- Exxon's balance sheet ensures the company can borrow at will. Acquisitions appear to be on the cards.
- EPS rose sequentially in Q3 primarily due to downstream profits. A growing EPS despite low oil prices is a good sign.
- Over time, I see dividend investors like ConocoPhillips investing in Exxon.
- Other upstream companies with high yields are too risky at present to be holding.
For Exxon Mobil (NYSE:XOM) the integrated model acts as a hedge for the company in the current climate because it can still generate excellent cash flow despite them being much lower than 12 months ago. While some upstream companies like Marathon Oil (NYSE:MRO) are down 40%+ over the last 12 months, Exxon Mobil stock has only lost 12% of its share price which is a testament to its integrated model. Exxon covered its dividend in the third quarter of this year by selling off some assets which increased its free cash flow. Bears point to the fact that the dividend is not sustainable long term because the company is running at a deficit, but when you look at the company's balance sheet, and at what is coming down the track in terms of production, I do not see the dividend at risk. This company has a stellar credit rating which was confirmed last week when Morning Star gave the company a AAA rating, which means that the company's risk of default is extremely low. Apart from the company's sheer size, the strength of its balance sheet ensure than it can sell bonds at will. Moreover if oil prices dropped more and Exxon's dividend yield spiked past 4% (presently it is 3.67%), you would see hoards of dividend investors piling into this stock. A 4% dividend yield from Exxon would be almost double the US 10 year bond yield which is 2.18% at present. However, this is only one of the many reasons why the stock will remain elevated. Let's discuss some more.
What protects integrated companies when oil prices are on the floor, is their downstream and chemicals business. These divisions thrive in a low price environment which we have had in the third quarter of this year (see chart)
Exxon's third quarter results (compared to the second quarter) really demonstrate the robustness of its integrated model. Although revenues came in lower in the third quarter compared to the second ($67.3 billion compared to $74.1 billion), the company's net income came in higher ($4.24 billion compared to $4.19 billion). Now as you can see from the chart above, oil prices were much higher in the second quarter compared to the third quarter and this company historically has made far more money on its upstream activities. However what was significant about the third quarter was that Exxon's downstream division's earnings increased by $527 million on stronger margins and lower maintenance (see chart). Upstream earnings decreased by $673 million which illustrate that growth in downstream earnings are now almost completely compensating for losses in upstream. I expect this trend to get better if oil prices stay low as the company's chemicals division (which was flat in Q3 compared to Q2) should follow downstream higher.
On the dividend front, Exxon seems to be the pick of the bunch when it comes to how safe the dividend is compared to other oil and gas companies. I would caution investors to do the necessary fundamental analysis in this sector and not blindly be attracted by dividend yield. Also just because an oil company raises its dividend (as ConocoPhillips (NYSE:COP) did recently ), this doesn't essentially mean that the dividend is safe. We have seen over the last few months what happens to the share price (Chesapeake & Marathon oil) when dividends are cut, and its not pretty. ConocoPhillips paid out a 5.63% yield compared to Exxon's 3.67%, despite having negative earnings of $1.7 billion in the third quarter of this year. On the contrary Exxon has a dividend payout ratio of about 60, as dividends are funded by "some" deficit spending, asset sales and positive earnings. The second reason why Exxon's dividend is far more stable is its price to cash ratio which is under 10.
Warren Buffet swears by this metric as his career has shown that companies with good fundamentals and p/c ratios of 10 usually provide solid shareholder returns over the long term. Investors shouldn't get hung on the low expected EPS this year of $4.74 compared to $7.60 last year, but instead watch the growth paths. Dividend pay-out ratio, price to cash ratio and earnings growth are the critical metrics that dividend investors watch. Exxon has already had 2 quarters of positive EPS growth. If this pattern continues, dividend investors will start to invest more in the oil major. Compare that with Conoco which has negative earnings growth and is abandoning its long term production growth targets in order to sustain the dividend. This is dangerous, as it has no downstream division to protect it. Therefore if oil prices remain low, the dividend will be cut. It is only a matter of time.
To sum up, I believe Exxon Mobil has significant downside protection compared to other companies in the oil and gas industry. The longer oil prices remain suppressed, the more likely it is for Exxon to pick up quality assets at cheap prices. Many upstream companies are facing bankruptcy which is bullish for Exxon as it should gain market share. Recently it acquired new acreage in the Permian. I see more purchases or acquisitions to come. Its integrated model will ensure it can outlast the present environment despite cap-ex being hit and continuing asset sales. Despite this, cash flow levels are predicted to improve from 2017 once long life assets come on stream which will provide larger cash flows due to reduced cap-ex spending.