The investment thesis
I first wrote about Exxon Mobil (NYSE:XOM) back in September 2021, arguing that its profitability has turned a corner and a decent long-term return can be expected ahead. Indeed, since then, its stock price has advanced by more than 30%. And currently, it is at a 52-week high, actually at a peak level in about two years.
Some readers asked if the thesis needs to be updated or not given such a large price movement. This article will show that there are still good reasons to be bullish both in the near term and in the long term. These reasons include:
- In the near term, as the oil price stays above XOM’s breakeven price (about $45 per barrel), an $80 target price can be conservatively supported.
- Also, as oil prices stabilize and travel recovers after the pandemic, XOM can resume reinvesting in itself and resume a healthy organic growth rate.
- In the longer term, as its renewable businesses begin to contribute, its profitability could further expand.
And we will dive in and examine all of them more closely in the remainder of this article.
XOM’s growth rate
As detailed in my previous article on XOM,
For a business that has demonstrated long-term staying power like XOM, the growth rate in the long-term is simply given by:
Long-term Grow Rate = ROCE * Reinvestment Rate
ROCE stands for the return on capital employed. Note that ROCE is different from the return on equity (and more fundamental and important in my view). ROCE considers the return of capital ACTUALLY employed, and therefore provides insight into how much additional capital a business needs to invest in order to earn a given extra amount of income. The reinvestment rate is the portion of the income the business plows back to fuel further growth.
So to analyze the long-term growth rate, we need to analyze two things: ROCE and reinvestment rate. And we will tackle them one by one in the next two sections immediately below.
XOM’s ROCE
The ROCE of XOM is shown below based on its quarterly TTM financials. In these calculations, I’ve included the following items as capital actually employed for XOM 1) Working capital, including payables and receivables, 2) Net Property Plant and Equipment, and 3) research and development expenses are also capitalized.
As can be seen, the ROCE of XOM has been in a nosedive in recent years since 2019 Q1, dropping from a long-term (“LT”) average of 13.5% all the way to a bottom of about 6% in 2020 when the COVID pandemic hit. Now, with the worst in the rearview mirror, its profitability has turned a corner and demonstrated a perfect V-shaped recovery. The current ROCE is at a very healthy 15.8%. Not only healthy in absolute terms but also higher than its long-term average by 230 basis points (or about 20% in relative terms).
As to be seen in the next section, as its ROCE recovers, decent long-term growth and return can be now expected.
XOM’s reinvestment rates
The next chart shows XOM’s deployment of cash. It shows XOM’s use of cash as a percentage of CFO (cash from operations) in recent quarters. Again, this chart is based on its quarterly TTM financials. As you can see, unfortunately for XOM, its organic investment rate has been almost 0% since 2019 Q1. Since 2019 Q1, the business does not even generate enough operating income to cover its CAPEX and its dividends.
As its profitability recovers, as you can see from the chart, it finally begins to regain some flexibility in capital allocation starting in Q3 of 2021. In the third quarter of 2021, its dividend payment is about 42% of CFO. Therefore, as a result, these two mandatory expenses cost a combined 75% of the CFO. And XOM can deploy the remainder 25% to fuel organic growth.
To put things under perspective, its long-term average dividend payment ratio is about 40% of CFO. And its long-term average of CAPEX expenses as a percentage of CFO is about 50% of CFO. So currently, XOM is in a very strong position in terms of capital allocation.
XOM’s projected growth rates and returns
Now with both the ROCE and reinvestment rates available, we could make projections about its long-term growth rate and potential returns. My projections are summarized in the following table. Dividends are assumed to grow at the same rates as earnings, and dividends are not reinvested.
The bear case represents a projection based on a pressured ROCE of 10% and a reinvestment rate of 10%. Under this combination, the long-term organic growth rate will be about 1% per annum (10% ROCE x 10% reinvestment rates).
As a normal case, I expect both the ROCE and reinvestment rate to be a bit above the historical average. I expect ROCE to stabilize at 15% (a bit lower than its current TTM level) and the reinvestment rates to be about 15% (again remember that it currently can reinvest up to 25%). Under this combination, the long-term organic growth rate will be about 2.5% per annum (10% ROCE x 25% reinvestment rates).
Note the above are the real organic growth rate. I think it’s justifiable to add an inflation escalator (projected to be 2.5% on average) as XOM has demonstrated the pricing power to adjust for inflation. I actually consider a 2.5% inflation escalator to be very conservative for XOM. In the long term (say the past 30 or 50 years), the oil price has been rising far more quickly than inflation. For example, average inflation has been 3.9% CAGR on average in the past 50 years. But oil price has risen at a pace of 5.9% CAGR, beating inflation by a whole 2%. Even with the very conservative inflation escalator, the nominal growth rate – the growth rate we commonly quote – will be in the range from 3.5% (bear case) to 4.8% (normal case).
As for the valuation, the projection assumes a 10x PE multiple in the bear case (the historical average is about 15x PE for XOM), and a 15x PE in the normal case.
As can be seen, even under these rather conservative assumptions, the bear case won’t lose money. It can actually lead to a decent total return of 18% in the next few years. And the normal case is projected to lead to a quite handsome total return of 68%.
Lastly, note that my projections are more optimistic than average consensus estimates as shown below. My projections are closer to the high end of the consensus estimates. I think the average consensus underestimated the possibility of oil price hikes and also the optionality enabled by XOM’s cash generation capability.
Risks
Investment in XOM does involve its own risks, as detailed below.
- The biggest one as I can see is the pace and degree of the post-COVID economy recovery. Although the vaccination is progressing extensively and the economy is re-opening at a pace. However, the pandemic is far from over yet and uncertainties like the delta and omicron variant still exist.
- XOM’s also faces some interest rate risks, especially given the recent hawkish Fed comments. XOM’s current long-term debt is about $45B, a quite sizable debt burden, especially in absolute terms. A 1% increase in its interest rate would translate into $450M of additional interest expenses. Its TTM operating income is about $13.8B TTM (and $6.34B a year ago). Therefore, the additional interest expenses would be about 4% of its current TTM operating income (or 7% of its last year’s operation income) – a non-negligible impact.
Conclusion and final thoughts
XOM stock price has advanced by more than 30% since I first wrote about it back in Sept 2021. Currently, it’s at the highest level in about two years. However, there are still good reasons to be bullish both in the near term and in the long term. In particular,
- In the near term, as the oil price stays above XOM’s breakeven price (about $45 per barrel), an $80 target price can be conservatively supported.
- As oil prices stabilize and travel recovers after the pandemic, its profitability has turned a corner and demonstrated a perfect V-shaped recovery. The current ROCE is at a very healthy 15.8%. Not only healthy in absolute terms but also higher than its long-term average by 230 basis points.
- Furthermore, the improved cash flow also enables excellent capital allocation flexibility. XOM currently can deploy up to 25% of its operating cash flow to fuel organic growth, far above its long-term historical average 10% reinvestment rate.
- My projected returns are closer to the high end of the consensus estimates, leading to a 68% total return in the next three to five years. I think the average consensus underestimated the possibility of oil price hikes and also the optionality enabled by XOM’s cash generation capability.
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