While the broad stock market reaches for new all-time record highs, companies that produce oil and natural gas remain heavily out-of-favor. Yet, with Big Oil stock prices down by as much as 60% since oil prices peaked at over $100/barrel in mid-2014, they look like high-yielding bargains.
In this issue, we outline our bullish outlook for six major oil companies.
Cabot Turnaround Letter 1119
Big Oil, Big Yield
In this Issue:
Big Oil, Big Yield
Convertible Bonds
Recommendations:
Buy: Thor Industries:
Other Ratings Changes
News Notes & Performance
While the broad stock market reaches for new all-time record highs, companies that produce oil and natural gas remain heavily out-of-favor. This is true not only for higher-risk small-caps, but also for the well-capitalized and diversified majors. Yet, with Big Oil stock prices down by as much as 60% since oil prices peaked at over $100/barrel in mid-2014, they look like high-yielding bargains.
Investors are avoiding Big Oil stocks due to several concerns. Perhaps the most pressing are fears of another decline in oil prices from steady growth in U.S. production and a possible global recession. Also, investors wonder if the majors will be able to sustainably increase their production, worry that they will forget their new-found cost and capital discipline, and question whether they can navigate the eventual migration to a post-petroleum, low-carbon world.
While oil prices are notoriously difficult to predict, there are reasons to believe they could remain steady or even increase. Oil consumption continues to grow, now at nearly 100 million barrels/day, led by the strong U.S. economy and rising secular demand in developing countries. Also, the oil supply outlook may not be as rosy as forecast: fracking-based production growth in the U.S. is slowing and may not reach the lofty 12 million barrels/day that many are anticipating. Conflicts in the Middle East may threaten production there, and the industry-wide tapering of capital investment could mean less new supply growth in future years. It isn’t set in stone that oil prices will be weak forever.
Also, despite the interim environmental issues, a post-petroleum, low-carbon world is likely decades away, providing plenty of runway for the Big Oil companies to prosper while they develop their transition plans.
Chastened by the post-2014 oil price collapse, most major oil companies appear likely to maintain their spending discipline while also returning surplus cash to investors. Also helping: Big Oil companies have extensive “downstream” businesses such as refining, chemicals and marketing, which includes retail gas stations, which dampen cash flow volatility from their “upstream” oil production. Importantly, they generally maintain solid balance sheets to support their businesses.
We’ve outlined below our bullish outlook for six major oil companies. While they each carry risks related to commodity prices, production volumes and costs, they all offer “big yields” along with attractive valuations that should more than compensate. Potential investors should note that they all report third quarter results in the next week or so. While these companies are in many ways very similar, read the discussion below to help differentiate between them.
BP (BP) – For nearly a decade, BP has focused on recovering from the 2010 Deepwater Horizon disaster. While the total costs from that disaster will likely reach $65 billion, the 2016 final settlement removes the weighty overhang. BP has repositioned itself for steady 4-5% annual production growth, combined with more competitive downstream operations. Its already-healthy free cash flow, helped by its 19.75% stake in Russian energy firm Rosneft, should be further bolstered by lower operating costs and higher capital spending efficiency. Annual $2 billion Deepwater Horizon settlement payments will step down to $1 billion next year and beyond. Temporarily elevated debt from its $10.3 billion acquisition last year of BHP’s U.S. onshore operations is being repaid by proceeds from an on-going divestment plan. The company resumed paying dividends in cash-only and committed to repurchasing shares to offset dilution from the past few years’ scrip dividends.
Chevron (CVX) – Chevon’s shares have held their ground in recent years, bolstered by a well-executed strategy. As a result, it appears poised for free cash flow expansion as production could grow 3-4% a year while capital spending flattens. Their strong Permian Basin presence provides a low-cost, low-risk and high-visibility production base. Similarly, Chevron’s giant Australian LNG operations are reaching full production which should provide stable revenues for years yet require only minimal incremental capital spending. The company anticipates returning much of its cash flow through steady share repurchases and dividends that offer investors a very respectable 4.0% yield.
