Exxon Mobil: A Tiger Ready To Roar And Deliver Alpha

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While many sectors within the stock market range from slightly overvalued to considerably overvalued, the sector that appears to be the biggest bargain at this point is the energy sector in terms of Shiller PE.

Image Source: Gurufocus

Out of the 11 sectors of the economy measured by Gurufocus, the energy sector has the second lowest PE ratio at 15.5, which is just a bit more than the PE ratio of 15.1 for the financial services sector. Adjusting for variations in profit margins during business cycles by using the Shiller PE ratio, the energy sector is currently the most undervalued sector with a Shiller PE ratio of 17 compared to the second most undervalued sector's Shiller PE ratio of 20.4 for the financial services sector.

Today, I'll be following up on my previous Exxon Mobil article from earlier this year on why I believe an investment in Exxon Mobil (XOM) is likely to deliver alpha over the next decade.

I'll discuss the safety and growth profile of Exxon Mobil's dividend, the growth catalysts and risks facing Exxon Mobil, and what I believe to be Exxon Mobil's fair value compared to its current share price. I'll then use this information to piece together likely annual total returns over the next decade for Exxon Mobil.

Reason #1: A Safe And Moderately Fast Growing Dividend

As a dividend growth investor, I tend to examine both the safety and growth profiles of companies that catch my attention at any given time.

I'll first examine the safety of Exxon Mobil's dividend by discussing Exxon Mobil's EPS payout ratio and FCF payout ratio.

During 2018, the company generated diluted EPS of $4.88 against the $3.23 in dividends per share paid in 2018. This equates to a payout ratio of 66.2%, which is reasonably safe.

For 2019, analysts are expecting significantly reduced EPS of $4.08 because of the recent precipitous decline in oil prices below $60, driven in large part because of the uncertainty surrounding the US-China trade tension, as well as other global concerns such as Brexit. Exxon Mobil is slated to pay out $3.43 in dividends per share this year, which equates to a payout ratio of 84.1%.

Moving on to FCF, Exxon Mobil generated cash flow from operating activities of $36 billion against $19.6 billion in capital expenditures (according to page 69 of its most recent 10-K), for total FCF of $16.4 billion. The company paid out $13.6 billion in dividends during 2018, for an FCF payout ratio of 84%.

For 2019, Exxon Mobil is likely going to pay out around $14.4 billion in dividends against total FCF of likely a bit more than the $14.4 billion.

While the dividend coverage isn't exactly what we'd like to see, we do have to remember that Exxon Mobil operates in a highly cyclical industry that is subject to volatile swings in the price of its commodities. For a company like Exxon Mobil, I believe a higher payout ratio is fine in an environment like the ones we find ourselves in with oil prices under pressure for the short-term.

Image Source: Simply Safe Dividends

Perhaps not surprisingly, Simply Safe Dividends and I agree that Exxon Mobil's dividend is not only safe, but very safe for the foreseeable future.

Having said that, we'll now examine the growth prospects of Exxon Mobil's dividend going forward.

Image Source: Simply Safe Dividends

When we consider that Exxon Mobil's dividend has grown at a 6.2% clip since it began its dividend increase streak nearly four decades ago and that both its most recent dividend increase and 5 year DGR are 6%, it seems quite likely that the 6% growth of the past will continue in the years ahead.

This is further reinforced by the fact that analysts are estimating the company will grow its earnings by 13.3% annually over the next 5 years. While I believe this may ultimately prove to be a bit too high of a growth assumption for a company many have labeled as "dead money" for years, I do believe that it won't take gangbusters growth for Exxon Mobil to deliver alpha in the years ahead.

With that said, we'll now focus our attention on the reason analysts are so optimistic on Exxon Mobil's future.

Reason #2: Ambitious Growth Plans Led By Capable Management And A Fortress-Like Balance Sheet

Image Source: 2019 Scotia Howard Weil Conference Presentation

Exxon Mobil is among the largest oil and gas companies in the world, even rivaling all but a select group of the world's largest oil producing countries. The company operates in the following three segments:

Upstream: This segment focuses on the exploration and production of crude oil and natural gas. Overall, the Upstream segment accounted for 59.9% of earnings in 2018 without accounting for the impact of US tax reform and impairments.

Downstream: This segment focuses on the refinery of oil into gasoline, heating oil, jet fuel, diesel fuel, and lubricants. The Downstream segment accounted for 25.7% of earnings in 2018.

Chemicals: This segment focuses on the development of petrochemicals that are key to a variety of industries of great importance to our daily lives, such as consumer products, packaging, and a variety of automotive uses. The Chemicals segment accounted for 14.3% of earnings in 2018.

