Exxon Mobil - Trading At A Fair Price

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About: Exxon Mobil Corporation (XOM)
by: Societe Financiers
Summary

The company demonstrated positive financial results at the end of Q1 2017.

Working capital management needs improvement, while the operating and management efficiency are one of the best in the industry.

This stock is still a Buy for dividend investors, while our DCF model shows that the stock is trading at a fair price.

An aggressive scenario in our valuation model shows an upside opportunity of 19%.

The analysis provided in this article has not found any substantial upside potential in Exxon Mobil's (NYSE:XOM) shares in the near future. The company is transforming into a refined products producer, which seems to be a prudent step given the global energy transition. The positive developments related to the favorable financial results in the last quarter have been outweighed by poor working capital management. We suppose that all positive factors are already reflected in the market price of the stock.

Our DCF analysis shows that the stock is trading at a fair price in the base scenario, which is built on quite an optimistic rate of revenue growth in the forecast period. The aggressive scenario sets an upside opportunity of up to 19% from the current market price of the stock.

We start by analyzing the company's segments and financial results. The improved market conditions (driven by the OPEC's agreement) helped the company increase revenue. You can see that the top line has achieved a $55B mark in the last quarter, up 32% year-over-year:

(Source: Bloomberg, calculations by author)

The earnings increased to $2.2 billion on stronger Upstream results. You can see the net income broken into segments in the diagrams below. We would like to notice that the company's sales have been mostly dependent on revenues from the Downstream and Chemical divisions, except for the last quarter. Since Q1 2016, the Upstream segment has grown substantially, while revenues from the Downstream and Chemical segments remained flat.

The last press release contains interesting information about the development of the Downstream and chemical Businesses:

"The company announced plans to expand the production of high-quality lubricant basestocks at the Singapore refinery. The investment will increase the supply of lubricant basestocks designed to maximize the performance of all major automotive engine oil grades and to enhance the performance of finished lubricants used in multiple industries".

"Synthetic Genomics, Inc. and ExxonMobil announced they have extended their agreement to conduct joint research into advanced algae biofuels after making significant progress in understanding algae genetics" (Source: Q1 Earnings Call).

We believe that the company is making sufficient effort for shifts to the side of refining, petrochemicals and lubricants producer. Taking into account the changes in global oil demand (see below), we asses this transformation as a prudent step.

(Source: Q1 Earnings Call)

(Source: Q1 2017 IR Supplement, infographics by author)

As you can see, Exxon's operating ratios have recovered in the last quarter. The operating profit margin has grown from -3% to 7% since then. Moreover, these metrics are higher than the industry's averages, although some of the peers (in particular, from Russia and Brazil) have higher numbers. We can say the same about the management's efficiency: these metrics are substantially higher than the benchmarks. This is happening despite the decrease in financial leverage(the current figure is 1.9x), which affects the ROE ratio. The growth of this indicator is mainly explained by the increase in profits.

The current level of debt-to-equity ratio is around 14%, which seems to be very low compared to the competitors. Consequently, the interest coverage ratio has been improving continually and currently stands at 25x, so there is a lot of debt capacity to fuel expansion and expensive capital expenditure problems.

We believe that the company can support the tendency of improvement in operating efficiency and consider this a substantial factor of growth in the future. In addition, we have accounted for these factors in our DCF model presented later in the article.

(Source: Bloomberg, calculations by author)

Now let us turn to the company's working capital management. As you can see in the diagram below, the working capital management needs improvement. Since 2012, the operating cycle has been continually increasing from 49 days to 77 days. The main reason for this is the rising level of days of inventory on hand. This metric has risen from 16 days to 35 days. Another factor is the increase in the days of sales outstanding.

Moreover, we should notice that the days of payables have grown slightly by 4 days for the period of five years. This metric has ceased to cover the days of sales outstanding for the first time in 2016. It means that the company had a need to close the cash gap by borrowing short-term debt.

Consequently, the cash conversion cycle has increased to 36 days. We suppose that a further operating cycle optimization, especially the decrease in the days of inventory on hand, will result in a higher turnover and an uptrend in the asset turnover. This will positively contribute to revenue growth and the company's valuation. Unfortunately, the last press release does not include any information about the planned improvements in inventory management.

(Source: Bloomberg, calculations by author)

Exxon Mobil is recovering in terms of free cash flow generation ability. Moreover, you can notice that the company consistently pays dividends, even in the periods of negative free cash flows. We should mention the fact that Exxon is quite shareholder-friendly no matter how substantial its capital expenditures and other costs and obligations are. The dividend per share is constantly growing and now pays $3 per annum. As for the payout ratio, we see the last-twelve-months' figure at 125% of net income. While the figure is not alarming, paying out more than 100% of net income is usually unsustainable (unless there is a wide gap between GAAP net income and so-called cash earnings). The company can be considered a favorable investment opportunity for investors seeking current dividend income but what they need to do is monitor the dynamics of the payout ratio and examine the quality of earnings closely.

(Source: Bloomberg, calculations by author)

Apart from financial and operating results, we should also consider several industry-related risks in our valuation:

- Oil inventories continue to be at record-high levels, which has the impact on supply of oil. As a result, we see the growing abundance of world oil resources. According to the forecasts of experts from the International Energy Agency, the proven reserves are sufficient to meet oil demand through 2050.

