6% over the next 5 years according to Yahoo. With an EPS estimate of $8.03 for 2013 and a multiple of 15, the company would more reasonably trade at $120.45 as an indicator for fair value. With a current quote of $87 the company has about 38% upside potential. On the way, investors collect a 2.5% dividend and may even get an increase as the company continues to focus on free cash flow growth.

Interoil (IOC), on the other hand, is my clear sell candidate. The company has a market cap of $3.77 billion but fails, in my opinion, to produce tangible results. Analysts expect annual EPS to decline by 12% over the next five years.

Interoil has a P/E ratio of 489 and a P/CF of 94 both indicating massive overvaluation on hand, an difficulty in deviating an underlying EPS estimate on the other hand. IOC is estimated to earn about $0.16 per share in 2013. Even if we apply the high earnings estimate of $0.84 per share in 2013 and a premium multiple of 20x earnings, the fair price would be closer to $17 a share. Given a current price of over $78, the stock trades completely disconnected from its fundamentals and has material downside potential when the company continues to issue unsubstantiated press releases. Accordingly, I rate Interoil a Strong Sell.


I have valued the above BUY candidates based on what I believe is a moderate earnings multiple of 15 and based on average EPS estimates of 2013. The current market valuation of the companies mentioned neglects their strong cash flow growth prospects and margin improvements stemming from plant restructurings.

Interoil's metrics, particularly its EPS growth trends should serve investors as a red flag. A low profit margin of 2.2% and return on equity of 3.5% as well as the extremely high P/E and P/CF ratios depict the screaming current overvaluation of Interoil's stock.

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

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