Before we delve into the reasons from an operating standpoint to be bullish on Exxon Mobil, I'll be discussing the company's strong balance sheet and experienced management team that will be leading the company into the future.

Image Source: Exxon Mobil 2018 Annual Report

As illustrated above, Exxon Mobil possesses unrivaled financial strength, meaning the company boasts an industry-leading balance sheet. As referenced on page 66 of the company's most recent 10-K, Exxon Mobil generated EBIT of $30.953 billion against $766 million in interest expense, for an interest coverage ratio of 40.41 during 2018. With an interest coverage ratio of over 40 and a leverage ratio of around 10%, it's no secret why Exxon Mobil's credit rating is AA+.

Despite the volatility of the industry in which the company operates, this balance sheet means that Exxon Mobil is positioned well through just about any global conflicts or recessions. The reason the company enjoys a very safe dividend rating from Simply Safe Dividends is because of its strong balance sheet it can rely on in times of collapsing oil prices. While this isn't ideal and is a blow to Exxon Mobil in the short-term, the company will easily be able to deleverage back to an industry-leading balance sheet due to its economy of scale that is unmatched by most integrated oil and gas companies.

The second point to consider is that Exxon Mobil's management team is among the very best in the industry. Spearheaded by 27 year company veteran and CEO, Darren Woods, Exxon Mobil is in the process of executing a bold plan that will reshape the company, and when this plan is complete, it will take away most of the financial engineering and lack of innovation stigmas the company has earned until most recently when Mr. Woods took over as CEO.

Image Source: Exxon Mobil 2018 Annual Report

As a testament to the overall effectiveness of Exxon Mobil's management team, we can see that the company's 5 year average return on average capital employed is second only to Chevron, while the 10 year average easily trounces the other oil supermajors. It's this strong execution on the part of Exxon Mobil led by the company's management that has contributed greatly to the 6% CAGR since Exxon Mobil's dividend increase streak began under the Reagan administration.

Image Source: Exxon Mobil 2018 Annual Report

The graphics above show that there is a significant need for investment to meet oil and natural gas supply and demand of the future. And it's this management team that has so brilliantly executed on its plan to ramp up investment while most in the industry are expected to decrease their capex. This could lead to an eventual supply issue with oil, pushing prices up considerably from their current level. In 2019 and 2020 alone, Exxon Mobil is expecting to spend an absolutely massive $63-65 billion on capex.

While the previous oil crashes were detrimental to Exxon Mobil in the short-term, it has positioned them well over the long-term as their breakeven has come down considerably, and positioned them to double their return on average capital employed in by 2025, compared to 2017 earnings. Furthermore, the company is also expecting that its continued commitment to aggressive capex spending will lead to a 140% increase in earnings from 2017 levels by 2025, against the 135% expected in my last article, assuming oil prices at $60 a barrel and 2017 margins.

The big picture is that despite Exxon Mobil's lagging share price for the past 10+ years, the company is taking the right steps in ramping up its capex spending while most others aside from the other efficient capital deployer Chevron, are decreasing their capex spending, which is likely to lead to a supply issue a couple years down the road.

Between Exxon Mobil's aggressive capex spending plan, its strong management team, industry-leading balance sheet, and 4.7% yield, there is quite a bit to like about the future of Exxon Mobil as the company transforms its future.

Risks To Consider:

While Exxon Mobil is an excellent company, that doesn't mean it doesn't face its fair share of risks.

The overall investment thesis of Exxon Mobil hinges upon the ability of energy prices to increase and stabilize over the long-term, and as we recently experienced last year with the 25% decline in US crude and 19.5% decline in Brent crude, energy prices can rapidly fluctuate due to a variety of factors all coalescing.

Further, Exxon Mobil's diluted EPS fell from $7.60 a share in 2014 to $3.85 in 2015 in the midst of an oil crash which saw prices plummet 75% from peak to trough. As alluded to earlier, the instability in oil prices of late has led analysts to revise their earnings estimates downward for Exxon Mobil in 2019.

It's this level of volatility in earnings that have contributed to the company's poor stock price performance for a number of years now, so for those in the community looking for a stock to rent, Exxon Mobil is certainly not the one to do so. However, for those looking for stable and steadily increasing dividends at a rate greater than inflation, Exxon Mobil is worth further consideration.

It's also important to remember that as a company which fuels the global economy, Exxon Mobil is susceptible to economic downturns, leading to reduced demand for its products, thereby harming Exxon Mobil's profitability (Exxon Mobil 2018 10-K, page 2).

In addition to the near-term risks to Exxon Mobil, a longer-term risk is that due to the variability of oil production, it is incredibly complex to accurately estimate when peak oil will occur until it already has occurred. While the energy research firm Wood MacKenzie estimated in 2017 that peak oil would occur in 2030, they revised their estimate to 2036 as recently as last year.