- Strong competitiveness from renewable energy. The recent BP Energy Outlook demonstrates that this energy source is likely to quadruple over the next 20 years. Renewable energy is the fastest growing source of energy (7.1% p.a.), with its share in primary energy rising to 10% by 2035 (see diagram below).

- "The increasing implementation of electric cars and the wider mobility revolution will have a significant bearing on future oil demand"." The world economy continues to electrify, with nearly two-thirds of the increase in global energy will be send into the power sector. As a result, the share of energy used for power generation rises from 42% in 2015 to 47% by 2035" (Source: BP Energy Outlook 2017). The substantial threat for oil companies is that this rising demand for power generation is expected to be satisfied mainly by natural gas.

- Oil demand will grow in the future, but the pace of demand growth is slowing with the non-combusted use replacing transport as the main source of demand growth:

(Source: BP Energy Outlook 2017)

According to BP's outlook, "the gradual transition in the fuel mix is set to continue with renewables, together with nuclear and hydroelectric power, expected to account for half of the growth in energy supplies over the next 20 years. Oil continues to grow (0.7% p.a.), although its pace of growth is expected to slow gradually".

- In the short-term, the main threat is the slowdown in economic growth. This risk is difficult to forecast, and it is reflected in the discount rate used in our valuation model.

- In contrast, growth in non-combusted fuel use, particularly as a feedstock in petrochemicals, will remain relatively robust and remain at 2.1% p.a., according to BP. Non-combusted use, especially within the petrochemicals sector, takes over as the main source of growth for liquids fuel demand.

As a result, we admit that oil producers, especially the upstream-focused companies, will be under pressure in the long-term for reasons explained above.

Comparative Valuation

Our comparative analysis is based on three key ratios: P/E, P/S, and P/BV. Exxon seems to be overvalued by the P/S and P/E ratios, where the potential downside is nearly 20% relative to the market average. We believe that this method of assessment largely contains market noise. Thus, we have turned to the DCF model to build a more solid foundation for our investment case.

(Source: Bloomberg, calculations by author)

DCF Model

Our DCF model is presented in the diagrams below. The DCF model incorporates historical data and certain assumptions about the future:

- Revenue CAGR is set at 3% in the forecast period (2017-2021). The total revenue is forecasted to be around $222B in FY2017. We expect a 9% revenue growth rate in 2017, which will decline thereafter;

- The EBIT margin is set at 6 % for 2017 and 5% for the period of 2018-2021;

- The net income is expected to be around $11B in 2017, while the net margin is set at 5% of revenue;

- The effective tax rate is expected to be around 18% in the forecast period;

- The growth rate for CAPEX for the forecast period is set at 7% in 2017;

- We use the EV/EBITDA multiple of 9.8X, which is based on the five-year average.

We admit that our projections are quite optimistic.

The model shows that, after adjusting for balance sheet items, the fair value of equity is around $328B. Consequently, the stock's fair value is around $78 per share, which is 3% lower than the current share price.

(Source: Author's DCF Model)

Sensitivity

Our analysis is based on certain assumptions. The sensitivity analysis covers a range of possibilities resulting from deviations from the base scenario. Assumptions related to WACC and the Terminal EV/EBITDA multiple show that the base scenario implies a fair price range between $73 and $82 per share. This means that the downside risk is between 0% and -9%:

(Source: Author's DCF Model)

However, if investors estimate the value of the company by using the multiple of 11.8x, they will find an upside opportunity in the stock. This aggressive scenario sees an upside opportunity of up to 19%, depending on what WACC is chosen. The model's WACC of 5.3% is calculated in-line with the current capital structure of company (almost 92% of assets is financed by equity).

(Source: Author's DCF Model)

We should notice that the implementation of the 11.8x EBITDA multiple is quite feasible. As you can see in the diagram above, the implied perpetuity growth rate of free cash flows at the 11.8x multiple is realistic, particularly at the current WACC value of 5%.

Conclusion

In the fundamental analysis of Exxon Mobil, we did not identify significant positive catalysts supporting a further appreciation in the stock's value in the near future. We support the company's shift to Downstream & Chemical businesses in light of the global energy transition. However, we think that substantial positive factors are already reflected in the price. Hence, we issue a Hold recommendation on the company's shares.

According to the comparative analysis and the comprehensive DCF model presented above, we set a target price range of $73 - $82 per share in the base scenario, while the aggressive scenario implies an upside opportunity of around 19%. However, we also think the company's stock can be considered a good opportunity for investors seeking stable dividend income, especially given the growing free cash flow tendency.

Disclaimer: Societe Financiers is an investment research team focused on long-term, long- and short-only ideas. Our research objective is to cover equities in various regions, such as North America, EMEA, Asia, Australia, and Emerging Markets. Readers should consider whether any advice or recommendation in our research articles is suitable for their particular circumstances and, if appropriate, seek professional advice, including tax advice. The price and value of investments referred to in our research articles and the income from them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Fluctuations in exchange rates could have adverse effects on the value or price of, or income derived from, certain investments. Certain transactions, including those involving futures, options, and other derivatives, give rise to substantial risk and are not suitable for all investors. Transaction costs may be significant in option strategies calling for multiple purchase and sales of options such as spreads.

Supporting Documents

  1. XOM.xlsx

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.