ConocoPhillips (COP) – While its yield isn’t quite as high as its peers, ConocoPhillips has arguably stronger fundamentals. Not only does the company have decent production growth, rising free cash flow and a low-risk focus on North America, it has committed to paying out 30% of its operating cash flow each year. While the constraint may limit production growth, it addresses a recurring investor concern: that major oil companies tend to squander their capital. Bolstering management’s credibility is that they will pay out most of the cash through buybacks, allowing it some flexibility should oil prices weaken.
ExxonMobil (XOM) – Despite its reputation as being fiercely efficient, ExxonMobil’s daily production has remained flat at around 4 million barrels for years. Its share performance is among the worst of its peers, down 33% from its mid-2014 peak. Perhaps characteristic of Exxon’s go-it-alone legacy, it is implementing a contrarian strategy by ramping up capital spending while the rest of the industry shows restraint. Its goal is to double its earnings and cash flow from operations by 2025 at today’s oil prices, with contributions from all three of its segments (upstream, downstream and chemicals). If successful, Exxon would be a much larger, more dominant and valuable company. In the meantime, the company must sell assets and defer buybacks to cover its dividends and capital outlays. Execution risk is high despite XOM’s reputation as one of better operators in the industry.
Occidental Petroleum (OXY) – Under attack from activist Carl Icahn for its high-priced, massive and controversial $55 billion acquisition of Anadarko Petroleum in August, “Oxy” offers a unique turnaround prospect among the majors. The combined company’s post-merger cash flows need to service a heavy debt burden, with a further constraint that Berkshire Hathaway gets an $800 million annual preferred dividend on its $10 billion investment before the company can fund its capital spending program and $2.8 billion in common stock dividends. Occidental is focusing on aggressive cost-cutting and assets sales to whittle down the debt burden, although both efforts may take some time. Another opportunity: Occidental will apply its highly-regarded drilling processes to boost the efficiency of Anadarko’s Permian oil fields. The company’s shares are cheaper and higher-yielding for a reason, but also offer the opportunity for outsized returns if the turnaround is successful.
Royal Dutch/Shell (RDS/B) – Royal Dutch/Shell shares trade 30% below their mid-2014 peak, even after bouncing 10% following surprisingly weak 2Q results. Despite a difficult near-term outlook, management is implementing an ambitious plan to significantly boost free cash flow over the next five years. Helping its prospects are benefits from its cost-cutting program and its giant $70 billion acquisition in 2016 of BG (British Gas). Shell’s capital spending budget remains tight, partly hampered by its elevated production costs and sub-par margins in its European downstream business. Nevertheless, the company appears committed to heavy stock buybacks and supporting its dividend, especially as it restored the latter to full cash pay after a period of issuing some of the dividend in the form of shares.
Convertible Bonds: The Best of Two Worlds
Convertible bonds, which have been ignored by investors and Wall Street for years, may be worth a fresh look. A convertible bond is an unusual security in that it carries a fixed coupon and matures at par like a bond, but can also be converted into common stock. As such, if the company’s stock price rises high enough, the bond price will trade closer to the value of the issuer’s shares. For example, if XYZ Industries’ $1,000 par value bond converts into 25 common shares, the conversion price is $40/share. If the stock trades at $30, the bond will perform like a bond. However, if the stock appreciates to $50, the bond will trade at around $1,250 ($25 shares x $50). Therefore, convertible bond investors get the downside protection that a bond offers, yet also participate in the upside should the common stock appreciate meaningfully.
The U.S. convertible bond market is relatively small, with only about $200 billion in bonds outstanding, although this year has seen strong new issuances of $44 billion so far. Most convertibles are unrated or below investment grade, reflecting their use primarily by lower-quality or rapidly growing companies as a source of cheap financing. Rapidly growing security software company Okta illustrates this well: in September, the company issued $1 billion in convertible bonds with a 0.125% interest rate, yet they convert at $188.71/share, nearly 75% above the current share price.
