Thursday, September 29, 2011

BP - Is it Cheap?

I have found out I really don’t like to disclose my research, particularly because people are lazy and don’t share their own (or don't perform any).  Since I have a blog I had initially wanted to share value ideas monthly, so I will share this one. BP is a British integrated oil company that has fallen on hard times. I noticed a few high profile investors, like Seth Klarman, recent took a position so I decided to take a look. BP has come under extreme pressure due to the blowout failure in the Gulf of Mexico. The subsequent oil spillage was difficult to contain but it appears that they are doing much better keeping costs associated with the blowout contained.

Because of the spill many investors will not touch BP. Investors hate uncertainty, just look at Bank of America for instance. Moreover, investors don’t care if the lawsuits have any merit or not. It’s guilty until proven innocent.

Now BP did set up a $20 billion fund to pay for any damages that arose from the oil spill. The basically took the earnings hit in 2010 (non cash) and committed to fund the $20 billion through the end of 2013. They contributed $5 billion in 2010, and will contribute $1.25 billion/quarter or $5 billion annually for years 2011, 2012, and 2013. I will attempt to put some numbers on that liability below but let’s first determine the normalized earnings power of BP.

Normalized Earnings Power

To analyze the normalized earnings power I first determined the earnings before interest and taxes for the last 5 years and took the average. I adjusted the numbers for 2010 to exclude $40 billion (pretax) hit they took that year (non cash).

5 Year Average EBIT = $32.9 billion (EBIT = Earnings before interest and taxes)
5 Year Average Interest = $1.3 billion (debt to equity is very constant)
5 Year Average EBT = $31.6 billion (EBT = Earning before taxes)
Taxes at 35% = $11.0 billion

5 Year Average Earnings = $20.5 billion

Given that there are 3.2 million American Depository Shares (ADS) equivalent, the normalized earnings = $6.45/ADS. BP normally pays 40% of their earnings as dividends so that would be $2.58/ADS.

If you take today’s price of $37/ADS, the normalized earnings yield is 17.5% and the normalized dividend yield is 7.0%.  Definitely Cheap.

Trust Claims Analysis

Emergency Trust Claims

There were approximately 169,000 emergency claims and 99.8% have been settled for a total amount of $2.6 billion (average claim = $15,400). There are 273 remaining claims in this pool and assuming each of these claims pay out 2 times the average, for a cost of $30,800/claim, that would be an additional $8.4 million to be paid out.

Regular Trust Claims

There were approximately 308,000 regular claims and 81% have been settled. Claims were either paid (49%), denied (29%), or withdrawn (0.2%). The total amount paid for claims were $1.7 billion to the end of Q2, 2011 (average claim = $11,300). There are 59,232 remaining claims (19%) in this pool and assuming each of these claims pay out 2 times the average, for a cost of $22,600/claim, that would be an additional $1.3 billion to be paid out.

Government Claims

There were 965 government claims and 83% have been settled for a total amount of $1.3 billion (average claim = $1.6 million). There are 168 remaining claims in this pool (17%) and assuming each of these claims pay out 2 times the average, for a cost of $3.2 million/claim, that would be an additional $0.5 billion to be paid out.

Claims Summary

There has been a total of $5.6 billion paid to the end of Q2 2011. Using the assumptions above of 2x historical payouts BP would be on the hook for an additional $1.9 billion bringing the total to $7.5 billion. Obviously this would leave $12.5 billion in the fund for other liabilities or lawsuits.

What if we are ultra pessimistic and believe remaining claims will be paid out at 10 times historical payouts? Additional payouts would then total $9.5 billion and combined with $5.6 billion already paid, the total would be $15.1 billion. That would leave $4.9 billion left in the fund for other liabilities or lawsuits.

Obviously it appears the company has the liabilities well under control and has some buffer. If the partners on the well are forced to pay their fair share of the cost BP’s contributions to the fund may be complete be the end of 2012.

Conclusion

BP appears to be in decent shape to rebound from the recent oil spill. BP typically earns lower than average net profit margins on its production, but the stock appears cheap. Please note the 5 year average realized price for BP is $69.31/bbl, as this is the most important factor. Oil prices have come down recently to sub $80/WTI, and I feel it may go down quite a bit more. Net speculative positions in oil are quite high, and if China implodes oil it will go way down.

It appears the company has a good handle on the claims from the oil spill.

At a 17.5% normalized earnings yield (normalized P/E = 5.7) BP appears to be cheap, however the past 5 years has included some very high prices for oil. The company is selling for a little more than 3x EBIT. If dividends return to normal levels and oil drops off a little more from here BP offers better price protection than most oil producers.  However, given the state of affairs in China I wouldn't touch anything commodity related.

Price is what you pay, value is what you get - Warren Buffett



Best Regards,
Kevin Graham

Disclosure - Long BAC and BAC.wt.a (both personally and for family)

2 comments:

  1. Hi Kevin,

    It's a strange market when everybody has to be a macroeconomic and geopolitical analyst in order to properly analyst the strong variables of their investments!

    Ultimately if one's position on the future price of crude is bearish then investing in an integrated oil firm may not be the best bet... however, this could be hedged by shorting crude contracts in conjunction with longing the shares.

    The hidden question is what the market is assuming to justify what, on paper, seems to be a very cheap valuation. I don't think the oil spill loss accruals are the issue.

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  2. Got to love a guy who thinks "value" is in financials, but think commodity plays are untouchable - it would be laughable if not so pathetic.

    Say, how's list of "top 2011 investments" working out? BAC, WFC, GE, GS all hitting it out of the park? Or are they all striking out?.

    You proclaimed they were significantly undervalued when they were twice their current value at the beginning of the year - talk about delusional.

    Don't quit your day job...

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