Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...
With its shares up 17%, U.S. oil major Chevron Corporation (NYSE:CVX) is neck and neck with the S&P 500 for performance over the past year, lagging by just a couple of percentage points at last count. But here's the really good news: According to the analysts at Australian banker Macquarie, Chevron is about to surge into the lead!
Here's what you need to know.
Cash is king (again)
Macquarie's buy thesis on Chevron begins and ends with cash -- free cash flow (FCF), to be precise.
As explained in a write-up on TheFly.com this morning, Macquarie -- which ranks in the top 5% of investors we track on Motley Fool CAPS -- sees "cost reduction efforts and new production volumes driving outstanding free cash generation" at Chevron already.
Data from S&P Global Market Intelligence confirm this. According to S&P Global, it's been five years since Chevron generated positive free cash flow in any full-year period, and more than a decade (2005) since the last time Chevron generated positive free cash flow anywhere near to approximating positive GAAP earnings results. The past six months, however, have seen Chevron churn out $2.4 billion in real cash profit -- still short of reported GAAP earnings of $4.1 billion, but at least positive. Free cash flow was likewise positive in H2 of last year -- $1.1 billion.
What that means to investors
Now admittedly, the combination of free cash flow numbers from H1 2017 and H2 2016 still only adds up to about $3.5 billion in real cash profit, which is considerably less than the $5.8 billion in net income that Chevron reported under GAAP. It's probably not enough cash to justify Chevron's still high market capitalization of $227.6 billion.
As a reminder, this disconnect between reported "income" and actual cash profits is endemic in the oil industry, and the No. 1 reason I don't buy oil stocks for my personal account. That said, at least Chevron is generating some cash now, and as Macquarie points out, it's probably generating enough cash to "cover capex and the dividend at an oil price below $40/bbl from 2018 onward."
This fact alone makes Chevron a viable option for investors focused on earning dividend income, and less interested in capital appreciation. It's enough to make Macquarie feel "very positive" about Chevron's prospects, and is the key reason this analyst is upgrading Chevron stock to outperform and assigning a $135 price target on the stock.
How Chevron stacks up to the competition
But should Chevron stock be good enough for you?
Not necessarily. To reiterate, oil companies as a group have a habit of claiming much stronger net income under GAAP accounting standards than they ever produce as real cash profit on their cash flow statements. This is the main reason I have historically avoided the oil industry. That said, oil companies' numbers have been improving as oil execs have worked to trim costs and right-size production in the current low-price oil environment.
It's not just Chevron that's begun generating cash again. Over the past 12 months, Chevron rival ConocoPhillips (NYSE:COP) reported GAAP losses of $3.9 billion, but positive free cash flow of $2.4 billion. ExxonMobil (NYSE:XOM) generated $14.6 billion in free cash flow versus $11.7 billion reported net income. Of the really big names, only BP (NYSE:BP) seems to be playing odd man out, reporting a small GAAP profit ($3.7 billion) but showing a free cash flow deficit of $4.1 billion.
And even BP was FCF-positive in each of 2014 and 2015, so there's reason to hope that BP can also turn itself back around and resume generating cash, too.
The upshot for investors
Oil majors' discovery of the virtues of cost-cutting is good news for income investors who like the industry's long history of paying robust dividends. If cash is flowing again, those dividend checks should keep on flowing, too. That said, if strong, positive free cash flow is becoming the new normal for oil majors, then I have to say I'm more enthusiastic about the valuation at Chevron rival Exxon, which currently sells for 24 times trailing free cash flow, or even ConocoPhillips, which costs about 25 times FCF, than I am about Chevron at 65 times FCF.
Good is good, but cheaper is better.