BP Is A Strong Buy, But Not Because Of Takeover Speculation

| About: BP p.l.c. (BP)
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Summary

Once again, the rumor that BP will be acquired by Royal Dutch Shell has resurfaced. But a deal doesn't make sense, and investors shouldn't count on it happening.

That doesn't mean BP isn't a buy. Quite the contrary - its cheap valuation and extremely high dividend yield are very attractive.

Plus, BP will recover from any recovery in the oil markets, which would serve as a huge future growth catalyst.

A rumor of a major takeover in the energy space has reared its ugly head once again. In a rehash of speculation first raised several years ago, the financial media has reported that Royal Dutch Shell (NYSE:RDS.B) may once again attempt an acquisition of fellow European oil giant BP (NYSE:BP). This caused a spike in BP's share price on Dec. 3, which ultimately proved short-lived. That's because this is a story investors have heard before. It seems that every few years these rumors resurface. On the surface, a deal makes some sense. BP is vulnerable to a takeover because it is a much smaller company in the wake of the 2010 oil spill, and has had to sell off billions in assets.

To be sure, BP is indeed a strong buy below $40 per share. But it has nothing to do with the tiring takeover rumors that are unlikely to materialize. Instead, investors should buy BP based on its compellingly cheap valuation in relation to its competitors, its 6% dividend yield (which is near the top of its peer group), and its potential for future growth when and if oil prices recover.

Ignore Unsubstantiated M&A Rumors, Focus on Fundamentals

It's true that if a company were to launch a takeover bid for BP, the time is right for such a move. BP is now just a $122 billion company by market capitalization. This is a far cry from where BP used to be; BP was a $225 billion company by market value as recently as 2008. Since the 2010 oil spill, BP sold off a great deal of assets in an attempt to raise the necessary funds to cover the $43 billion in spill-related expenses taken so far. To compensate for this, BP has divested $38 billion of assets already and plans to offload an additional $10 billion in assets by the end of next year.

However, future liabilities associated with BP's ongoing civil trial are yet to be determined, and this uncertainty is precisely why it's extremely unlikely Royal Dutch Shell will attempt a takeover. BP could face as much as $18 billion in additional penalties if it is hit with the maximum penalties possible due to a violation of the Clean Water Act. It's hard to imagine Royal Dutch Shell buying out BP with this lingering uncertainty.

Still, that doesn't mean BP is doomed. Far from it: BP's potential future spill-related damages appear more than priced in to its very cheap valuation. BP is far cheaper on a valuation basis, and offers a significantly higher dividend yield, than the other integrated majors in its peer group, including Exxon Mobil (NYSE:XOM) and Chevron (NYSE:CVX). Here is a breakdown of the relative value offered by BP right now:

EV/EBITDA

Price/Book

Dividend Yield

BP

4.5

0.98

6%

Exxon Mobil

6.8

2.21

2.9%

Chevron

5.6

1.36

3.8%

Source: Data taken from Capital IQ.

As you can see, BP offers impressive value when stacked up against its competitors. BP trades below book value and for just four times enterprise-value-to-EBITDA, meaning its assets and their ability to generate cash flow are not properly valued by the market. On an EV/EBITDA basis, BP is 33% cheaper than Exxon Mobil and 24% cheaper than Chevron.

Moreover, BP's 6% yield is 220 basis points higher than Chevron's dividend and 310 basis points higher than Exxon Mobil's dividend. BP has steadily increased its dividend since reinstituting it in 2011. In that time, BP's dividend has grown 42%, from $0.42 per share to its current level of $0.60 per share. This demonstrates the underlying strength of BP's fundamentals. Plus, it's worth noting that BP's $2.40 annualized dividend accounts for 80% of its trailing earnings per share, which is not an alarming payout ratio.

Future Growth Catalyst: Any Recovery in the Oil Market

Clearly, the biggest anchor weighing BP down right now is the sudden and swift collapse in oil prices. Brent crude is all the way down to $68 per barrel. This represents a stunning 40% decline from its high of $113 per barrel, reached in June this year. This has caused the major oil stocks to suffer greatly, but it's important to remember the integrated majors have a unique advantage working in their favor. While upstream operations are suffering right now, downstream results are quite strong.

BP generated $1.5 billion in profits last quarter from its downstream business, which includes refining and lubricants. This represented huge growth from $730 million in downstream profits in the previous quarter. This helped BP produce $9.4 billion in operating cash flow last quarter, up 19% from the prior quarter, despite a deterioration in upstream results.

The bottom line is that BP's share price has been hammered this year by falling oil and the uncertainty pertaining to the 2010 spill. But the sell-off is overdone. While I don't expect BP's shares to rise as a result of a takeover bid from Royal Dutch Shell, I do believe BP will generate strong future returns due to its compelling valuation, high dividend yield, and the tailwind of any recovery in oil prices.

Disclosure: The author is long BP.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.