Marathon Oil's DCF: Why The Stock Is Getting Cheaper
Summary
- Marathon Oil Corporation is an oil exploration and production company with resource plays in the Bakken in North Dakota, STACK, and the Eagle Ford in Texas among other regions.
- The rights to produce the reserves are worth many dollars. If the oil price increases, the rights will be worth much more.
- Like many other analysts, I believe that MRO will pay its debt in 2022. The reduction in debt will most likely enhance the FCF.
- In my base case scenario, with long-term growth of 4%-5.5% and a WACC of 11%, I obtained an implied price of $14.7-$18.7. Notice that MRO currently sells at $10-$12.
- The FCF will most likely be around $1.8 billion and $739 million in 2021 and 2025, respectively. My numbers are not far from that given by other analysts.
Marathon Oil (NYSE:MRO) offers an upside potential in the stock price as well as limited downside risk. In my base case scenario, using market estimates and a WACC of 11%, the implied share price is $14.7-$18.7. Traders are currently buying the stock at $14.7-$18.7. In my opinion, the reduction in the debt, which the company is currently undertaking, will diminish the cost of capital and increase the future FCF. As a result, I would expect the share price to go north.
Marathon Oil Corporation: FCF Generation And Reserves
Marathon Oil Corporation is an oil exploration and production company with resource plays in the Bakken in North Dakota, STACK, and the Eagle Ford in Texas, among other regions. The company’s strategy will most likely be appreciated by the analysts running DCF models. MRO focuses on FCF generation:
Our overall business strategy is to deliver competitive and improving corporate level returns and sustainable free cash flow through a disciplined reinvestment rate capital allocation framework. Our framework prioritizes free cash flow generation across a broad range of commodity prices by limiting our capital expenditures relative to our expected cash flow from operations. Source: 10-k
Source: 10-k
MRO increased its oil productive wells in 2018, 2019, and 2020. With this information in mind, I don’t believe that the company’s crude oil business is declining:
Source: 10-k
If the oil price increases in the coming years, the company will be more valuable because of its production. MRO has both proved and undeveloped reserves. The rights to produce the reserves are worth many dollars. If the oil price increases, the rights will be worth much more, which will most likely lead to an increase in the company’s valuation:
Source: 10-k
Base Case Scenario - MRO Will Most Likely Pay Down Its Debt
Like many other analysts, I believe that MRO will pay its debt in 2022. The reduction in debt will most likely enhance the FCF from 2021 and reduce the company’s EV/EBITDA. If we look at the company’s EV/EBITDA figures, the company appears cheap now, and analysts expect the company to be cheap in 2022-2023:
Source: Analysts Expectations
In my base case scenario, I used market estimates from 2021 to 2023 and my own assumptions from 2024 to 2025. I expect sales to increase significantly from 2021 to 2022, and gradually decline in 2021 and 2025 as more and more customers buy electric vehicles. In my opinion, the decline in oil demand will cause the oil price to go down. MRO sales will reach $4.3 billion in 2023, and decline in 2024 and 2025. I believe that the company will try to invest a bit less in capital expenditures as the management will see fewer investors willing to put money in the oil and gas markets:
Our response has included reducing our 2020 and 2021 capital expenditure programs, lowering our cost structure and protecting our balance sheet, liquidity and cash generation. We believe our financial strength, quality portfolio and ongoing focus on reducing our cost structure better position us to navigate a variety of commodity price environments. Source: 10-k
Capital expenditures will be between $2 billion and $1.5 billion. Finally, the FCF will be around $1.8 billion and $739 million in 2021 and 2025, respectively. My numbers are not far from that given by other analysts, and the company delivered larger FCF than my FCF estimates:
Source: Ycharts
Source: MRO With WACC @ 11%
I used a WACC of 11%, which I believe is what most analysts out there are using. If the market conditions change, and volatility increases, the company’s WACC may increase. However, I wouldn’t expect the company to see a WACC of a lot more than 11%. With the risk-free interest rate close to zero, in my opinion, the company’s WACC is already relatively elevated:
Source: finbox.com
