The oil and gas sector is facing an existential crisis, and BP (NYSE:BP) stock is feeling the heat. But can you blame investors? Plunging oil prices and storage capacity fears are dominating headlines as the novel coronavirus wreaks havoc on the entire industry.
Nevertheless, some companies are still marching on. BP stock is certainly a bright spot in that regard.
The energy giant recently unveiled its first-quarter results, and although the company reported a 67% year-over-year decline in net income for the first quarter, it wasn’t all bad news. You must remember, this comes just a month after oil prices slumped to their lowest levels since the 2008 recession.
BP maintained its dividend and revealed it wants to be a net-zero company by 2050. Still, the market was hoping for a smaller drop in net profit and healthier returns. BP stock did gain as a result of the positive dividend announcement.
Overall, I understand the situation that management finds itself in, and I am happy that they are fighting it out. BP has said that the company will try to cut corners and reduce expenses wherever it can, in order to maintain the dividend.
Although it’s probably unsustainable, you have to give it to BP for trying everything possible to keep investors happy.
BP Stock Is Throwing a Dividend Party
As I mentioned earlier, BP is committed to maintaining dividends at present levels through the crisis. But with operating cash flow falling so steeply in the recent quarter, is this sustainable? The interest coverage ratio is also negative for the company, underling the toll the crisis has taken.
However, what most analysts need to understand is that Covid-19 is an unprecedented event. And if it’s over in a few months, we should expect operating cash flows to be back to sustainable levels. That would help the company manage its dividend and interest payments.
Remarking on the importance of the dividend, Stuart Lamont, investment manager at Brewin Dolphin told CNBC, “There will be a sigh of relief from many retail investors that BP has committed to paying a dividend.”
Alaska Divestiture Should Shore Up BP’s Value
Fortunately, BP should get some breathing room soon. The company negotiated a $5.6 billion deal for its Alaska business to privately held Hilcorp Energy, expected to complete in mid-2020.
This deal should give BP enough breathing room to make sure it can manage dividend payments and operational expenses for the next few quarters. Why is this important? Well, because BP does have a lot of debt on its balance sheet, and loading up on more of it to satisfy dividend payments and operational expenses would not be the best strategy at this point. It would also do a number on BP’s stock price.
BP’s Financial and Debt Position
If you are perusing the financials for BP, it’s quite apparent that the company could be in better shape. However, the coronavirus has a lot to do with this. Free cash flow increased by almost 75% in the fourth quarter of 2019 — a very healthy sign for BP. That quarter also saw the dividend payout ratio grow to 4.2 times, after it logged a ratio of 2.96 times a year ago. Unfortunately, all those numbers have dwindled due to the virus.
BP now finds itself in an unenviable position where its liquidity stats have taken a beating.
Regardless, it’s not the company’s fault, but it will be hoping that oil prices return to pre-crisis levels so that it doesn’t face a going concern issue in the coming future.
The pandemic has hit BP hard, but the company has also made some avoidable mistakes. Debt, as shown in the chart above, has grown substantially over the last ten years. While revenues were healthy, it was tolerable. But in the years when the company should have deleveraged, it instead went ahead and loaded up on dry powder. That has proved to be an imprudent strategy.
Also, the company will increase its debt by $7 billion through a bond issue and is looking to obtain a $10 billion credit facility. Management must be hoping that this will be enough to get through the crisis. But at the same time, we have to understand that the situation is fluid. If free cash flow does not turn positive soon, all this debt could lead to headaches for the energy giant.
The Bottom Line
If you take a 9.5% growth multiple and project free cash flow (taking a six-year average of cash flows), you’d come to $29.68 per share. That implies 23.9% upside BP stock’s May 12 closing price. Refinitiv data shows analysts have a 12-month price target of $32.30, a 34.4% increase over the current price. So, the stock will eventually bounce back once oil prices normalize.
There’s no doubt that BP stock has suffered due to the coronavirus. But if recent financials were any indicator, things were on the up and up. Sadly, it will have to adjust to the new “normal” and hope things get better before the year-end.
Regardless, I believe BP stock is a buy here. Management has done well to steer the company in the right direction, and once the crisis is over, the share price will reflect their efforts.
As of this writing, Faizan Farooque did not hold any of the aforementioned securities.
