ExxonMobil (XOM): A Blue-Chip Energy Company Likely to Provide Double-Digit Returns
Member write-up by Trey Henninger
Exxon Mobil (XOM) is one of the oil majors. Traditionally, being an oil major has meant being a fully vertically integrated company from oil exploration, drilling, refining, and chemical production. ExxonMobil continues to fulfill that role, but they are much more than an oil company today. Although they are typically billed as an oil AND gas company, they are much more.
Business Model Overview
ExxonMobil is a very complicated business with many different parts. The simple way to look at the business is that ExxonMobil operates as a vertically integrated company. They source and sell commodity products. Since ExxonMobil’s focus is in commodities, they have no general pricing power in the market.
Consequently, Exxon’s profits are quite cyclical, and hard to predict. However, the vertically integrated nature of the company dampens the cyclicality of the business cycle to a large degree. When oil prices are low, refining margins are usually high. Alternatively, the chemicals business could continue to make a profit while both oil sourcing and refining are less profitable.
This vertical integration and diversified structure is the key advantage of ExxonMobil and the other oil majors.
Durability
I believe that ExxonMobil is a company with infinite durability. The company traces its history back to the original days of Rockefeller and Standard Oil of New Jersey. Exxon has been in continuous operation for over 100 years. You should be able to expect them to continue to operate for at least another 100 years. At a minimum, well beyond your investment time horizon.
The reason for this is quite simple. Although ExxonMobil’s business is currently focused on the commodities oil and natural gas, that won’t always be true.
ExxonMobil is best analyzed as an “Energy” company. While the individual commodity product might change, the overall goal is the same. ExxonMobil is in the business of providing energy to their customers. Currently, this takes the form of oil and gas, but they certainly are not limited to that.
ExxonMobil was originally simply a diversified oil company. Then, as the market changed as natural gas become a larger portion of our energy sources, ExxonMobil acquired a major natural gas company, and has become one of the world’s largest natural gas producers.
The same will occur if the mix of energy ever shifts again in the future. Currently, the thought is that renewables, such as solar or wind power will disrupt the oil majors, such as ExxonMobil. This is not likely to happen. Instead, I would expect ExxonMobil to operate in the oil and gas business until they recognize that renewables are finally ready for the mainstream. Once they do, they’ll acquire a major renewable energy company, and quickly build it up. It won’t be long before ExxonMobil is then one of the largest renewable energy producers on the planet.
ExxonMobil has both the scale and the financial resources to accomplish this goal.
Competition
ExxonMobil faces enormous competitive pressures. While a business like NACCO might be said to have no direct competitors, ExxonMobil is exactly the opposite. ExxonMobil competes with anyone and everyone willing to search for and sell oil. As a consequence of this, ExxonMobil has ZERO pricing power.
All of ExxonMobil’s primary oil and natural gas sales are made at market price, based upon commodity pricing. There can be some contracts in place, and hedging of prices, but basically ExxonMobil doesn’t have any control over the long or short term pricing of their products.
While this doesn’t sound good, it can also be misleading. Although ExxonMobil can’t control its selling prices, it does a great job of controlling costs. This is one of the primary sources of Exxon’s quality.
Quality and Growth
ExxonMobil is definitely blue-chip quality. ExxonMobil has paid a continuous dividend every year for the past 107 years (since 1911). The dividend has been raised every year since 1982 for a dividend growth rate of 6.3% annually. This is a company which has made a religion out of paying its dividend and raising it each year.
While there are other companies with similar records, there are very few cyclical companies with similar records. The reason that ExxonMobil can create a sacrosanct dividend in a cyclical industry is because the company is run with a focus on a long-term time horizon. There is a culture at ExxonMobil that focuses on 20-50 year time horizons, instead of simply looking to beat earnings in the next quarter.
This time horizon differential is a key part of the moat for ExxonMobil.
The second aspect of ExxonMobil’s moat is that ExxonMobil has a lower cost of commodity production than nearly all other producers. Very few companies can match Exxon’s cost of oil production per barrel. This allows ExxonMobil to remain profitable in more oil pricing environments than their competitors. This competitive advantage has also been quite durable over the decades.