This is a perfect illustration of the dozens, if not hundreds of individual factors that all play into when oil demand will peak. Will electric vehicles eventually penetrate the market to the extent our vehicles of the present time did beginning after the age of horse and buggy? If so, how does that factor into oil demand? Will we find additional petrochemical uses to spur demand? These are just a few of the many questions that will determine the overall date of peak oil, which we won't definitively know until it actually happens.

While I don't believe peak oil will happen overnight, so to speak, I do believe that investors need to be cognizant of this risk, so that they can monitor it and take appropriate actions when necessary, such as if the investment thesis of Exxon Mobil possibly breaks.

We will also need to monitor the actions that Exxon Mobil takes to address these changes in the overall energy landscape to make sure they are taking the steps necessary to position themselves for the next generation of energy.

The final risk is from a regulatory and legal standpoint. As we all know, oil and gas companies hold a prominent position among the companies that are most hated by the American public and by politicians. Whether you agree with the beliefs of those attacking Exxon Mobil or not, it goes without saying that defending yourself against a number of lawsuits isn't cheap, and these types of lawsuits only seem to be accelerating by the year.

While this is by no means a comprehensive listing of the risks facing Exxon Mobil, I would refer interested readers to Exxon Mobil's Risk Factors section listed within its most recent 10-K for a more comprehensive listing of risks.

Reason #3: A High-Quality Company Trading At A Discount

Now that we've established Exxon Mobil is a blue-chip company that is likely to return to its former glory, we'll discuss the valuation aspect of an investment in Exxon Mobil.

Rather than use the 13 year median dividend yield, I will be using the 5 year average dividend yield because it reflects the higher recent payout ratio of Exxon Mobil, whereas the 13 year median yield of 2.64% would not represent a reasonable valuation for Exxon Mobil.

Exxon Mobil's current 4.69% dividend yield compares favorably to its 5 year average yield of 3.66%, especially if one believes that the fundamentals of Exxon Mobil are relatively intact for the next 5+ years compared to the previous 5 year period.

I believe in a conservative scenario, Exxon Mobil should demand a fair value yield of 4.25%, which would mean a fair value of $81.88.

This implies at its current price of $74.10 (as of May 25, 2019), Exxon Mobil is trading at a 9.5% discount to fair value while offering 10.5% upside.

Per Gurufocus, Exxon Mobil is also trading at a Shiller PE ratio of just 11.60 compared to its 13 year median of 12.62. This implies that Exxon Mobil's fair value is $80.62, which represents an 8.1% discount to fair value and offers 8.8% upside.

Image Source: Investopedia

The final valuation method that I'll use is the dividend discount model or DDM.

The first variable is very straightforward with the expected annualized dividend per share of Exxon Mobil currently at $3.48.

The second variable of the formula of cost of capital equity, which is another term for an investor's required rate of return is a subjective input that varies from one investor to the next.

In my case, I use a 10% required rate of return as that has historically outperformed the broader market by a bit.

The final variable of dividend growth rate is the most difficult to predict because there are a number of factors that go into the DGR. To determine the long-term DGR, I examine factors such as past dividend growth, the industry and company outlook, and the current payout ratio.

Given that Exxon Mobil boasts a 6% most recent dividend increase and a 5 year DGR of 6%, I believe it is reasonable to assume this trend will continue because Exxon Mobil's payout ratio can't really be viably increased any further and dividend growth will follow whatever earnings growth the company is able to deliver over the long-term.

When we plug in the variables, we arrive at a fair value of $87.00 a share. This indicates that Exxon Mobil is trading at a 14.8% discount to fair value and offers 17.4% upside.

The average of the above 3 fair values is $83.17, which implies Exxon Mobil is 10.9% undervalued and offers 12.2% upside.

Summary: A Tiger That Will Roar And Deliver Alpha

Exxon Mobil is a Dividend Aristocrat with a history of delivering a dividend CAGR of 6%, which is especially appealing when we consider the dividend yield that is approaching 5%.

While the company faces its fair share of risks like any equity investment, I believe the risk is certainly priced in at these levels, and that management will be able to return this company to the meaningful growth necessary to continue its strong dividend growth for years to come.

Adding to the case for an investment in Exxon Mobil, the company is also trading at an 11% discount to fair value. For a company of Exxon Mobil's quality, a double digit discount to fair value is nothing to sneeze at.

When we put it all together, the current 4.7% dividend yield, conservative 10-year earnings growth rate of 6-7%, and 1.2% valuation multiple expansion, will mean average annual total returns in the ballpark of 11.9-12.9% over the next decade.

Disclosure: I am/we are long XOM. 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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