BofA Equity Research says Sweet 16 have lots of upside
Posted: Mon Sep 27, 2021 7:07 pm
From BofA this morning (9/27/2021)
Under our valuation framework US oils ‘discount’ $50WTI
We continue to believe the US oils are at the early stages of an extended cyclical
recovery, with many similarities compared to the mid-2000’s. While valuations have
recovered from last year’s lows, only a handful are up compared to pre-COVID. The
culprit exposed by our valuation framework is a steeply backwardated oil curve that has
capped valuations for the simple reason that the conditions necessary to lift the long
end of the curve are not yet in place – namely a post-COVID recovery in demand. Still,
based on our ex growth valuation analysis we suggest the sector is discounting longterm
oil prices around $50 WTI (range $41-$57) substantially below the current forward curve.
Free cash yields average 19% in 2022, 13% normalized
Value is underlined by the strength of free cashflow - average FcF yields ~19% in 2022
normalizing at ~13% in 2024. Some are higher: APA & OXY stand at 32% and 34%
respectively noting both have no oil hedging. In common is significant debt but with no
liquidity issues. Strength in sector free cashflow has polarized debate over the best use
of cash after debt reduction acknowledged as the first priority by most managements.
But after that the sector appears to be increasingly split between two camps – variable
dividends or share buy backs with the debate taken on renewed interest as four high
profile E&P’s have entered the fray on different sides – Pioneer & Devon with variable
distribution policies vs Ovintiv & Diamondback preferring share buy backs.
We see windfall cash best recognized in buy backs
The question in our mind however is whether variable distributions will be recognized –
and whether this is the optimal use of free cash for a depleting business, with a finite
inventory. In our view, for as long as there is an identifiable value gap between the share
price and embedded value, buy backs offer the best value for shareholders albeit
acknowledging historical flaws mainly related to timing – albeit without the immediate
return of cash that may impact who owns the shares. While shareholders are made
whole and may be agnostic, the theoretical reality is nevertheless that a variable
dividend payout is backward looking, does nothing for the sustainable value recognized
by the market for a depleting business and may in fact reduce forward equity value.
Who’s best placed? XOM, OXY, APA, CLR, OVV & FANG
If the choice is between debt reduction, buy backs or variable dividends we see several
stocks standing out: APA & OXY have the best opportunity to transfer value from debt to
equity; OVV & FANG could consider exploiting dislocations in value through buy backs.
CLR is an outlier with the impact of buy backs amplified by limited free float. As a
footnote, adjusting for a lower share count expected with 3Q21 earnings our PO moves
up to $48. Finally there is ExxonMobil. In our view there is a transition in the market on
when the value of a dividend is recognized. Reviewed in our 2Q21 XOM Recap (see
report), we believe XOM will be in a position to raise its dividend with 3Q21 earnings
having met its <25% net debt target, likely reinforcing confidence in its capacity for
future growth in its Dividend Discount Model (DDM).
Under our valuation framework US oils ‘discount’ $50WTI
We continue to believe the US oils are at the early stages of an extended cyclical
recovery, with many similarities compared to the mid-2000’s. While valuations have
recovered from last year’s lows, only a handful are up compared to pre-COVID. The
culprit exposed by our valuation framework is a steeply backwardated oil curve that has
capped valuations for the simple reason that the conditions necessary to lift the long
end of the curve are not yet in place – namely a post-COVID recovery in demand. Still,
based on our ex growth valuation analysis we suggest the sector is discounting longterm
oil prices around $50 WTI (range $41-$57) substantially below the current forward curve.
Free cash yields average 19% in 2022, 13% normalized
Value is underlined by the strength of free cashflow - average FcF yields ~19% in 2022
normalizing at ~13% in 2024. Some are higher: APA & OXY stand at 32% and 34%
respectively noting both have no oil hedging. In common is significant debt but with no
liquidity issues. Strength in sector free cashflow has polarized debate over the best use
of cash after debt reduction acknowledged as the first priority by most managements.
But after that the sector appears to be increasingly split between two camps – variable
dividends or share buy backs with the debate taken on renewed interest as four high
profile E&P’s have entered the fray on different sides – Pioneer & Devon with variable
distribution policies vs Ovintiv & Diamondback preferring share buy backs.
We see windfall cash best recognized in buy backs
The question in our mind however is whether variable distributions will be recognized –
and whether this is the optimal use of free cash for a depleting business, with a finite
inventory. In our view, for as long as there is an identifiable value gap between the share
price and embedded value, buy backs offer the best value for shareholders albeit
acknowledging historical flaws mainly related to timing – albeit without the immediate
return of cash that may impact who owns the shares. While shareholders are made
whole and may be agnostic, the theoretical reality is nevertheless that a variable
dividend payout is backward looking, does nothing for the sustainable value recognized
by the market for a depleting business and may in fact reduce forward equity value.
Who’s best placed? XOM, OXY, APA, CLR, OVV & FANG
If the choice is between debt reduction, buy backs or variable dividends we see several
stocks standing out: APA & OXY have the best opportunity to transfer value from debt to
equity; OVV & FANG could consider exploiting dislocations in value through buy backs.
CLR is an outlier with the impact of buy backs amplified by limited free float. As a
footnote, adjusting for a lower share count expected with 3Q21 earnings our PO moves
up to $48. Finally there is ExxonMobil. In our view there is a transition in the market on
when the value of a dividend is recognized. Reviewed in our 2Q21 XOM Recap (see
report), we believe XOM will be in a position to raise its dividend with 3Q21 earnings
having met its <25% net debt target, likely reinforcing confidence in its capacity for
future growth in its Dividend Discount Model (DDM).