When we discuss growth, it’s important to highlight that growth is always unpredictable at any company. The uncertainty is even higher at a commodity company like ExxonMobil. However, management has recently given guidelines that their goal is to double profits by the year 2025 (assuming current oil prices stay the same.) This is a critical assumption, because oil prices will most definitely NOT be the exact same they are today. They will move both up and down over the next 7 years.
However, let’s assume for a minute that this assumption is accurate. Although management isn’t using those words, they are basically saying “We plan to double our earnings power over the next 7 years.” Even though we can’t definitely say what the actual earnings will be, all we care about is earnings power anyway. So, it’s sufficient to base our analysis on this.
If management is successful in doubling earnings power over the next 7 years, then earnings power would grow at approximately 10% per year. That is a significant growth rate for a company with a market cap in the hundreds of billions of dollars. Consequently, I’m going to assume that management is optimistic, and that they are only able to achieve a 6% earnings power growth rate. This is in-line with historic dividend growth rates, so I believe it is a reasonable basis.
Capital Allocation
ExxonMobil is an extremely capital intensive business. It is very expensive to search for oil and gas deposits. Additional money is then spent to extract the commodities for sale. Oil refineries typically cost billions of dollars to build.
As a result, ExxonMobil regularly spends billions of dollars every year in both capital maintenance and capital expansion. Therefore, an analysis of ExxonMobil needs to understand that cash flow and free cash flow have a large difference.
Free cash flow has historically been used by ExxonMobil for three purposes: dividends, acquisitions, and share repurchases. They follow that order of preference within the company. The basic goal has been for ExxonMobil to acquire new large businesses or deposits on a regular basis. If none are available that meet the high internal return standards, then the rest of free cash flow is used to retire large blocks of shares. Thus, if you look at historic reports, ExxonMobil has had a consistently falling number of shares outstanding.
Recently, ExxonMobil announced that they would be limiting share buybacks as they reinvest more money into their internal businesses through capital expenditures. This large amount of expenditures is apparently required to achieve their target 10% growth rate over the next 7 years. As such, we should expect, at least for the next 2 or 3 years, for share repurchases to be less than the historical norm.
Value
Determining an intrinsic value for ExxonMobil is difficult. The cyclical nature of the business means that profit or free cash flow based multipliers are likely to be flawed. Use of a P/E ratio for instance is likely to make the company look expensive when it is cheap and vice versa.
Therefore, my favorite method of valuing ExxonMobil is simply a dividend yield + growth based approach. Basically, we focus on estimating prospective returns from the current dividend and a conservative growth rate.
The current dividend on a trailing 12 month basis is $0.77 per quarter. This equates to $3.08 per year. However, ExxonMobil traditionally raises their dividend in April of each year, so it’s quite likely that using $3.08 will be conservative for future analysis. We’ll continue to use $3.08 for this analysis though.
The current stock price of ExxonMobil is approximately $75. This means that the dividend of $3.08 represents a 4.1% dividend yield.
We determined that our expected earnings power growth rate is between 6-10% for the following 7 year period. Dividends have historically tracked earnings power as determined by ExxonMobil management. In addition, because ExxonMobil’s dividend is treated as sacrosanct, we can use a simple dividend discount model.
Basically, expected return will equal dividend yield + dividend growth rate.
Therefore, current prices value ExxonMobil with a forward return potential of 10.1-14.1% over the next seven years.
I believe this is a reasonably attractive opportunity at current prices and am in the process of adding to my current long position.
Potential Errors
Although downside is limited in an ownership position of ExxonMobil if held for a 5 year time period, your biggest risk is not being able to handle volatility of owning a cyclical stock.
ExxonMobil is very cyclical in both profits and stock price. It’s not abnormal to see large swings in the stock price, or have dividends temporarily exceed free cash flow. Yet, two years later, dividends might be only 20% of free cash flow.
Some alternative risks to consider is that ExxonMobil might be harmed from legislation limiting carbon emissions. It’s worth noting that ExxonMobil management does not believe that to be the case. ExxonMobil is one of the oil companies that support implementation of a carbon tax.
Another risk is the use of more electric vehicles. However, projections for oil and gas usage continue to rise even though they account for an increasing use of electric vehicles.
Conclusion
ExxonMobil is an attractive buy at current prices and offers useful diversification for those not exposed to the oil and gas industry. It’s one of the few safe investments in the industry that can be held through all points of the business cycle.