Why I Bought Chevron

By Chad Henage - August 6, 2012 | Tickers: BP, CVX, XOM, RDS-A | 0 Comments

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Though alternative fuels, hybrid technology, and all electric vehicles get a lot of press, there is no question that the oil industry is still the dominant force in fuel. When I reevaluated my personal portfolio a few weeks ago, I realized I did not own a major integrated oil company. I've read several articles in the past that would suggest that Exxon Mobil (NYSE: XOM) is the key player in the industry, and the only stock investors should consider. However, I personally believe that Chevron Corporation (NYSE: CVX) is an equally, if not more attractive choice.

In the oil industry there are multiple multibillion dollar giants that investors can choose from. Exxon Mobil is probably the most well-known, but I also included in my research Chevron, BP (NYSE: BP), and Royal Dutch Shell (NYSE: RDS-A). Based on their dividends and potential future growth, I wanted exposure to this industry through at least one of these four companies. In the spirit of full disclosure I actually ended up buying both Chevron and Royal Dutch Shell. Since all four of these companies are valued in part based on the commodity oil, buying their shares represents a hedge on the future growth in this commodity. In addition, investors get to collect dividends along the way and have the potential for capital gains. When trying to decide which company to invest in, there are a few metrics that I like to compare:

You can see that while none of the four companies is expected to post huge growth going forward, there's quite a difference in their valuations, yields, and gross margin. The two primary reasons that I chose Chevron had to do with their yield and gross margin. In a commodity business like this, the company with the highest gross margin, in theory is the most efficient operator. Chevron's recent gross margin of over 33% is not an anomaly, as even in 2009 and 2010 the company shows a gross margin in excess of 32%. Where their yield is concerned, the company pays a higher yield than Exxon, and over time the oil majors' earnings increase at about the same amount. This of course assumes no major individual company issues. Since Chevron sells for a cheaper multiple than Exxon, this was yet another factor that led me to choose the company. As a brief note, the reason I chose Royal Dutch Shell is that this company has the highest yield of the three that are expecting positive earnings growth. Knowing that Chevron is reasonably positioned within its industry, another question I wanted to answer was, could the company afford its current dividend payment?

To determine if the company can afford its current dividend payment, the most reasonable numbers to compare are dividend payments versus free cash flow. If a company's free cash flow exceeds the level of their dividend payment, that alone is a positive sign. In fact, as an investor I feel the most comfortable when a company's free cash flow payout ratio is below 50%, and the lower the better. This is for two reasons: First a low payout ratio protects investors from having to worry about a dividend cut if business conditions deteriorate. Second, if the company's payout ratio is low enough, it should allow them room to increase the dividend in the future. In Chevron's case, their free cash flow payout ratio has declined dramatically in the last three years. In 2009, the company was investing heavily for future growth. In this year alone, Chevron actually paid out more in dividends than it generated in cash flow. If this were an ongoing issue I would never have touched the stock. However, this was a one year event and in the last two years the ratio has dropped below 50%. In fact, as of last year, the company's payout ratio was only about 42%. Knowing the company can afford its current dividend left me wondering about the potential for dividend growth.

Looking at the company's dividend growth over the last six years, you can see the dip because of the Great Recession, but since then dividend growth has sped up significantly.

In fact, since 2009 the rate of dividend increase has quadrupled from about 4.5%, to an over 16% increase this year. Much of the company's ability to increase dividends going forward will be determined by the oil market, and their ability to maintain significant cash flow generation. This is where Chevron's higher gross margin should help if conditions deteriorate.The company was recently named as a dividend aristocrat, and based on the numbers we've reviewed, this 25 year streak appears to be just the beginning. The company has a great brand name and oil prices are very likely to stay at their current level or increase going forward. Additionally, the company's current yield and dividend growth are impressive. These are just a few of the reasons I ended up purchasing shares, and investors looking for a play on the oil industry should take a hard look at the value that Chevron represents.

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