Since I first controversially declared that the Macondo spill was "overblown" and recommended going long BP (BP), the stock has soared right past the bears at 30.6%. I still find the company significantly attractive and believe that the company's recent settlement will allow investors to focus more on the firm's solid fundamentals.
BP has agreed to pay a group of 100K+ plaintiffs $7.8B, having already established a $20B trust fund. As an investor relations consultant, I have worked on crisis communication efforts. My belief is that BP should have been more aggressive in rejecting culpability. Ironically, the more BP did to allay fears of wrongdoing, the more the public became incensed by its very possibility.
With the turning over of a new leaf, a review of the fundamentals is in order. The sector provides excellent return opportunities: Paradigm Oil & Gas (PDGO.OB), Avalon Oil & Gas, BP (AOGN.PK), and Marathon (MRO) are among my top picks. In this article, I will run you through my DCF analysis on BP and then will triangulate the result with an exit multiple calculations and a review of the fundamentals compared to Marathon and Exxon Mobil (XOM).
First, let's begin with an assumption about revenues. BP ended FY2011 with $386.5B in revenue, which represented a 25.1% gain off the preceding year. Analysts model a 5% per annum growth rate over the next five years, and I find this sentiment to be, if anything, bearish. But for the sake of staying safe, I accept the projection.
Moving on to the cost-side of the equation, there are several items to address: operating expenses, taxes, and capital expenditures. I model that cost of goods sold will eat 82% of revenue the next few years compared to 4% for SG&A and 0.3% for R&D. These estimates are roughly around historical 3-year average levels. Taxes are also estimated at around 35%. Contrary to claims that the oil sector doesn't pay their "fair share" in taxes (whatever that means), the major players, in fact, pay by far above the corporate average.
We then need to subtract out net increases in working capital: we model accounts receivable as 12% of revenue; inventories as 9% of COGS; prepaid expenses as 12% of SG&A; and accrued expenses as 44% of SG&A; and accounts payable as 15% of OPEX.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 8.7%, the rough intrinsic value of the stock is $60.74, implying 29.2% upside. The WACC is calculating through considering the firm's unlevered beta of 0.94 and equity-skewed capital structure.
From a multiples perspective, BP is also incredibly cheap. It trades at just a respective 5.8x and 6.9x past and forward earnings versus 14x and 7.6x for Marathon and 10.1x and 9.4x for Exxon. To put this in context, consider that BP is valued at only 68% of its historical 5-year average PE multiple. Assuming a multiple of 9x and a conservative 2013 EPS of $6.75, the rough intrinsic value of the stock is $60.75 - in-line with my estimate. This is still well below peer levels and thus is a conservative case.
Consensus estimates for Marathon's EPS forecast that it will grow by 15% to $3.69 in 2012, grow by 20.1% in 2013, and then fall by 2.5% in 2014. Assuming a multiple of 10x and a conservative 2013 EPS of $4.39, the rough intrinsic value of the stock is $43.90, implying 30.9% upside. Management typically is reserved on guidance, which sets the bar low and allows for high risk-adjusted returns in the event of a recovery. The company has excellent production in Eagle Ford, Bakken, Noiobrara, and Anadarka, and its $4.8B capes budget showcases confidence.
Exxon is similarly investing in core growth avenues, and I am particularly optimistic about its execution in takeover activity. The XTO Energy acquisition may be around 3% dilutive for the immediate year, but I believe natural gas has strong secular trends - this bet, in my view, is bound to yield dividends. Exxon's vertical integration allows for meaningful long-term accretion from M&A.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in BP, MRO over the next 72 hours.
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