Exxon Mobil Corporation (XOM) is one of the leading integrated oil companies in the world, and for this reason, investors often look up to its earnings to gauge a measure of the performance of the energy sector.
According to Reuters data, the company is expected to report second-quarter earnings on July 31, and investors might have to settle for disappointing numbers going by the data Exxon released in a filing with the Securities and Exchange Commission on July 2.
On the bright side, Exxon will likely honor dividend payments this year, even though many less financially stable oil companies have decided to cut back on shareholder distributions this year as a result of challenging macro-economic conditions.
After a careful analysis of company fundamentals and the outlook, I have come to the conclusion that a decision on whether or not to invest in Exxon should depend on the risk appetite of the investor.
Details from the recent company filing
Exxon Mobil has estimated the impact resulting from lower crude oil prices and the contraction in downstream refining margins for the second quarter, and the numbers do not look promising. As illustrated below, the negative impact on net earnings from the oil price crash is expected to range between $2.1 billion to $2.5 billion. To give perspective, the company reported a profit of $3.1 billion in the corresponding period last year. This suggests that year-over-year earnings will decline substantially, which is likely to lead to a sell-off in the market once the company releases numbers later this month.
Source: Company filings
The downstream sector is also facing headwinds as a result of a decline in margins, which is projected to result in earnings contracting of another $700 to $900 million. The expectations, therefore, are quite grim.
Wall Street analysts are beginning to turn bearish
Goldman Sachs analyst Neil Mehta released an investor note on July 1 citing concerns regarding the ability of Exxon Mobil to generate sufficient free cash flows to remain well-funded until the macro-economic environment turns positive. As a result of Exxon’s poor cash flow profile, the analyst expects the debt levels of the company to reach new highs before the global economy comes out of this recession. Specifically, he wrote:
“We expect ConocoPhillips and Chevron could see net debt broadly unchanged at quarter-end, thanks to capital discipline and boosted by asset sales closed during the second quarter, while Exxon could see large debt builds.”
He went on to note that shares of Exxon Mobil are still trading at lofty valuation multiples, which amplifies the risk of investing in this oil major.
The balance sheet health of the company has been deteriorating for quite some time. At the beginning of this year, Exxon had just over $24 billion in long-term debt. However, in the first quarter, the company had to aggressively issue new debt securities to bridge the gap between cash inflows and outflows, which saw total debt climbing to over $31 billion, according to company filings. This is a bad sign, as the company could underperform the large-cap energy sector due to this debt burden even when business conditions return to normalcy.
The company remains committed to rewarding shareholders
Amid all the dark clouds, there’s a silver lining in the form of the ability of Exxon to honor dividend distributions in the short term. Appearing on CNBC last April, company CEO Darren Woods said:
“A lot of our shareholders are retail shareholders - people who depend on that dividend - so we've been pretty committed to maintaining that and if necessary in the short-term using the balance sheet to support it. It's a capital-intensive commodity business so we know we are going to go through cycles, and the way we have prepared ourselves to manage through those cycles is to maintain a strong balance sheet. It will be a function of how long this plays out. If we haven't seen a recovery next year, you know it will be a different environment that we're in."
When analyzing the ability of a company to pay dividends, the first step is to determine the commitment of the management. In Exxon’s case, the outlook is promising from this front, as a reduction in dividend would only occur if the company fails to gather momentum next year, which is still a long way out in the future. Going by the remarks of many leading analysts and the International Monetary Fund, the economic growth in the United States will be stellar in 2021, which is likely to result in higher demand for oil.
On the other hand, Exxon has a reputation to safeguard as well. The company has increased dividends per share for 38 consecutive years, which is one for the record books.
Source: GuruFocus
The commitment by the management and historical data, however, are not guarantees of continued distributions, and the free cash flow position is flashing red signals for investors.
Source: GuruFocus
In the long run, dividends might come under pressure due to the poor balance sheet position of the company. This will depend primarily on the pace of recovery, which is still a grey area.
Takeaway
When I last wrote about Exxon Mobil, shares were trading around $37 and I suggested investors follow the lead given by company insiders and buy the stock in anticipation of handsome long-term returns.
Shares have already gained 19% to trade around $44 on July 6, but the recession is proving to be more severe than the estimates of many analysts. The debt burden of Exxon, as a result, is proving a bigger risk for the survival of the company.
Taking this outlook into consideration, risk-averse investors might want to book the profits and focus on energy companies that are in better financial health. However, the risk-reward profile seems to be very attractive for high-risk investors as the recovery in oil prices is already set in motion. There seems to be no immediate threat for income investors as the company is fully committed to maintaining its quarterly dividend payments at the current rate in the foreseeable future. However, the outlook beyond the next 12 months is questionable. An investment decision in Exxon Mobil should be determined by the objective of an investor and the appetite for risk.
Disclosure: I own shares of Exxon Mobil.
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