Raymond James analyst James Jenkins, who has been bearish on Exxon Mobil Corp. (XOM, Financial) since 2018, has turned bullish on the oil giant after taking into account the improving outlook for the energy industry and the attractive valuation level of the company. According to a research note sent to clients, Jenkins wrote on April 14 :
"With the recent downdraft in the stock (off ~10% over the past month), we think it's the right time to get less negative in our outlook for Exxon Mobil. Q1 2021 earnings indicators show a solid measure of improvement, pushing the company in the right direction of that part of the show me story."
Even though Exxon stock is down close to 10% in the last four weeks, the market value of the company has appreciated over 40% in the last 12 months primarily as a result of the stellar recovery of crude oil prices. Even on the back of these strong returns, Exxon still seems to be valued very cheaply in the market, presenting value investors with an opportunity to invest in a mature, cash-flow positive company at a fair price.
The energy sector is still very cheap
All the major U.S. market indexes are trading close to their all-time highs, suggesting there could be a bubble in the making. Stock prices are supposed to be forward-looking, and investors are currently focused on the expected recovery of the U.S. economy in the second half of the year. Although there is nothing to be surprised about considering the forward-looking nature of the market, there is reason to believe that some companies and business sectors have already appreciated beyond reasonable levels. This, however, is not true for the energy sector. As illustrated below, this troubled business sector remains the most cheaply valued from a Shiller price-earnings ratio perspective. To add some more color, the energy sector is trading at a discount of almost 50% to the S&P 500 index.
Source: GuruFocus.
The outlook for the sector, however, is continuing to improve, although the market performance of energy stocks does not fully reflect these improvements. According to data collected by Morningstar, global demand for crude oil slumped below the supply level in the market in the second quarter of 2020, resulting in a sharp increase in the inventory level. This, on the other hand, exerted pressure on oil prices for the better part of 2020. As illustrated below, Morningstar projects a substantial decline in the inventory level in 2021 along with the expected recovery of the global economy.
Source: Morningstar.
Going by these estimates, oil prices can be expected to stabilize around the current price of $63 as of April 16 or even gradually increase through the end of 2022. This will pave the way for low-cost oil producers to report strong revenue and earnings growth.
Exxon's focus on conventional oil drilling will help the company thrive
Many large oil giants, including BP PLC (BP, Financial) and Royal Dutch Shell PLC (RDS.A, Financial), have taken the first steps in diversifying their businesses into the renewable energy sector. Policymakers around the world are expected to support the adoption of renewable energy in the next decade in a bid to promote sustainable alternatives to fossil fuels. Considering this shift by regulators, it makes sense for oil companies to implement changes to their business strategy by embracing renewable energy. Exxon Mobil, however, remains true to its tried and tested strategy of prioritizing the fossil fuel business, which is likely to help the company deliver strong financial results in the next five years.
Exxon's strategy will have two contrasting implications for investors.
- The focus on fossil fuels will help the company generate higher revenue and profits in the short to intermediate term.
- Many large oil companies are likely to trade at higher valuation multiples in comparison to Exxon because of their focus on environmental, social and governance factors.
At this point, it is difficult to evaluate which of these factors – higher earnings or the deteriorating investor sentiment toward Exxon – will dominate the stock market performance of the oil giant. In the long run, it would be reasonable to assume that earnings will dictate terms over any other factor in determining the market value of a company, and this creates an opportunity for value investors.
A best-in-class dividend is on offer for investors
Exxon Mobil is well-known for rewarding investors handsomely by distributing earnings via dividends and stock repurchases. The company has paid a dividend in each of the last 39 years, which is a testament to the shareholder-friendly nature of past and present company managers. Even when oil prices crashed last year as a result of the economic recession, Exxon did not reduce its quarterly dividend of 87 cents per share.
Although many Wall Street analysts suggested it would be a better decision to cut the dividend and reallocate the savings into repaying debt, company management repeatedly highlighted that, because of its cash-rich business model, it will continue to prioritize shareholder distributions over debt reduction. As a mature company that does not have massive growth potential, Exxon seems to be doing the correct thing to create value for shareholders, which makes investing in this oil giant even more attractive for value investors. As illustrated below, the comapny has consistently covered dividends with free cash flow in the last 30 years except for a few rare instances, including 2020.
Taking into account the expectations for higher oil prices in the coming years, it would be reasonable to assume the worst is over for Exxon and the energy industry. Improving macroeconomic conditions are likely to trigger dividend hikes from Exxon as well, which would be additional compensation for investors who take on the risks associated with the company today.
Takeaway
Crude oil prices have already fully recovered from the lows seen last year, and the prospects are improving as a result of the success of the vaccination program. Exxon, which is one of the very few oil companies that continue to focus on a traditional business strategy centered around fossil fuels, is well-positioned to thrive in the coming years on the back of stable oil prices. The oil giant's lack of focus on renewable energy will be a drag on the stock performance in the short run, but corporate earnings are likely to dominate the performance in the long run, and this presents a good opportunity for value investors.
Disclosure: The author owns Exxon Mobil shares.
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