Paul Morigi
Occidental Petroleum Corporation (NYSE:OXY) just released its third quarter earnings. The release showed a large beat on GAAP earnings and a very slight miss on normalized earnings. The release exceeded expectations overall, as OXY received many downgrades during the third quarter, which saw oil prices fall.
OXY has been one of this year’s best performing oil stocks. Up 144% for the year, it is outperforming the oil sector, which is really saying something because oil is outperforming every other sector this year.
OXY has a number of advantages over other oil companies. These advantages are taking its price higher. For one thing, it has the blessing of Warren Buffett, who owns so much OXY he’s now accounting for it through the equity method. News that Buffett owns a stock has been known to move markets, and he has bought enough OXY at this point (over 20%) that he is supporting the price by making the float smaller.
For another thing, OXY got beaten down so badly in the 2020 oil bear market that high growth from the weak base period was pretty easy to achieve. In 2020, OXY ran a truly staggering $17 per share loss. It also had an enormous pile of debt. When you’ve got that kind of weakness in your past history, it’s not hard to look better in the future. So, it’s not surprising that OXY is now rising faster than other oil companies. It’s paying off debt and generally getting rid of the things that made it such a catastrophe two and a half years ago. As we saw in OXY’s third quarter release, that’s paying off. That bodes well for the company’s future earnings.
It’s natural at this stage in the game to worry that OXY’s rally is getting long in the tooth. Personally, I think the low hanging fruit has been picked; the stock may not be a “multi-bagger” from these levels. It does, however, have a valuation that suggests long term upside even if you assume that oil prices fall a bit from today’s levels. For this reason I consider OXY a moderate buy; a basically above-average stock, though not the mind-blowing opportunity it once was.
Occidental Petroleum – Earnings Recap
Occidental Petroleum’s recent earnings release was better than expected. In the release, the company revealed:
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$2.52 in diluted GAAP EPS, a significant beat (the estimate was for $2.41).
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$4.3 billion in cash from continuing operations.
- $3.6 billion in free cash flow.
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$1.8 billion in debt repayment.
- $1.8 billion in buybacks.
It was a pretty decent showing all around. The earnings were pretty decent, and the continued debt repayment points to a path to improved profitability in the future. The lower your debt, the lower your interest expense, which can result in a profit jump in later periods even if oil prices only stay flat. It’s very hard to say where oil prices will head from today’s level. The end of the SPR release and OPEC production cuts point to lower supply and higher prices, but the Fed’s continued rate hiking may reduce demand. So, Occidental’s debt reduction bodes well. It’s not clear that oil prices will keep rising forever, and OXY has taken steps to ensure profitability despite that.
Why OXY Did So Well This Year
As we saw earlier today, OXY’s latest earnings release was pretty strong. The release was only one of several good ones from the company this year, and companies putting out impressive earnings tend to see their stock prices appreciate. However, that doesn’t explain why OXY has done so much better than other oil companies. The vast majority of oil companies have been growing this year, and XLE (the energy sector ETF) is up 63%. So, why is OXY doing so much better than its peers?
Setting aside speculation about a possible buyout by Berkshire Hathaway (BRK.A, BRK.B), one factor driving OXY’s returns is the sheer weakness in the company’s base period. In its 2020 annual report, OXY reported a staggering $17 per share loss, and $35 billion in debt. The debt was nearly double shareholders’ equity at the time, and nearly ten times operating cash flows. It was a pretty scary situation, which is why Buffett initially invested in OXY through preferred stock and warrants rather than common stock. But later, oil prices rallied to extreme highs and OXY paid off a lot of its debt. In the second quarter, it was able to grow its earnings by $3.6 billion year-over-year.
So, OXY’s stock price rose faster than other oil stocks because of weakness in the base period. In economics, there is a concept called “base effects,” which says that inflation is likely to be slower after a fast growth period and vice versa. The same concept applies to corporate earnings. A company that starts at $10 in earnings and grows to $11 in earnings, grows at 10%. A company that starts at $10 in earnings and grows to $12, grows at 20%. Both companies end up with $12 in earnings, but the latter one grows faster. If it’s publicly listed, its stock price probably goes up faster too.
Occidental Petroleum Valuation
Having looked at OXY’s earnings and the reasons for its rapid price appreciation, it’s time to value it.
Before today’s earnings release came out, OXY traded at:
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9.96 times adjusted earnings.
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2 times sales.
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3.9 times book value.
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4.8 times operating cash flow.
As a result of today’s release, OXY’s 12 month free cash flow per share has grown from $12.12 to $13.09.
Using this new data, we can do a basic discounted cash flow model for OXY.
As I wrote previously, OXY is in a great position to grow its earnings and cash flows from here. Due to the ongoing debt reduction, it can increase its earnings even without rising oil prices. So, it’s safe to assume that there will be some year-over-year growth going forward. However, for the sake of conservatism, I will assume it’s only 10% per year.
Now, if we assume 0% growth, we can come up with a terminal value estimate for OXY. Using an 10% discount rate, the last 12 months’ cash flows are worth $130.09. So, we’ve got a lot of upside here assuming no growth. 10% is higher than the treasury yield, but the Fed is still tightening and there are some risks in all stocks, so a higher rate is warranted.
If we assume 10% CAGR growth over 5 years and no growth after that, we get a $196 price target. That’s a truly enormous amount of upside to today’s prices, but of course, this estimate involves a future growth projection that may not correspond to what unfolds.
Nevertheless, even with 0% growth, OXY has upside. So, despite all of the gains it has already made, the stock looks appealing.
Risks and Challenges
As I showed in this article, OXY is a strong business that is rapidly repaying its debt. It certainly looks like a winner. Nevertheless, there are some risks and challenges to keep in mind, including:
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A truly staggering collapse in oil prices. Given its debt reduction, OXY can remain very profitable even with oil prices far lower than today’s prices. However, no commodity producer can withstand infinitely low commodity prices. When oil futures went negative in 2020, the vast majority of oil companies lost money. There is little to indicate that oil prices will go negative again in the future, but if they went below $40, OXY would be in trouble.
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Regulatory risk. Occidental Petroleum is an oil company, which means that it is not very popular with the environmental movement. Depending on who takes office in the ongoing midterm elections, OXY could face increasing regulations. Many people think that taxing oil companies’ profits is key to fighting climate change and inflation. If such people take office then Occidental Petroleum might face some cost increases.
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Berkshire making an offer after a big dip in OXY’s stock price. Many people think that Warren Buffett is interested in buying Occidental Petroleum. He already owns a lot of it, and has warrants to acquire more. Buyout offers are usually made at a premium to the share price on the day they’re announced. However, that wouldn’t help someone who buys OXY today if the stock price were to fall in the future. Let’s imagine something happened that caused OXY to fall to $50, then Buffett came in and offered $60. That would be a premium price in that scenario, but not to an investor buying today.
The Bottom Line
The bottom line on Occidental Petroleum is that it’s a thriving oil company that just put out solid earnings. It’s cheap, it’s growing fast, and it’s paying off its debt. This stock has been among the S&P 500’s best performers this year for a reason. Few companies have turned their fortunes around quite like OXY has since 2020. Yes, the company is subject to certain risk factors. But on the whole, the risks inherent in buying OXY are risks I’m comfortable taking. If you’re a risk-averse investor who is uncomfortable with volatility, then oil stocks might not be for you. For those willing to bet on the future of a very strong company, Occidental Petroleum Corporation is a worthy pick.
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