A Stock That Will Come Roaring Back

Ryan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

After the oil spill, I reasoned that British Petroleum (NYSE: BP) would follow the pattern that similarly situated stocks have followed: they get crushed because the market hates uncertainty and it overreacts, then they become dead money while they stabilize, and then they come roaring back.

A few days ago I started to research British Petroleum.  I was trying to determine whether or not BP is in still in the middle stage (stabilization / dead money) and whether or not BP is going to come roaring back like great – and even not so great – companies often do after they get unfairly pummeled. 

Mixed Feelings

After a quick scan of the financials, I was a little surprised when I saw that BP had a record year in 2011, earning close to $40 billion – far more than BP has ever earned. 

That feeling was quickly tempered, however, when I read that BP agreed to pay a $4.5 billion fine and plead guilty to criminal charges for its role in the 2010 Macondo incident.  But that doesn’t seem like that much money for a company that earned nearly $40 billion, particularly if it provides closure, limits exposure to future claims, reduces uncertainty, and is spread out over several years.          

Generally speaking, it appears that the analysts, who tend to be overly conservative in these sorts of situations, feel that there is still a lot of uncertainty surrounding BP, that BP is in the midst of a transformation, and that BP is a clearly a Hold. 

Because many analysts believe that there are still many issues surrounding the Macondo incident that are unresolved, it appears as though they are ensuring that they error on the side of caution and are therefore undervaluing shares of BP.

A Closer Look

A deep dive into various metrics suggests that BP is undervalued.  Compared to peers such as Chevron (NYSE: CVX) and ExxonMobil (NYSE: XOM), as well as BP’s historical valuations, BP has a low Price to Earnings ratio, a low Price to Sales ratio, a low Price to Cash Flow ratio, a low Price to Book ratio, and a healthy balance sheet.    

<table> <tbody> <tr> <td> <p> </p> </td> <td> <p>BP</p> </td> <td> <p>CVX</p> </td> <td> <p>XOM</p> </td> </tr> <tr> <td> <p>Price to Earnings</p> </td> <td> <p>8.0</p> </td> <td> <p>9.0</p> </td> <td> <p>9.4</p> </td> </tr> <tr> <td> <p>Price to Sales</p> </td> <td> <p>0.37</p> </td> <td> <p>0.89</p> </td> <td> <p>0.82</p> </td> </tr> <tr> <td> <p>Price to Cash Flow</p> </td> <td> <p>4.7</p> </td> <td> <p>5.7</p> </td> <td> <p>6.4</p> </td> </tr> <tr> <td> <p>Price to Book Value</p> </td> <td> <p>1.2</p> </td> <td> <p>1.6</p> </td> <td> <p>2.4</p> </td> </tr> </tbody> </table>

Of these three stocks, although BP may experience volatility in the short term, I feel that BP has the most potential upside long term.  Compared to Exxon and Chevron, BP is not only the most attractively valued given these metrics but also the company with the most potential to improve the operating conditions that underlie these metrics. 

In other words, in contrast to Exxon and Chevron, BP has more potential to improve its profitability by improving its return on equity and return on assets.  Unlike Exxon and Chevron, however, BP may have trouble gaining access to resources in the United States and faces other risks, namely those associated with litigation.      

What Are the Key Risks?

A risk that has the potential to have a material impact on BP’s future profitability is that BP could still incur a penalty under the Clean Water Act.  That penalty could top $21 million. 

Another risk that BP faces is that the United States Government – specifically the EPA – has temporarily suspended BP from certain government contracts and activity.  At this juncture, however, it is unclear how long this will last and what impact that this will have on BP’s operations and financial metrics, particularly given that the suspension only relates to ‘future potential contracts,’ whatever that means.    

And, of course, there is the risk that BP has another incident similar to Macondo.  Prior to this incident nobody completely understood the risks associated with deepwater activity.  Even now it is still unclear whether or not all of these risks are well understood.    

What are the Catalysts?

There are several near and long term catalysts that could cause BP shares to rally.  A favorable resolution of British Petroleum’s Macondo litigation, for instance, could cause the shares to pop.  In addition, BP’s restructuring efforts and asset sell off could provide a boost to BP’s earnings.

In the medium to long term, the projects that BP planned to initiate in years 2012 – 2014 in places like Angola, the Gulf of Mexico, the North Sea, and Azerbaijan, could positively impact BP’s revenue and net income.  By focusing on these locations as well as other very profitable locations in Africa, the Asia Pacific, and South America, BP has the potential to improve earnings.

3 Reasons to Buy BP

  1. Valuation.  British Petroleum currently generates nearly $120 per share annually in revenue, trades at a P/E ratio of around 7, and yields roughly 5% (BP raised its quarterly dividend on June 30, 2012 from 48 cents per share to 54 cents per share).          
  2. British Petroleum is managing its capital structure very conservatively.  That means that BP has plenty of room to raise capital in order to grow. 
  3. British Petroleum appears to be executing a strategy similar to the strategy that Conoco Phillips executed: a ‘shrink to grow’ strategy.  In other words, BP is selling off assets that have a low return and investing that money in assets that have a high return. 

My Foolish Take

I feel that BP is very attractively valued at around $40 per share and offers a reasonable upside with downside risk that is overstated.  BP was very profitable in 2011 and the fact that BP raised its dividend by 12.5% in 2012 signals that management appears confident in BP’s future profitability.  Although there are a lot of unknowns surrounding BP, I feel that BP’s risk/reward profile is attractive, that analysts are too conservative, and that the market has overreacted to the uncertainty surrounding BP.  Conservative investors might want to consider dollar-cost averaging while BP is somewhat range-bound.            

RyanPeckyno is long BP. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus