Peter Lynch is one of the best professional portfolio managers of all time. During his tenure as portfolio manager of the Fidelity Magellan Fund between 1977 and 1990, his fund generated annual returns of 29.2%. To put this into perspective, a 29.2% annual return over 13 years would have turned a $10,000 investment into nearly $280,000. One of Lynch’s core investing principles is to do your research, meaning investors should always conduct thorough due diligence before buying individual stocks. This includes valuation analysis as an important part of the research process.
The price-to-earnings growth ratio, or PEG ratio for short, can be a helpful valuation tool for investors to find undervalued stocks. Occidental Petroleum Corporation (OXY) currently has a PEG ratio of just 0.24, based on its expected earnings growth over the next five years. This low of a PEG ratio means the stock could be significantly undervalued. In addition, the stock has a high dividend yield of 4%. As a result, Occidental Petroleum could be an attractive stock for value and income investors.
Why The PEG Ratio Matters
The PEG ratio compares a company’s expected earnings growth with its current share price. A low PEG ratio, typically viewed as less than 1.0, indicates a stock is valued at a discount to its future earnings growth. The lower the PEG ratio, the greater the potential undervaluation. In this case, Occidental Petroleum has a low PEG ratio because its share price is actually lower today than it was five years ago. The stock generated total returns of 10.9% in the past five years, compared with 88% total returns for the S&P 500 Index in the same period.
This is not surprising, as Occidental Petroleum was severely impacted by the decline in oil and gas prices from 2014 through 2016. The company’s profits shrank as commodity prices plunged, which caused the share price to stagnate. As a result, Occidental Petroleum stock has deeply underperformed the broader market index over the past five years.
The good news is, Occidental Petroleum is back to growth, which could be a major boost to the stock going forward. The other reason for Occidental Petroleum’s low PEG ratio is because the company is expected to grow earnings at a high rate. For example, the average analyst estimate calls for 15.5% earnings growth next year, and nearly 50% earnings growth by 2021. Such a high rate of expected growth is due primarily to the potential for rising oil and gas prices in the years ahead.
Business Overview and Growth Prospects
Occidental Petroleum is a global oil and gas company. It has a number of businesses, including oil and gas production, midstream operations, and a chemicals segment. The primary business is oil and gas exploration and production, which is highly sensitive to changes in oil and gas prices. The company’s most important resource base is the Permian Basin, which is one of the largest and most prominent oil fields in the United States.
Source: Energy-Power Conference Presentation, page 4
This is a huge competitive advantage for Occidental, as it is the leading producer in the Permian. The company has significantly expanded its Permian production in just the past year. For example, by the fourth quarter of 2018 Occidental Petroleum expects to be producing 235,000 to 255,000 barrels per day from the Permian. At the midpoint of this range, production is expected to increase 54% from the fourth quarter of 2017.
Permian production is highly beneficial to Occidental Petroleum, because the company is a low-cost operator. The Permian Basin has high resource quality, with low drilling costs and low rates of decline. This gives Occidental Petroleum low breakeven points for its Permian assets, which helps the company generate positive cash flow, even during periods of falling oil and gas prices. Significant cost reductions and a focus on high-quality Permian resources have helped lower Occidental Petroleum’s cash flow break-even point to $50 per barrel. At that price level, Occidental Petroleum would generate enough cash flow to maintain its dividend and also grow production by 5% to 8% per year.
As of September 24th, oil prices were trading above $72 per barrel in the United States. This is well above Occidental Petroleum’s breakeven point, which means the company should report strong earnings growth in 2018. And, there is potential for oil prices to rise even further. Heightened geopolitical concerns, including trade wars and supply cuts among major oil-producing countries, could fuel a prolonged rally in oil prices.
As a major oil and gas producer, Occidental Petroleum’s bottom line is closely tied to the price of oil and gas. According to the company, its operating cash flow fluctuates by $120 million for every $1 per barrel change in oil prices. Consequently, Occidental Petroleum’s earnings have soared so far in 2018 due to the rise in oil and gas prices. Over the first half, the company reported earnings-per-share of $2.02, a 149% increase from $0.81 per share earned in the first half of 2017.
Such a high rate of earnings growth means Occidental Petroleum stock could be undervalued, given the low PEG ratio. Another benefit of its massive growth is that the company can return cash to shareholders through rising dividends.
Source: Source: Energy-Power Conference Presentation, page 7
Occidental Petroleum has increased its dividend for 16 years in a row. Over that period, it increased its dividend by 12% per year, on average. Dividend growth has slowed in recent years, due to the prolonged period of falling commodity prices, but it is still highly impressive that the company has been able to maintain its dividend growth. The recent downturn caused several oil and gas exploration and production companies to cut their dividends or eliminate them entirely.
With oil and gas prices back on the rise, Occidental Petroleum expects to generate significant excess cash flow, which it will also use to repurchase its stock. The company sees the opportunity for at least $2 billion of share repurchases over the next 12 to 18 months. The share buyback could provide a boost of 3%-4% to Occidental Petroleum’s earnings growth, based on its current market capitalization.
Putting It All Together
Occidental Petroleum—along with the rest of the oil and gas industry—underperformed the S&P 500 during the downturn of 2014 to 2016. But if commodity prices continue to climb, the company is likely to grow earnings at a high rate, given its rising oil production. Occidental’s low stock valuation (as measured by the PEG ratio) could indicate a buying opportunity.