A few caveats: convertible bonds are often “junior” to straight bonds, meaning they have lower priority claims, and so in a bankruptcy convertible bondholders may not receive much recovery (although they would come ahead of stockholders). Also, most convertible bonds are usually callable by the company which could limit their upside potential.
Listed below are five interesting convertible bonds with relatively high yields that also trade reasonably close to their conversion value.
Blackstone Mortgage Trust 4.75% due 2023 – Blackstone is a real estate investment trust that provides secured senior loans to high quality office buildings, hotels and other properties in major gateway cities. Conservative and well-managed by the eponymous and highly-regarded private equity firm, the Blackstone convertibles offer investors the ability to participate in the stock while receiving a generous coupon. Investors may also want to look into the underlying stock as an investment in its own right.
Eagle Bulk Shipping 5.0% due 2024 – U.S.-based Eagle Shipping is one of the world’s largest owner/operators of drybulk commodity cargo ships. The 5% bond was recently issued in July to help finance vessel acquisitions. Industry conditions have been weak, but the company could be well-positioned for new emissions restrictions that go into effect next year. Notably, highly-regarded private equity firm Oaktree Capital owns 38.5% of the common stock.
MGIC Investment Corp 9.0% due 2063 – MGIC provides private mortgage insurance for homeowners, competing with government insurers like the FHA and the VA. The company barely survived the 2009 mortgage crisis, yet now is well on the road to recovery. Capital levels and ratings continue to strengthen, while their in-force insurance book is seeing healthy growth. The bond is increasingly trading like the underlying common stock, which is approaching its post-recession highs but offers only a 1.7% dividend yield.
Gannett 4.75% due 2024 – Turnaround Letter Buy-recommended Gannett is being acquired for $1.4 billion by New Media Investment Group, creating what will be the largest newspaper company in the United States. We think the combination will generate considerable cost savings, although it will also bring a high level of debt. Interestingly, the convertible offers a lower yield than Gannett’s common stock (currently at 5.7%) and the post-deal New Media shares (estimated at 8.4%). However, the dividend is subject to the new company’s cash flows, while the convertible dividend is a fixed obligation. This unusual situation is worth watching.
U.S. Steel 5.0% due 2026 – U.S. Steel is struggling with weak steel prices due to slowing demand in China, relentless capacity increases in the United States and the demand-reducing effects of the General Motors labor strike. However, any recovery in prices would boost the profits of the high fixed-cost U.S. Steel operations. The company has considerable debt, and so the risks are elevated, but the 5% coupon helps buffer the volatility while offering participation in any sharp increases in the share price.
Purchase Recommendation: Thor Industries
Thor Industries
601 East Beardsley Avenue
Elkhart, Indiana 46514
574-970-7460
www.thorindustries.com/
Category: Mid Cap ($3.6 billion)
Symbol: THO
Exchange: NYSE
Business: Recreational Vehicles Manufacturing
Annual Revenues (FY2019): $7.9 billion
Earnings (FY2019): $133 million
10/28/19 Price: $67.60
52-Week Range: $76.16-42.05
Estimated Dividend Yield: 2.5%
Price Target: $98
Background: Thor Industries is the world’s largest manufacturer of recreational vehicles, including motor homes, trailers and accessories. Founded in 1980 when two entrepreneurs acquired then-struggling Airstream from Beatrice Foods, the company quickly recovered under the new ownership and completed an initial public offering in 1984. Following decades of acquisition-driven and organic growth, the company now holds a 45% market share in North America. This past February, Thor completed its first acquisition outside of North America, with the $1.9 billion purchase of Germany-based Erwin Hymer Group, one of Europe’s largest RV manufacturers. Conservative and well-managed, Thor Industries is one of the few remaining companies that reports only GAAP-based earnings.
For nearly a decade, the North American RV industry boomed, driven by the strong economy, growing demand from baby boomers and emerging interest from a younger population who developed a taste for the outdoors. Industry sales reached over 500,000 units by 2017, three times the 2009 recessionary lows. Thor shares surged as well, reaching $157 by January 2018 as growth investors chased the company’s rising sales and expanding margins.
