Summary
- Investors today face a unique opportunity to purchase energy-sector stocks at deeply discounted prices.
- Three large-cap names appear to offer excellent, asymmetric risk/reward for conservative investors.
- The broad indices are hitting new highs, and the energy sector is trolling lows; discounts are hiding in plain sight.
- Bear markets breed opportunity for patient investors.
Today, I offer three well-known, large-cap energy stocks that may be purchased significantly below fair value: Royal Dutch Shell (RDS.A, RDS.B), Halliburton (NYSE:HAL), and EOG Resources (NYSE:EOG).
This trio possesses the basic, fundamental characteristics I seek when purchasing any security. Namely, their businesses:
- Are well managed
- Have strong franchises
- Are marked by sound balance sheets
- Earn profits largely in cash
- Are shareholder-friendly
Those who have followed my work on Seeking Alpha may recognize that I regularly write about - and own - shares of RDS.A, HAL, and EOG. Therefore, I will not spend much time here re-validating the aforementioned fundamental characteristics. If you are interested in doing so, please review some of my previous articles for a cross-check.
So let's get right to the valuation exercise and find out why I believe these particular energy names may afford the patient investor excellent forward total returns:
Royal Dutch Shell (Industry: Integrated Energy)
Currently, RDS.A shares (ADRs) trade for $67.13 each, down ~18% from summertime highs.
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Royal Dutch Shell - 5 Month Price And Volume
Source: Bigcharts.marketwatch.com.
The Federal Reserve Board publishes daily the interest rates for Moody's seasoned Baa bonds. It is now 4.78%. The Wall Street Journal publishes the yield for the High Yield 100 (the 100 largest junk bonds). That index is pegged at 5.54%.
Royal Dutch Shell shares have a 5.60% forward dividend yield; and the payout rock-solid. The annual dividend has not been cut since WWII.
Shell common shares now offer a secure income component that is greater than either mid-level or junk bonds. The company holds an S&P 500 "AA" credit rating.
When evaluating or comparing Super Major energy stocks, I prefer to utilize an historic multiple of operating cash flow instead of price-to-earnings. To help validate relative valuation, I like to use price-to-book.
The table below summarizes the data. Shell appears undervalued versus peers. I added price-to-earnings for additional color. Please note that this metric further supports the premise that Shell is undervalued:
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If Shell is undervalued, by how much? What's the fair value estimate?
Let's go back to price-to-cash flow multiples. A 10-year F.A.S.T. graph illustrates the long-term P/CF multiple has been 6.4x. Price has tracked this metric well.
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Source: Fastgraphs.com.
We see the ADR shares are trading below fair value when using consensus 2014 cash flow estimates on the normalized average price-to-cash multiple: an $86 price target is the result. In 2014, Royal Dutch Shell generated $35.4 billion cash flow in the first three quarters. Therefore, the company can make the 2014 estimate of $13.57 OCF per share (or ~$43 billion) on 4Q cash flow of only $7.5 billion. Such a result would be down 32% from reported 3Q 2014 figure.
For 2015 estimates, I have a bit of a rub with Wall Street - where analysts anticipate the company will experience a 15% decrease from 2014 cash flow. While I understand that Shell is divesting about 5% of its total assets in 2014/2015, and this will reduce 2015 cash flow; I disagree with such a large projected drop. CEO Ben van Beurden has stated his objective to improve operating cash flows to $50 billion within two years. Meanwhile, the other Super Majors are expected to record 2015 YoY operating cash flows ranging from -4% to +15%.
Even if one elects to utilize the current 2015 S&P estimate and 15% OCF decrease, the Shell price target is still $74 on the historic P/CF ratio. From today's price, that's 10% capital appreciation and a 5.6% yield for a total potential return of 15.6%.
Personally, I believe the upside is greater. I contend Shell stock goes to $78 per ADR next year if oil stabilizes around $80 by mid-year 2015.
Halliburton (Industry: Energy Services)
Next up is Halliburton, arguably one of the most hated stocks on the NYSE. The shares trade at $40.37, down a whopping 44% from July highs. A one-two punch of cratering oil prices and a much-maligned Baker Hughes (NYSE:BHI) acquisition has soured investors. Halliburton stock's 44% decline has eclipsed the 35% drop in the Market Vectors Oil Services ETF (NYSEARCA:OIH). Pretty harsh treatment, huh?
I admit I did not anticipate the steep drop in crude prices when I wrote aSeptember SA article stating HAL shares were a deal below $60. While I own that article, I'm undeterred longer term.
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Halliburton - 5 Month Price And Volume
Source: Bigcharts.marketwatch.com.
So where do we go from here?
Performing a valuation exercise on HAL shares requires manifold assumptions, given the anticipated Baker Hughes takeover. Fellow Seeking Alpha contributor DAG1996 did a fine job of outlining parameters and potential outcomes in his recent article found here.
I'll proceed with a relatively simple approach:
First, with one quarter to go, I believe Halliburton and Baker Hughes' 2014 EBITDA may be safely projected to be $7.15 billion and 4.25 billion, respectively. Prior to the merger, HAL shares traded ~$55 each, and BHI stock changed hands at ~$60. Utilizing the current number of shares outstanding for each company and doing the math, Halliburton shares went for 6.6x Price/EBITDA versus Baker Hughes' 6.2x multiple.
Next, if we take the combined 2014 EBITDA of $11.4 billion and apply a 6.5x multiple, the aggregate entity could be worth $74.2 billion. Taking the total number of shares outstanding and diluting the count to reflect the HAL-BHI buyout terms, we arrive at a $55.34 price target.
This is 37% higher than Halliburton's share price today.