If I assume long-term growth of 4%-5.5%, the company’s implied share price stands at $14.7-$18.7. MRO currently trades at $10-$12. Hence, under this case scenario, the company appears undervalued. The upside potential in the stock price would be close to 70%. Note that in my opinion, this is the most likely scenario:
Source: MRO With WACC @ 11% And Growth @ 4-5%.5%
Very Pessimistic Scenario
In the worst-case scenario, the oil price would increase significantly from 2022 to 2025. MRO would report as many sales as in 2015 to 2018. The company would invest significantly in capital expenditures, which remain close to $2.2 billion per year. However, interest rates, inflation, and costs would increase significantly. As a result, the FCF would stand at $660-$917 million in 2023-2025. The company would pay its debt, but the WACC used by analysts would remain at 13%-12% from 2022 to 2023. As shown in the image below, increases in the WACC make the discounted FCF decline significantly:
Source: MRO With WACC @ 13%-9%
The DCF model shows that increases in the growth rate of 4%-5.5% don’t lead to good results when interest rates increase. The implied share price obtained is equal to $5.1-$6.7. In this case, shareholders would suffer a loss of 39%. In my opinion, this is quite unlikely because the figures are far from market estimates:
Source: MRO With WACC @ 13%-9% And Growth of 4%-5.5%
Risk: Difficulty in Accessing Capital And Climate Change Regulations
In 2020, the company’s credit ratings were marked as negative by Moody’s Investor Services, but they were marked as stable by Standard & Poor’s and Fitch Ratings. If the company does not improve its ratings, the management may have issues accessing capital at good terms. In this case scenario, the WACC would most likely increase, which would lead to a reduction in the company’s valuation.
The new Biden administration issued several executive orders changing the regulatory framework because of climate change. It is still not very clear whether the new regulations will increase the oil price, or reduce the demand for oil. The company believes that the actions taken by the president will not have a material impact on MRO’s business. I am not sure about that:
At this time, applicability of the actions taken by the new administration appear to largely exclude tribal lands and we do not believe that the new executive and temporary orders currently in effect will have a material adverse impact on our business. Amendments or extensions along with implementation of the announced policy positions and initiatives that flow from these orders may have a material adverse impact on our business. Source: 10-k
The media is constantly distributing detrimental publicity about the oil and gas business and its environmental impact. As a result of these practices, MRO’s reputation is indirectly damaged. Besides, adverse press coverage will most likely trigger additional legislation and law enforcement against the oil and gas industry.
Minor Risks From Contractual Obligations And Debt
According to the company’s publications, MRO has to pay $1.98 billion in contractual obligations in 2022-2023 and $2.15 billion in 2024-2025:
Source: 10-k
Taking into account the FCF of more than $1 billion and $1.12 billion in cash, I believe that MRO will be able to pay its future financial obligations. If MRO does not deliver sufficient EBITDA, the negotiations with the debt holders may be a bit tense. However, I wouldn’t expect implementation of chapter 11 or anything related. Investors may suffer some volatility without major consequences:
Source: 10-Q
The company is paying a weighted average interest rate of 2.25%. If debt holders thought that MRO may not be able to pay its debt obligations, I believe that the interest rate would be larger than 2.25%. Also, notice that the company is paying some of its notes:
We remarketed $400 million sub-series B (tax-exempt) bonds in August at a weighted average interest rate of 2.25%. In October, we completed a cash tender for $500 million of our then-outstanding $1 billion 2.8% 2022 Notes, funded by cash on hand. Source: 10-k
Conclusion
I believe that MRO offers significant upside potential and small downside risk. In my base case scenario, with long-term growth of 4%-5.5% and a WACC of 11%, I obtained an implied price of $14.7-$18.7. Notice that MRO currently sells at $10-$12. As the company reduces its total amount of debt, I believe that the FCF will increase. At the same time, I would expect the WACC to diminish when the debt is paid, which will lead to an increase in the company’s valuation.
This article was written by
Analyst’s Disclosure: I/we have a beneficial long position in the shares of MRO either through stock ownership, options, or other derivatives. 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.
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