However, optimism toward the RV market has turned to worry over a possible recession, weakening end-market demand and excess industry inventory from over-production. Investors also worry about Thor’s EHG acquisition – it is outside of the company’s familiar North American market, added over $2 billion in new debt and exposes the company to Brexit and the vagaries of a slowing European economy. THO shares plummeted by over 70%, touching $43 this past August. Despite a recent rebound in Thor’s shares since August, investors remain highly skeptical about the company’s prospects.
Analysis: Unlike many companies that grow through acquisitions, Thor has preserved its sturdy balance sheet and margins. Prior to the EHG acquisition, Thor was debt-free and had essentially no increase in its share-count in eight years despite several acquisitions. Similarly, its pre-tax profit margin increased to 7.7% by fiscal 2017, among the highest in a decade, just before the weaker fiscal 2018 and fiscal 2019 results. Half a year after the EHG acquisition, Thor has already paid down $480 million of its debt. We think they could repay the entire debt balance in as little as three years.
Thor is highly focused on a successful integration. The two companies seem quite compatible, and EHG’s founding family is retaining $144 million in THO shares in a sign of confidence in a post-merger Thor.
The North American economy remains remarkably resilient, providing a supportive environment, while conditions in Europe appear stable. North American dealer inventories have been shrinking dramatically and the current glut appears likely to be gone by January, while European dealer inventories appear matched to customer demand. Despite this and other near-term headwinds including Brexit and tariffs, the secular growth outlook is healthy.
Even in weaker conditions, Thor’s highly variable cost structure allows it to defend its margins. In the most recent quarter, its North American gross margins expanded by 1.8 percentage points even as sales fell 15% due to dealer inventory rebalancing. Also, new product innovations help preserve the company’s profits and relevancy.
Valuation is attractive at 7.5x expected FY2020 EBITDA. Thor’s modest 2.5% dividend yield seems secure, particularly as the company raised it on October 11th.
The beaten down share price gives investors an attractive entry point into a well-managed company that is likely to generate considerable value over the next several years.
We recommend the PURCHASE of shares of Thor Industries (THO) with a $98 price target.
Other Ratings/Price Target Changes
We are moving Ford Motor shares to a Sell as the turnaround is not working under the current CEO. Promises of improvement haven’t converted into reality and we currently see little chance of this happening with current management team. Automotive operating profits continue to decline even at the top of the cycle and nearly all performance metrics including revenue growth, market share and EBIT margins, are moving in an unfavorable direction. Ford’s Automotive guidance outlook indicates more weakness ahead. While Ford Credit remains very healthy, any slowdown could threaten the dividend and exert pressure on the barely-investment-grade credit rating.
The turnaround of homebuilder Hovnanian Enterprises appears on track with its encouraging earnings report in September. The shares have advanced sharply to over $25 from $5.50 only a few months ago, well-above our $19.50 price target. While the shares remain below the price at our recommendation, the now-weaker fundamental position and the potential return no longer outweigh the risks, particularly given the company’s very high financial leverage. We moved HOV shares to a Sell on October 17, as noted in an update email and on our website.
News Notes
Xerox reported strong third quarter results. While revenues fell 7%, adjusted earnings per share increased by 27% from a year ago and were 24% higher than consensus expectations. Xerox raised its full-year adjusted earnings per share guidance by about 5% and its operating cash flow and free cash flow guidance by between 5% and 10%. The Xerox thesis is based largely on the company continuing to generate strong free cash flows, bolstered by its cost-cutting initiatives. Xerox is delivering on its strategy, motivated in part by the 10.6% stake held by activist Carl Icahn.
After the bell today, Mattel reported surprisingly strong 3Q revenues and earnings, and announced that it has resolved a prior accounting issue along with the departure of its CFO. Mattel shares jumped higher in after-hours trading.
