General Electric’s share-price collapse is a reminder that investing in a company based solely on past reputation and dividend yield is dangerous.
GE GE, +1.07% is also a great example that dividends are not paid out of earnings, especially massaged-to-death non-GAAP earnings, but from free cash flows. GE’s non-GAAP earnings were double its dividend payment.
This brings up another Dow Jones Industrial Average DJIA, -0.62% stalwart and American icon of the past: Exxon Mobil XOM, +0.91% .
The oil giant was one of the world’s most-respected companies. Its stock was passed from generation to generation, often with a deathbed whisper “Never sell Exxon.” And for a long time, if you listened to that whisper you grew richer as Exxon continued to grow earnings, raise its dividend, and buy-back stock.
These days are long gone. Today Exxon is slipping into the sunset. The company has been in self-liquidation, but investors never got the memo.
Over the past 10 years Exxon spent $275 billion returning money to shareholders through dividends and stock buybacks while earning $318 billion of net income. On the surface these numbers look great. There is only one problem: Exxon’s reported earnings dramatically overstate the company’s true earning power. Finding new oil and extracting it has become much more expensive, and thus Exxon’s capital expenditures — the cash it spends on replenishing reserves and extracting oil — significantly exceed the company’s depreciation expense (an income-statement figure).
Exxon Mobil’s cumulative free cash flows — the cash earnings left after the company has paid for replenishing reserves and extraction — were $183 billion over the last 10 years, not enough to cover its giant, 10-year $275 billion return of capital to shareholders, and leaving a shortfall of almost $100 billion. To finance dividends and buybacks, Exxon had to leverage its balance sheet. Over a decade the company went from floating on $24 billion of (net) cash to drowning in $38 billion of net debt.
It gets worse. “Over the last ten years ExxonMobil replaced 82 percent of produced volumes. ExxonMobil’s reserves life at current production rates is 13 years.” That comes directly from Exxon’s 2016 annual report. Results for 2017 were no better, with oil production down 3%.
What is truly amazing is that Exxon investors’ vision is so thoroughly obfuscated by the company’s “better than bonds” dividend yield of 4%. Let me tell you what it “obfuscates.” Today investors are paying $330 billion for a company that earned $15 billion in 2017 ($20 billion on non-GAAP basis) or about 22 times earnings. That is not cheap for a company that has been selling fewer and fewer barrels of oil every year. Moreover, Exxon’s 2017 free cash flow was only $7 billion (The same as in 2016, when oil prices were low; in 2017 prices rebounded.), thus putting its price to free cash flow multiple at around 47. The 4% dividend that investors are so magnetized by cost the company $13 billion in 2017. And, yes, $6 billion of that dividend was subsidized by bond holders (again).
If you are buying Exon stock today you betting that oil prices will rise and Exxon’s financial situation will improve considerably, even though production will continue to decline. If oil prices remain at current levels, at some point bond investors will lose their willingness to support this shrinking enterprise. Exxon Mobil’s dividend will get cut and investors will wake up to the rude awakening that they paid a lot for very little.
So, how does one invest in this overvalued stock market? Our strategy is spelled out in this fairly lengthy article.
Vitaliy Katsenelson is chief investment officer at Investment Management Associates in Denver, Colo., which holds no shares of either Exxon Mobil or GE. He is the author of “Active Value Investing” (Wiley) and “The Little Book of Sideways Markets” (Wiley). Read more on Katsenelson’s Contrarian Edge blog.
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