Marathon Oil (NYSE:MRO) has had it rough for the past several months. MRO stock is down almost $10, or 70% from its recent peak in January 2020. But I believe the stock will do just fine as the economy recovers.
Moreover, its dividend looks pretty secure. MRO has a 4.61% dividend yield. For example, in its fourth-quater, the company made $84 million in free cash flow, but its dividend cost only $64 million.
So it made enough to pay for the dividend before the price of oil dropped. In fact, in the past year to December 2019, FCF was $199 million, and the dividend was just $162 million.
Capex Cuts Will Keep Dividend Secure
On April 8, Marathon announced a second update on its expected capex spending budget. The bottom line is that Marathon decided to cut its capex budget by about 50%. Instead of spending $2.55 billion, it is now only going to spend $1.3 billion in capital expenditures.
This will go a long way to securing the dividend. For example, assuming that cash flow from operations declines 40% to $1.649 billion, there will still be room for the dividend.
That is because FCF would then be $349 million ($1.649 billion in CFFO minus $1.3 in capex equals $349 million). Since the dividend only costs $162 million, there will still be room in FCF to cover it.
Keep in mind that that this assumes that cash flow declines 40% over the next year. I highly suspect that oil prices will begin to rise once Russia and Saudi Arabia finalize an agreement on cutting production.
The Purpose of Capex Cutbacks
In the announcement on April 8, Marathon discussed which areas of the U.S. they are cutting back exploration and drilling activities. But they also reserved their flexibility to adjust capital spending plans as necessary.
The company made it clear that the purpose of their cutbacks was to maintain financial strength:
…these decisive actions are designed first and foremost to protect our balance sheet and our hard earned financial strength. We remain investment grade at all primary rating agencies, with recent reviews by both Fitch and S&P, and maintain a strong liquidity position with no near-term debt maturities.
This shows that Marathon management is very conservative. This is exactly the kind of decision-making you want to see in a company subject to rapidly changing market conditions.
For example, the company has just $4.64 billion in net debt and $12.15 billion in shareholders’ equity. This puts its net gearing ratio at just 27.6% (i.e. $4.64 billion divided by equity plus net debt of $16.8 billion). This is a relatively low leverage ratio for an oil company, especially compared to some of the majors like BP (NYSE:BP).
Marathon’s Hedging Strategy Shows It Is Bullish on Oil
In addition, Marathon laid bare its hedging strategy in the announcement. It shows that the company had sold puts on a portion of its production for Q3 and Q4 2020 at $48 (WTI oil).
What that means is that it expects the price of oil to be at least $48 by that time (six months from now). That is a very bullish outlook for the price of oil.
MRO said it would provide an update to its revised 2020 business plan as part of its Q1 earnings release in May.
Dividend Yield at MRO Stock Is Very Attractive
MRO has kept its quarterly dividend at five cents per quarter for a number of years. It has not raised it continuously like a number of its peers. This has allowed the company to keep a fairly healthy financial condition as mentioned above.
According to Seeking Alpha, MRO’s average dividend yield over the past four years has been 1.62%. Let’s assume that the average yield over the next year is twice that level, or 3.24%. We can estimate MRO’s true value.
Taking the present annual dividend of twenty cents per share and dividing it by 3.24% results in a price of $6.17 per share. That represents an upside of 50% from today’s price of $4.12 for MRO stock.
In other words, assuming Marathon’s hedging strategy is correct, that oil will rise a lot in the next six months, MRO’s dividend yield will fall. So there is good reason to believe that MRO stock is at least 50% undervalued.
Stick with MRO stock at this price if you are an investor. If not, look for an entry point near today’s price. You will likely do quite well over time.
As of this writing, Mark Hake, CFA does not hold a position in any of the aforementioned securities. Mark Hake runs the Total Yield Value Guide which you can review here.
