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BP Stock Upgraded: What You Need to Know

By Rich Smith - Sep 5, 2018 at 1:07PM

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Morgan Stanley argues investors should look past the past, and focus on the future.

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...

At nearly $142 billion in market capitalization, with more than $38 billion in net debt on its balance sheet, oil major BP ( BP 0.77% ) carries an enterprise value of $180 billion. Valued on its $7 billion in trailing GAAP net income, the stock costs 25.5 times earnings. Valued on its much weaker free cash flow -- $6.25 billion over the past 12 months -- it sells for nearly 29 times FCF.

Say what you want about BP, but one thing this oil company is not is a cheap stock.

And yet, this morning, investment banker Morgan Stanley made the argument that if all goes as planned, BP could become an attractive investment in relatively short order. Is it right about that?

Let's find out.

Oil derricks against a sunrise

Image source: Getty Images.

A lesson in cash flow

BP arguably hit its high-water mark for profitability 10 years ago, in 2008, when its mammoth oil business generated more than $38 billion in cash from operations, and spent only $22.6 billion in capital investment to do it. That left BP with $15.4 billion in positive free cash flow -- a record BP hasn't matched again to this day.

To the contrary, the $6.25 billion in positive free cash flow that BP generated over the past 12 months is less than half the cash profit this company earned 10 years ago. And yet, BP's FCF number is already more than twice what it was for 2017 as a whole. It's firmly positive, which was not the case as recently as 2016, and it's growing.

And this, in a nutshell, is Morgan Stanley's argument in favor of upgrading BP to an overweight rating. In a note covered on StreetInsider.com (subscription required), the analyst argues that investors are failing to fully appreciate the strength of BP's free cash flow growth potential, or the attractiveness of the very high 5.8% dividend that this free cash flow permits BP to pay. 

BP's story takes a turn

BP's free cash flow growth story, which appeals to Morgan Stanley despite BP's plans to invest between $13 billion to $14 billion in FCF-draining capital investment annually over the next few years, took a turn for the better this past summer. In July, BP announced a $10.5 billion deal to buy BHP Billiton's shale assets in the Permian Basin, Eagle Ford and Haynesville regions.

As my fellow Fool.com contributor and energy specialist Matthew DiLallo explained at the time, BP's purchase will give it access to nearly half a million acres of oil-producing shale, generating 190,000 barrels of oil equivalent per day -- immediately boosting both cash flow and profits once the deal closes next month. By 2021, BP expects to be generating positive free cash flow (again, that's cash from operations minus capital spending) of between $14 billion and $15 billion per year -- maybe more, if oil prices stay above $55 a barrel. (For context, Brent crude costs more than $77 a barrel right now.)

Valuing BP stock

Thus, Morgan Stanley's thesis in a nutshell is this: Although BP stock may look expensive right now, the company has significant potential to grow free cash flow massively -- on the order of 100% or more -- and in relatively short order, too.

Is Morgan Stanley right about that?

The valuation logic seems sound, so far as it goes. About $15 billion in annual free cash flow, weighed against $180 billion in enterprise value, would value BP stock at only 12 times FCF. The stock's 5.8% dividend yield probably justifies about half that multiple and, as Matthew notes, BP would be growing production at 5% annually. Even at stable profit margins, that would appear to pay for the rest of the multiple.

Granted, we won't know for certain whether BP can generate the $14 billion to $15 billion in free cash flow that it's promising for three more years, which adds some measure of risk to the investment thesis. It's also worth remembering that -- as noted above -- BP has not generated anywhere near $15 billion in positive free cash flow in nearly a decade. For that matter, it's only generated $14 billion-plus in FCF twice in its history.

Predicting consistent, $14 billion-plus free cash flow for BP from 2021 on therefore is something of a stretch. Then again, if all BP needs is $55 oil to accomplish this, and if oil is selling for north of $77 a barrel today, it's possible BP stock could be cheaper than even Morgan Stanley thinks it is.

At the very least, this is a situation that bears watching, and if BP's FCF number keeps going up, Morgan Stanley's move could prove prescient.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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