Why commodity companies might not be as cheap as they seem (and GMO is likely wrong)

Excellent piece by GMO on investing in commodity stocks (I do not know why they call them resource equities, probably for marketing reasons).

There are very useful long-term charts comparing investing in equities vs. investing in the commodity directly. They show that equities in commodity producers have delivered a significant positive return even in the absence of a secular commodity bull market. Further, they demonstrate that for financial investors it is really the only alternative, as the long-term returns from investing in futures are horrible, as a result of negative roll returns. The charts are very useful if you want to market a commodity equity fund.

However, the following statement irritated me,

gmoenergycompanies

According to the metric they use, a combination of normalized historical earnings, P/B and Dividend Yield, the valuation of the energy/metals sector has the lowest historical relative valuation on record only matched with 1998 the days of 10 dollar oil.

The reason I was irritated, is that recently when I looked at a few oil mayors, I felt that at the current price level their valuation was excessive and their dividend not sustainable. Moreover this was true across the board, whether it is Exxon mobile or OMV (Austrian integrated oil company).

Just look at Royal Dutch Shell, with a dividend yield of over 6 percent, a normalized (5y) PE of 11 and trading at a price book of 1.3. That’s looks cheap according to GMO’s chosen metric and, no doubt, represents a significant discount the S&P 500.

Just how reliable are these metrics in this case?

The dividend yield at over 6 percent, no doubt is sporty, but in 2014 the dividend cover was a meagre 1.3 whereas in 2015 it dropped to an absolutely unsustainable 0.2. In other words: in the recent past Royal Dutch has paid dividends by tapping the generous debt markets. Clearly, there could be one-off effects on net income that have distorted the dividend cover and we should take that into account.

This brings us to normalized earnings. Obviously, if you believe that the normalized PE of 11 is representative, you will not be overly worried by the low dividend cover of the last two years, as it implies a sustainable 9 percent earnings yield.

But how representative is it?

Let’s look at the main P&L categories to get a better feel for the figures.

Year Net Income EBIT EBITDA
2011 30.9 42.7 55.9
2012 26.7 37.7 52.3
2013 16.4 26.9 48.3
2014 14.9 19.9 44.4
2015 1.9 -3.3 23.5
Average (bn USD) 18.2 24.8 44.9

Unsurprisingly, the figures show that the degree of profitability of any integrated energy company heavily depends on the price of energy. Furthermore it can be seen that 2014, when oil prices started to drop from 94 dollar per barrel to 50 dollar at YE, was still a very good year courtesy of a high average oil price for the whole of 2014. So, for four out of five years used to normalize the earnings saw an oil price trading in the 80-100 USD range – pretty much 100 percent above where we are now.

Normalizing earnings in this case only gives you a good picture if you forecast significantly higher oil prices going forward. But this would involve bold forecasting of oil prices and even Jeremy Grantham contends in his piece that this is impossible.

Unless oil prices significantly increase from here, expect the dividend to be cut or debt to increase further.

Now let’s look at P/B the last metric GMO uses. No doubt, Royal Dutch at a P/B of 1.3 looks cheap relative to the market, but this should not be surprising in a market dominated by tech and service companies with their high (and mostly irrelevant) P/B ratios.

The biggest issue I have with this metric, however, stems from the fact that book value is not what it used to be, i.e. a pure and objective measure of how much has been invested in the business so far. Royal Dutch values most of its assets on an expected cash flow and DCF basis, i.e. it is forward-looking and subjective in nature. Currently they are implying a 6 percent discount rate reflecting the record low-interest rate environment. Put differently, the book value is an implicit bet on low rates.

For this reason I prefer another valuation metric. Given that I cannot forecast oil prices the most reasonable assumption is to take the average price for last year, the first full year of 50-60 USD oil and see what they can earn on that basis. As it seems that net income and EBIT figures for 2015 are somewhat distorted by impairments on assets, I will base my analysis on the EBITDA for 2015 which amounted to 23.5 billion dollars. I will be generous and assume that management is able to cut costs (after all not all profitability depend on the price alone) to deal with the new environment as well as squeeze some synergies from their recent acquisition and postulate that the normalized EBITDA at the current price level can be around 30 billion dollars, i.e. an improvement of 30 percent.

At an enterprise value of 350 billion this translates into a very high normalized EV/EBITDA ratio of slightly below 12. Remember, this is for a business which depends on higher commodity prices and substantial capex for sales growth. Furthermore, the nature of the business is such that constant investment is required to replenish reserves. Over the past 10 years, for instance, Royal Dutch has constantly invested between 150-200 percent of depreciation without significantly increasing its oil reserves (although they have increased their liquefied nat gas capacity), a period over which it has constantly been free cash flow negative.

In line with that, management expects capex spending of about 25 billion per annum for the for the forseeable future. All this results in an expected free cash flow to the firm of 5 billion USD, not even 2 percent of the value of the business. The valuation rests on energy prices rebounding substantially.

Conclusion

All three metrics used by GMO rely on a significant rebound in oil prices in order to be valid. I believe the case of Royal Dutch Shell to be representative to a large extent, at least for the large players. Mr. Grantham implicitly is forecasting higher energy/metals prices. Whether this will happen or not is anybody’s guess, but given that nothing has happened in China yet, I would not bet on it.

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