'Notorious' BP to Possibly Double
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
When you think about all of the behavioral anomalies on the market - the aggressive risk discounting of financials, the hype surrounding many social media businesses, the application of biotech growth to mature companies - perhaps nothing stands out as much as BP's (NYSE: BP) present valuation. Yes, that company… the one that no one wants to talk about. Valued at only a respective 5.5x and 7.1x past and forward earnings with a leading dividend yield of 4.6%, BP is simply a steal at current prices. I recommend investors buy shares in the leading energy company alongside those of Marathon (NYSE: MRO) over Exxon (NYSE: XOM). Below, I review the fundamentals of each.
BP
As I expressed in the opening paragraph, BP is incredibly cheap at current prices. Analysts expect 5% annual EPS growth over the next five years, which means 2016 EPS of around $6.86. At a 12x multiple, the future stock value of BP would be $82.32, implying that the stock will nearly double in value. Discounting backwards by a rate of 10% yields a price target of $51.11. In my view, the 5% annual growth forecast is overly low, so I believe that has a ~25% margin of safety at a minim.
But, what fundamentally makes BP so undervalued? Several things. First, the $132.8 billion company has an excellent moat and scale. Debt is also low. But, most importantly, free cash flow is solid. Dominated in an industry with heavy capital expenditures, BP generated more than $4.3 billion in free cash flow last year. This kind of excellent operational history was showcased in 2009 and 2008; but, investors nevertheless remain singularly focused on the devastating 2010 performance.
From the Macondo oil spill to uncertainty in Russian operations, BP's risks have also been overblown. In fact, the market would have to be discounting future streams of free cash flow at a rate of around 15% to justify the current valuation. Management should sell part of its Russian business and use the extra liquidity to improve scale abroad. 2Q may be weak, but cash flow is solidly in an up trend.
Marathon Oil
Marathon is another integrated oil & gas play that I recommend aggressively. Falling oil and weak natural gas prices are not fundamentally static, and I expect a dramatic reversal over the long-term. Marathon has a stable base from which to grow production and valuable shale acreage. At the same time, investors also remain overly concerned about liquidity. With a quick ratio of 0.7, Marathon has pressures, but the PEG ratio is fairly low relative to the sector. Put differently, future growth has not been factored into the stock price and can be leveraged for expansion.
Moreover, production is doing just fine. Eagle Ford volumes are up, and management is aiming to sell $3 billion of its assets to grow production elsewhere. If management can cut capital expenditures, improve efficiency, and make meaningful progress in its divestment plan, I believe it will sustain volatile commodity prices.
In the meantime, investors are focusing on the firm's debt. As leverage increases, I see the company's Baa2 rating holding steady and possibly improving depending on how the company manages to collateralize obligations. Marathon has long duration production operations, which also offer greater sustainability than the industry at large. Accordingly, I recommend buying shares.
Exxon Mobil
The Standard Oil heir is, in my view, among the safest energy companies out there. While it trades at a premium to BP and Marathon, the 2nd most valuable company in the world still trades at 10.4x past earnings. Even still, the law of large numbers is working against the firm, as evidenced by analyst forecasts of just 7.8% annual EPS growth over the next five years.
What makes Exxon so impressive from a defensive standpoint is that it has (1) one of the most successful and extended operating histories, (2) $18.7 billion in cash for accretive takeover activity, and (3) solid free cash flow generation. Over the last twelve trailing months, Exxon generated $22.7 billion in free cash flow. On the other hand, I am concerned about potentially more burdensome EPA regulations. With a production capacity of 6.3 million barrels per day, Exxon has plenty to lose and little room to penetrate.
Moreover, I believe that energy investors will increasingly seek the smaller players that can substantially expand margins, receive takeover offers, and outperform from positive secular trends in natural gas. Thus, Exxon's safety comes with a drawback: lower upside. Moreover, mega-cap energy firms that already have a proven operating history, like BP, are cheaper than Exxon on a PE basis. Accordingly, I only recommend Exxon for risk-averse investors who are unwilling to "ride" the volatile ups and downs of the short-term market.
TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of ExxonMobil. 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.If you have questions about this post or the Fool’s blog network, click here for information.
