Super Star or Falling Star?

by Brian Graney (TMFPanic@aol.com)

ALEXANDRIA, VA (March 3, 1999) -- It's time to take a look at "The Star of the American Road" and see how things are going over at White Plains, N.Y.-based Texaco Inc. (NYSE: TX).

Description: Texaco started life as The Texas Company in 1902 in the booming oil town of (you guessed it) Beaumont, Texas. A year earlier, the first oil strike in Texas had occurred at a little hill called Spindletop, and a fellow named "Buckskin Joe" Cullinan saw a chance to get in on the action. Since Buckskin Joe had the good fortune of already having built an oil storage facility just 20 miles down the road from Spindletop, he had an early advantage over many of his better-capitalized rivals during the great Texas oil rush. In short order, Joe became the foremost oil man in the region.

Buckskin Joe's Texas Company wasted little time diversifying its operations, supplementing its exploration and production activities with a pipeline and a gasoline refinery. The well-known red Texaco star with the "T" in the middle became the company's trademark in 1906. By 1928, the logo was gracing fueling stations in all 48 states. In the years that followed, Texaco was a leader at marketing its brandname, which became one of the first well-recognized national brands of gasoline. To get the word out, Texaco sponsored the Metropolitan Opera's radio show, invited viewers to watch The Texaco Star Theater TV program, and signed up Milton Berle and Bob Hope as pitchmen. The exposure worked, as Buckskin Joe's company is today one of the world's largest integrated oil and gas companies.

Currently, Texaco is the integrated major most leveraged to the oil price roller coaster. Proven reserves total 4.7 billion barrels of oil equivalent (BOE) and daily production came in at about 1.3 million BOE per day in 1998, roughly 70% of which was oil. The company owns or has interests in 28 refineries around the globe and sells an average of 33 million gallons of gasoline daily through its 23,000 branded gasoline stations. Texaco also operates natural gas storage facilities and 1,000 miles of pipelines in the U.S. and markets lubricants under the Havoline brand name.

Financials: As has been our custom throughout this industry study, our initial look at Texaco will focus on only a few key elements: How is the company valued by the market? How profitable are its chosen operations? How does the company finance its operations? And what does management do with the money that it earns?

Valuation: We can find Texaco's market capitalization by multiplying its 525.4 million shares outstanding at the end of Q4 by the current share price of $45 3/8, giving us a figure of $23.8 billion. Adding in $6 billion in long-term debt and subtracting out $250 million in cash at the end of Q3 gives us an enterprise value of $29.5 billion, making Texaco roughly one-fifth the size of BP Amoco and one-tenth the size of the combined Exxon Mobil.

Texaco's shares currently trade at 22 times fiscal 1999 earnings estimates of $2.09 per share and 16 times 2000 estimates of $2.85 per share. The estimated long-term earnings growth rate is 9.2%, according to IBES.

Profitability: To measure the firm's profitability, we will rely on our standard industry gauge of return on capital employed, or ROCE.

Because its business is closely tied to oil prices, Texaco's relative profitability has taken a beating as oil prices have slumped over the past 18 months or so. ROCE fell from 12.4% in 1996 to 11.2% in 1997, excluding a $488 million tax benefit from the IRS during the year. Coming up with a reliable figure for 1998 is tough to do with the information Texaco has made available so far, but crack statistician Spanky the Wonder Pooch is willing to give it a shot, anyway. Spanky has been reading up on ROCE between his daily walks and feels pretty confident in his ability to calculate this important ratio.

Given the $964 million in after-tax operating income recently reported by Texaco in its 1998 earnings statement, Spanky divides that number by the sum of the $11.8 billion in shareholders' equity and $7.3 billion in total debt also listed by the company and finds an ROCE figure of 5%. Bow wow, what a dog!, Spanky exclaims. Of course, this is just an estimate and very well may be understating Texaco's current profitability. However, it's a safe bet that Texaco's ROCE last year was well south of 10%. That compares unfavorably with Exxon, Mobil, and BP Amoco, which all appeared to keep ROCE close to 10% in 1998 despite the downturn in oil and gas prices.

Leverage: The numbers we used to calculate Texaco's 1998 ROCE are also handy for calculating the company's debt-to-capitalization ratio (total debt divided by the sum of total debt plus shareholders' equity.) For 1998, we come up with a figure of 38%, which seems about right considering we calculated a ratio of 36% using numbers from Texaco's 10-Q for the third quarter. This is in the 30% to 40% "comfort zone" preferred by Texaco Chairman and CEO Peter Bijur, but is still about 10 percentage points below the ratios we calculated for Exxon and BP Amoco. Mobil's leverage is even lower still.

Use of Cash Flow: Texaco's current dividend yield is 3.97%, tops among the major integrated firms we have looked at so far. The company also has a solid history of buying back its own shares, repurchasing 9.6 million shares in 1998 (or 1.8% of its 1997 diluted sharecount) and 20 million shares since 1996. However, Texaco reported earlier this week that it suspended its current $1 billion share buyback plan last September in an effort to better cope with continuing low oil prices.

As the industry consolidates through mergers and cost reductions, Texaco is feeling the heat to streamline its operations in order to remain competitive. A U.S. downstream joint venture with Shell Oil Co. was signed last year, but efforts to extend the partnership to the European market fell through. For 1999, Texaco's management is forecasting $400 million in pre-tax cost savings, mostly through layoffs. The annual cost savings are expected to rise to $600 million in 2000, although the company has yet to detail exactly how these savings will be realized.

The Snapshot for Texaco: Click here for a brief look at Texaco's financial picture.

Conclusion: Texaco finds itself in a tough situation -- it is too small to acquire another major integrated firm and make a run at the super-majors, but it is too big to derive major cost-savings or synergies by acquiring smaller firms, such as independent exploration and production companies. Its high oil production leverage will allow for considerable upside when oil prices rise again, but its small scale leaves a glaring profitability gap between itself and the likes of Exxon Mobil, BP Amoco, and Royal Dutch/Shell. Head honcho Bijur is hoping for ROCE of 13% by 2002, but that is factoring in oil prices of $15 per barrel this year and even higher levels in the years to come.

Texaco will have a difficult time finding the cost-savings to keep up with the super-majors in the years ahead, and it will continue to be one of the least profitable integrated firms so long as oil prices remain at their current low levels of around $12 per barrel. The longer the price stays down, the worse Texaco will do. We want to put our investment dollars in a company that can outperform its peers in good times and in bad. With that in mind, we are going to bid "adieu" to Texaco and focus on its larger rivals Exxon Mobil and BP Amoco in round two.

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