Going a step further, recent Wall Street estimates indicate Halliburton is expected to grow earnings in 2015 and 2016 by 13% a year. Baker Hughes is forecast to grow EPS by 14% each year. Over the past 10 years, Baker Hughes has grown cash flow (a rough proxy for EBITDA) faster than EPS. Halliburton has grown earnings faster than cash flow. Two F.A.S.T. graphs highlight this:
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Source: Fastgraphs.com.
Let's premise the combined company grows EBITDA by just 10% a year for the next two years: that equates to 2016 EBITDA of $13.8 billion. In addition, Halliburton indicated the combined companies could generate $2 billion in synergies. We'll take management's word and add that, too. If so, the new business generates 2016 EBITDA of $10.30 a share; placing a 6.5x multiple on it, suggests a $67 stock.
This is 67% higher than Halliburton's share price today.
True, these figures do not consider required asset sales to avoid antitrust issues. However, these figures do not include any share repurchases, either. HAL management noted that asset sale proceeds are likely to be used to repurchase shares. Certainly, senior leadership team has set the precedent for such activity: over the past year, Halliburton has reduced its number of shares outstanding by 9%.
Bottom line: The noted assumptions and methodology suggests extraordinary potential stockholder capital appreciation. The assumptions don't even have to be right; just reasonably close.
It's difficult to come up with any scenario so dour that it justifies HAL shares trading barely above $40. The last time HAL stock traded ~$40, trailing operating EPS was $2.77 and the P/E was 14x. Today, the trailing earnings are $3.76 and the multiple is 10x.
HAL/BHI 2014 combined EBITDA would have to fall about 25% with no synergies on a 6.4x multiple to justify a post-acquisition $40 Halliburton share price.
EOG Resources (Industry: Oil & Gas Exploration and Production)
My third pick is EOG Resources. This enterprise is far and away my favorite domestic energy producer. Indeed, I consider EOG the "Apple Inc. (NASDAQ:AAPL)" of the E&P business. Falling spot crude prices have resulted in EOG shares bouncing up and down, but mostly down. Summer highs of $118 have given way to recent lows between $85 and $90 a share, or declines of 24-28%.
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EOG Resources - 5 Month Price And Volume
Source: Bigcharts.marketwatch.com.
Nonetheless, in my recent discussion with EOG management, it was stated that the company can make cost of capital returns in some major shale plays even if oil prices fall below $60/bbl. There is no intent to back off 2015 production plans.
While my EOG valuation approach is similar, my fair value outlook for the company is somewhat more abstract. For a detailed basic valuation presentation, you may find my October SA article helpful. It is found here.
Summing up, from a straight valuation standpoint, I suggest an analysis using historic price-to-cash is a valid metric. Over the past 15 years (and two energy recessions), EOG shares have commanded an average 6.7x P/CF ratio. In 2014, the business is expected to make ~$15.60 operating cash per share. Through three quarters this year, the company has made $11.90 a share, so making the estimate requires meeting the average of the previous quarters. Historical results have shown EOG improving QvQ cash flow each quarter.
A F.A.S.T. graph illustrates the aforementioned:
(click to enlarge)
Source: Fastgraphs.com.
The chart indicates a $105 price target on 2014 cash flow, or an 11% uplift from a recent close. However, we know Mr. Market is more interested in forward expectations than past results.
Based upon reviewing corporate releases and presentation materials, I believe EOG can generate flat cash flow in 2015, even at $70 spot oil. Management has stated if spot prices stay down, the business will simply redirect capital to its most prolific and profitable leases.
Effectively, EOG is in the enviable position of having superior leaseholds in the best North American domestic energy basins. If crude prices go down, the company just produces oil where it's cheapest. Importantly, EOG consistently improves its energy extraction technology, thereby lowering production costs. This unique combo of strength and flexibility is the primary reason EOG leadership has not backed off 2015 production plans.
On a Price/Sales basis, EOG is also at a low ebb; assuming shares at $90, year-end 2014 P/S should come in at 2.8x. Over the past 15 years, the only time this ratio has been lower was during the Great Recession. Another F.A.S.T. graph offers this overview:
(click to enlarge)
Please note the preceding doesn't even capture my long-term investment thesis: while EOG shares appear to be undervalued now, I believe LT fair value is much higher than the current metrics indicate. By "much higher," I mean magnitudes higher. Here's why:
Historically, spot crude prices behave similar to the stock market: prices go up and down, but the general long-term trend is up.
During times of market dislocation or panic (as I believe is ongoing today), prices tend to overreact. Eventually, they stabilize, then "revert to the mean," or return to the long-term trend line. I believe probability is high we are going through just such an adjustment episode today.
Here's a long-term chart of WTI spot prices:
(click to enlarge)
Is it possible the current sag in prices represents terminal price declines and "new normal?" Sure, most any scenario is possible. However, when viewing the big picture, is that the most probable outcome?
Based upon 30 years in the oil path, I don't think so.
Oil supply/demand has a remarkable propensity to self-correct. For the foreseeable future, increasing crude oil demand is embedded into every viable nation's economy. Even if developed nations somehow choose to lower collective consumption, I predict it will be overwhelmed by developing nations' increasing demand. The reasoning is simple; people seek improved living standards, and oil is a necessary vehicle to obtain those standards.
Within the domestic energy business, EOG Resources has a strong balance sheet, the highest margins and returns, possesses superior leases in the best basins, has years of proven and profitable reserves, generates high cash flows consistently, employs leading-edge industry technologies, and has outstanding management.
Indeed, the company will weather the temporary price storm today, just as in the past. When the dust clears and oil prices recover, which they will, I expect the enterprise and the stock will be positioned to run ahead of its peers.
The shares are trading at a good discount today. Put the stock away for a couple of years and let's talk again.
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