Drip Portfolio Report

<THE DRIP PORTFOLIO>
R-O-C-E in the U.S.A.
Plus, Touchstone Friday

by Brian Graney ([email protected])

ALEXANDRIA, VA (Feb. 26, 1999) -- Ah, February. That month where the attention of a weather-beaten and winterized nation turns to glorious leaders from yesteryear (President's Day), loves lost and hearts burning anew (St. Valentine's Day), and a media-hyped marmot (Groundhog Day). All of this in a mere 28 days, 29 at the most.

Alas, our splendid month of February has all but come and gone, relinquishing the reins of Father Time's ever-charging team of Percherons to the foggy and dewy early-spring splendor of March. And we all know what gift March brings to the world:

March Madness!

Yes, college basketball's annual bacchanal is coming soon to a TV set near you. Here at the Drip Port, we're getting ready for some March Madness of our own -- we're driving the lane and closing in on an investment decision in the oil and gas industry. March will be the fifth and final month of our industry study, come hell or high-tops. Which company, if any, will we be dunking our investment money into next? Start those office pools now and keep an eye out for a Drippy full-court press of our own in the days ahead!

If we do decide to park some investment dollars in the oil and gas industry next month, it will be in a company that we feel is heads and tails above all of its peers in profitability. As our study has moved forward (perhaps crawled forward is a better phrase), we've discovered that a handy and fairly straightforward gauge for comparing the relative profitability levels of the companies on our list is return on capital employed, or ROCE. (By the way, we like to pronounce ROCE as "Roc-E." As in Rocky "Yo, Adrian!" Balboa, one of Jeff's childhood heroes.)

However, the road to understanding ROCE can be, well, rocky. We define ROCE as after-tax operating profits divided by the sum of total debt plus shareholders' equity. This may sound fairly simple, but in the complex financial statements of the energy industry, deriving an accurate number from this formula can be more challenging than squeezing oil from a rock.

First, a brief review of why ROCE is so important to the oil and gas industry. If your Foolish investment nose has come to prefer the scent of hydrocarbons, then take the time to fully understand the concept of return on capital employed. It is the industry's preferred benchmark for comparing one company's performance to another, bar none. If we had to decide whether to place money in an oil and gas company based on a single data point alone (not a Foolish idea, mind you), we would choose ROCE over the P/E ratio, dividend yield, book value, share price, or any other piece of information out there any day of the week.

Why?

It's important to remember what analytical function ROCE serves. This ratio shows how much money is coming out of a business relative to how much moolah is going in. It resembles its better-known cousin, return on invested capital (ROIC). This ratio is used prolifically by the Fools over in the Boring Portfolio to get an idea of how much value a company is creating for its shareholders. For a superb introduction to the strengths of ROIC as an analytical tool, click here.

Our ROCE guinea pig will be Exxon. To keep things simple, we'll look at the denominator first, using data from the liabilities portion of the balance sheet included in Exxon's latest form 10-K:

(in millions of $)
Current liabilities
Notes and loans payable:                    2,902
Accounts payable and accrued liabilities:  14,683
Income taxes payable:                       2,069

Other liabilities
Long-term debt:                             7,050
Annuity reserves and accrued liabilities:   9,302
Deferred income tax liabilities:           13,452
Deferred credits:                             575
Equity of minority interest in affiliates:  2,371

Total shareholders' equity:                43,660

Right away, we know how much shareholders' equity the company has at its disposal. Finding how much total debt Exxon uses to fund its operations is not quite so clear-cut. Long-term debt definitely must be factored in, but what other liabilities should be included? Notes and loans payable is actually another phrase for short-term debt. While often we will ignore short-term debt and focus on longer-term maturities when looking at a company's leverage, here short-term debt must be included. Exxon uses those notes and loans for whichever part of its business has short-term funding needs. So, into ROCE it goes.

Finally, the equity of minority interest in affiliates line should also be thought of as part of the firm's equity capital. This item represents the equity of Exxon's business partners' in combined ventures around the globe. Joint ventures and other such business combinations are common in the oil and gas industry, so this item will appear on a lot of balance sheets. It's equity that is being employed by Exxon, in an accounting way of thinking, so it should be included in ROCE.

So, our denominator looks like this:
43,660 + 7,050 + 2,902 + 2,371 = 55,983

Now, onto the income statement to find a numerator:

Total revenue:                        137,242

Costs
Crude oil and product purchases:       57,971
Operating expenses:                    13,045
SG&A expenses:                          8,406
Depreciation and depletion:             5,474
Exploration expenses:                     753
Interest expense:                         415
Excise taxes:                          14,863
Other taxes and duties:                23,111
Income applicable to minority interests:  406
Total Costs:                          124,444

Income before income taxes:            12,798
Income taxes:                           4,338
Net income:                             8,460

We're looking for after-tax operating earnings for our numerator. Often, we can use net income for this number. However, Exxon has the income applicable to minority interests under the costs heading of the income statement. This is the company's way of expressing how much of its earnings from those equity interests must be "paid out" to its partners. We're going to add this back into income before income taxes to show all of the company's profits from the capital it is employing, just to keep things consistent.

For our purposes, then, income before income taxes is 12,798 + 406 = 13,204

Exxon's income tax rate is 34% (4,338 divided by 12,798). Multiplying the adjusted income before the income taxes figure found above by the inverse of Exxon's tax rate gives us after-tax operating earnings of 8,715.

Finally, putting the numerator and denominator together gives us ROCE of 15.6% (8,715 divided by 55,983), which is what we found when we looked at Exxon two weeks ago.

One last thought on deriving after-tax operating earnings for use in ROCE. The coming avalanche of 1998 10-K's from oil and gas companies will include a bunch of asset write-downs and extraordinary losses due to low oil and gas prices last year. These should not be included in the numerator of your ROCE calculations.

Touchstone Friday. On Monday, we started the week with a column chock full o' accounting lessons for Drippers courtesy of the Drip Port's satellite office in Atlanta (that's George Runkle, for those following along at home.)

The rest of the week was devoted to the next three oil and gas companies up for consideration as investments, starting with Jeff's look at Phillips Petroleum on Tuesday. Frenchy topped himself on Wednesday with an illuminating piece on Ultramar Diamond Shamrock, and yours truly pontificated on the business of Sunoco on Thursday.

Next week, we'll decide whether any of these three companies deserves a closer look in our second round. In fact, we're leaving this decision up to you, fellow Drippers. If you haven't already, please post your thoughts and opinions this weekend on the Drip Companies message board.

Fool on!

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