Is this Gas and Oil Gaint Fairly Valued?

This is my second of, hopefully, many stock analysis on here. Nobody interested in investment in gerneral and stock investment in particular can have missed that, the oil sector has taken quite the blow lately as, oil prices have fallen to the lowest levels in 4 years.  

I want to examine if there is value inte sector and what better candidate to start with than the shareholder friendly oil and gas gaint - Chevron. In the following post I will examine the company against my investment criteria and determine the company's valuation. 

Distinct Competitive Advantage (Moat)?

Bigger is better (economies of scale). Chevron is one of the world's largest energy companies with operations worldwide. The company produces about 2.6 million barrels of oil per day, about 1.7 million barrels of gas and has more than 60 000 employees.

Chevron is involved in virtually every facet of the energy industry. The company explores, produces and transports crude oil and natural gas as well as refines, markets and distribute these products. The company manufactures and sells petrochemical products, generates power and produces geothermal energy and supplies renewable energy. Chevron has a strong balance sheet and the industry's largest and high-yielding project portfolios. Morningstar has awarded the company AA credit rating which only Exxon Mobile surpases.

Know how. For more than 130 years, Chevron has explored some of the world's most complex oil fields. Chevron has one of the highest profit margins in the industry and the second-highest ROE after Exxon Mobile, suggesting that Cheveron are specialists in what they do.

Low production costs. Chevron has for many years been the company that has the lowest cost per produced barrel of crude oil.

Chevron has historically proven, with high profit margins and high ROE, that the company possesses competitive advantages. However, there are at least four companies that are in the same league as Chevron and can take market share, namely ExxonMobil, BP, Shell and Total. 

Morningstar believes that Chevron has a narrow moat and I have to agree with the experts on this one. ExxonMobil is the only oil company that by Morningstar considered to have a wide moat. Chevron gets a pass on this criterion.

A Truly Global business?

The US accounts for about 21% and the rest of the world for 79% of the revenues.
Chevron passes this criterion. 

Strong Owners?

I'd like to se a business that I own to have strong owner behind it with financial muscle. I usually prefer a company that is family owned, since you tend to take better care of things close to home.

The bigest shareholders are: Vanguard Group, State Street Corporation and BlackRock Institutional Trust Company. Chevron passes this criterion. 

A Business That is Easy to Understand?

Chevron's business is fairly easy to understand and get a grip on.
There are predominantly two segments that are crucial for revenue and profit:

• Upstream - exploration and production of oil and natural gas.
• Downstream - refining, production and distribution of petroleum and petroleum-based products.

The upstream segment accounts for 90% of the profits. About one-fifth of Chevrons revenues come from gas. That number will increase as Chevron is investing more on gas by including two large projects in Australia. Until then, however, Chevron is dependent on the price of oil. Chevron passes this criterion. 

Rising Earnings Per Share (EPS), That Have Grown on Average at Least in Line with the Dividend for 10 Years?
On average EPS has increased in excess of 10% per year during the period. The main reason for the EPS growth is the fact that the profit margin increased from about 6% to almost 11% during the period. Chevron has had the best margins in the oil industry for a while now.

Sales growth has also contributed to the growth of VPA and averaging approximately 6% per year over the same period.

Both sales and profit margins fell sharply after the last crisis in 2009 resulting in low EPS. Chevron has a relatively large share buyback program. The number of shares has decreased by almost 8% during the period. The share repurchases have contributed an average VPA increase per year of 1% over the period. Chevron does get a pass on this criterion. 

A Dividend that has on Average Risen over the Period of 10 Years?
Chevron has increased its dividend every year since 1987. This is how the dividend has developed over the past 10 years.

The average dividend growth per year has been about 10%. I can't see Chevrons dividend streak coming to an end anytime soon, although the dividend growth has slowed down considerably in recent years. The payout ratio has risen during the period and in 2013 the payout ratio stod at 30% and is about 35% right now. Chevron passes this criterion.

 
A Company with Financial Strength?
Chevron's balance sheet is strong compared to it's peers, although there is some leverage there. The equity ratio (shareholders' equity) is about 60%. The interest coverage ratio is over 100 which means that they can cover their interest costs more 100 times over. Free cash flow has been stable during the period and has covered the dividend for the most part. Chevron has like other companies in the same industry large investment needs. From 2011 onwards, the investment costs increased significantly. Chevron passes this criterion. 

Risks and Uncertainties That May Affect Future Earnings?
I want to assure myself that political, regulatory, business and other specific risks that may affect a company's future earnings are as few as possible and preferably manageable.

There are many risks that could threaten an oil company's earnings and in worst case its existence. An oil spill with associated cost of billions of dollars is one risk. Commodity dependence represents another, as the price and availability of oil and gas affect Chevron's profit margin significantly. 

There is also though competition for these oil and gas resources, that are increasingly difficult and expansive to extract. ExxonMobil, BP, Shell and Total are the toughest competitors can compete on the same terms as Chevron. 
There is also political risk in the form of regulations and state-owned energy company that can get the idea to change the rules of the game on the market.

Even though oil prices are the lowest they have been for years, I think the company's size, balance sheet and gas projects will allow Chevron to weather most storms. Chevron passes this criterion. 

Summary and Valuation
Chevron meets all of investment criterion. In my eyes, Chevron as a company may not have the widest moat, but has proven competitive advantages as evidenced by the highest profit margins in the industry. The industry that Chevron operates in is however amongst the most risky, something that should weigh heavily in any purchasing decision.

The question is what the future looks like. Chevron's profits are depended on of the price of oil that accounts for the biggest part of the profit, even if the gas production is constantly expanding. How sales and the profit will develop in the future therefore depends mainly on the price of oil and to a lesser extent on the price of gas. In 2013, margins have been squeezed by high investment costs and the price of oil. EPS and dividend growth have slowed down. This trend continued all through last year and will persist for a time to come.

Even so Chevron has a strong balance sheet to fall back on if the negative price trend continues and the cash flow is strained further. I think we will start to see better numbers forward in 2015 when large investments which impacted cash flow in 2013 and 2014 start producing. Chevron is investing heavily to increase production of oil and gas in the upstream segment and has one of the world's most aggressive project portfolios for the purpose. A project portfolio that has historically delivered a nice return.

The question is what I am willing to pay for a high quality company that is so dependent on the price of oil and gas?

Valuation
My Price Cap is equivalent to 102 dollars. The Price Cap constitutes the price I'm willing to pay at the most for a given stock. The Price Cap is the average value obtained when Fair Price 1 (based on dividend growth and dividend yield) and Fair Price 2 (based on sustainable EPS and Sustainable P/E ratio) are compared. My Price Cap for Chevron is based on the following assumptions:

• I estimate that Chevron will have an average dividend growth rate going equivalent to about 9% going forward.
• I estimate sustainable EPS to be roughly 10 dollars and sustainable P/E-Ratio, based on the company's qualities and the dependents on commodities to be 11.

This concludes my stock analysis on Chevron. You can find all of the companies that I'm currently following under the meny item: Watch List in the main menu.

Until next time, good luck with your investments!