Defensive Energy 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 looking to buy energy stocks but hedge against macro uncertainty, you should consider backing the largest integrated producers. Exxon and Chevron are both "pieces" of Standard Oil and have consistently grown free cash flow over the long-term. While they both trade at historically low multiples, it is unclear whether this is a result of poor long-term growth prospects or a challenging near-term environment. This article attempts to analyze whether recent news will prevent, or perhaps warrant, outperformance.

ExxonMobil (NYSE: XOM)

As the United State's largest oil & gas company, Exxon commands an economic moat like none other. It still generates an incredible 23.9% return on invested capital, which is nearly 600 bps greater than peers. It also has less leveraged, as indicated by the 5.5x total debt to capital ratio. Partially because of these characteristics, the firm trades at a high 2.3x book value versus a 1.5x industry average. Is the strong execution, balance sheet, and fundamentals worth the price?

I believe so and encourage an investment but only for the risk-averse investor. Exxon offers a 2.6% dividend yield and is forecasted for a 6.1% annual growth rate, which makes for a 9.3% average annual return excluding share repurchases. Net repurchases have started to drop off since 2007, but they are still more than dividends. Further, the percentage of market cap returned to shareholders in both dividends and buybacks has increased from around 3% in 200 to around 6.5% in 2010. So, a 9.3% average annual return is a low estimate.

Exxon has guided for a positive long-term outlook with domestic and Canadian energy production maintaining power. A few concerns come from surpluses in West Texas, New Mexico, North Dakota, and Oklahoma. And 5 of the 6 concessions in Poland will be given after Exxon's sale of 2 shale gas projects. Imperial Oil (NYSE: IMO) is still planning  a LNG export business located in the West coast of Canada, but start-up in the Kearl oil sands mine has been slowed by a tough winter in northern Alberta and won't see production until probably next month. That said, Kearl may soon receive regulatory approval for 345K boe/d. Exxon is a 69.6% majority shareholder of the company, and they are also seeking regulatory approval in a partnership with BP to restart exploration drilling in the possibly 90 billion barrel rich Canadian Arctic as soon as summer 2013. 

Chevron (NYSE: CVX)

Chevron's Gorgno LNG project near the northwest of Australia has seen its costs balloon $15 billion to $52 billion due to a perfect storm of issues. The company has seen its longest decline in energy output in the last 4 years as global production fell to 2.52M boe/d, and average realized sales per barrel fell $6 to $91. But with Angola LNG shipments beginning next quarter and Australia LNG shipments beginning 1Q15, investors are focused on the upside. Moreover, some are speculating that the company will use its $21.6 billion in cash to acquire other businesses, like Kosmos and Cobalt.

The company has taken advantage of its cash to stage previous land buys, and with a new study out showing tremendous oil & gas resources in Alberta's shale play, the market will likely react more favorably to signs of new takeover activity. At 8.9x past earnings and little debt, I also find the company meaningfully undervalued. Dahlman Rose recently upgraded the stock to a "buy" , and 15 of 19 reporting analysts are calling the stock a "buy" or better. Non say "sell".

Return on invested capital is just below Exxon at 21.6%, but margins are above peer levels. It is expected to grow EPS by a rate of 11.3% over the next 5 years, which is 560 bps greater than integrated peers. Assuming expectations are met, 2016 EPS will come out to $16.72. At a multiple of 12x, this translates to a future stock value of just north of $200. Discounting backwards by 10% yields a present value of $124.18--in-line with the consensus price target. This provides a strong enough margin of safety on top of the 3.3% dividend yield to justify an investment.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of ExxonMobil. Motley Fool newsletter services recommend Chevron. 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!

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