3 Undervalued Oil & Gas Stocks
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
If you are a bull on oil & gas like me, it is critical that you understand how companies go about strategic alternatives. M&A has built the greatest energy companies, ranging from Chesapeake Energy to the great Standard Oil itself, and this will drive returns going forward. Below, I review the outlook on the upstream, downstream, and integrated producers.
Valero (NYSE: VLO): Valuable Under Strategic Alternatives
At a respective 10.2x and 6.1x past and forward earnings, Valero is quite cheap despite excellent fundamentals. There are several reasons to be optimistic about the business going forward. From attempting to sell its low margin gas convenience stores to potentially buying out BP's large Texas City refinery, Valero looks well positioned strategically in M&A. The former could generate $3.5 billion from oil & gas companies, which would, in turn, make Valero even more of a takeover target. Given the volatility in energy, the major producers are looking for firms with high enough margins to navigate the macro storms. Valero is currently sitting on a portfolio of assets worth more than the sum of the company, as evidenced by the fact that the stock trades under book value. And despite growing earnings 6.3% annually over the past five years, analysts are forecasting 42 bps less on an annual basis over the next five. Over the last four quarters, Valero has beaten consensus EPS estimates by an average of 10%. I recommend buying to capitalize not only off of positive earnings surprises but off of the takeover & strategic potential.
Better Ask Murphy Oil (NYSE: MUR)...
If Valero is to seek advice in strategic alternatives, they better ask Murphy Oil. The energy company was recently pursued by shareholder activist Third Point to sell off assets for boosting liquidity. It rightfully decided to spin off its downstream business as "Murphy Oil USA," which will enable investors to better allocate risk and invest. This has been a general trend in the industry: sell off low margin downstream operations. In addition, the spin-off will enable the core business to use the capital that would have been spent downstream on E&P activity.
Murphy, however, has its pros and cons in terms of multiples and earnings power. It trades at 15x forward earnings but is forecasted for 10.2% annual EPS growth over the next five years. To put that into perspective, consider that competitor HollyFrontier (NYSE: HFC) trades at a respective 5.4x and 7.1x past and forward earnings while it is forecasted flattish growth. Assuming Murphy meets expectations, it will generate 2016 EPS of nearly $8. At a multiple of 16x, this translates to a future stock value of $128. Discounting backwards by 10% yields a present value of $79.50, which is at around a 30% premium to the current market capitalization.
HollyFrontier, not to be ignored, also has excellent fundamentals. It has five refineries that are located in the middle part of America, and it has been able to exploit the differential in spot prices across different markets. The distribution of seven different special dividends since being formed in July 2011 has added up to a yield of 7%. This substantially reduces risk in the greater exposure to downstream operations.
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