Marathon Oil (NYSE:MRO) provided positive guidance on Aug. 5 for its second half. If that outlook comes to pass,expect MRO stock to push much higher.
Despite reporting a second-quarter loss of 60 cents per share, the company said that its free cash flow in the second half should be significantly higher. To underline the point the earnings report was subtitled: “Capital Efficiency Improvement Drives Positive Guidance Revisions.”
Here is what the company meant. The Q2 report said that Marathon Oil was reducing its capital expenditure budget (i.e. oil and gas well drilling) to $1.2 billion for 2020. This was down from $2.4 billion in its original 2020 budget released on Feb 12. And it was also later reduced to $1.3 billion or less on May 6 in the Q1 earnings report.
Free Cash Flow Expected In Second Half
Marathon Oil said one more thing that made it even clearer for investors what to expect. The company is “positioned for free cash flow generation at commodity prices well below forward curve.” In fact, to clarify this point, they said, “…second half 2020 free cash flow breakeven in $30/bbl WTI range.”
That means that in the low $30 range for West Texas Intermediate oil prices, the company will make breakeven FCF in Q3 and Q4. The good thing about that is the price of oil has been consistently between $40 and $41 for most of Q3. And we are already halfway through Q3.
Let’s model that out and see how it affects the MRO stock valuation. For example, let’s say that the company makes $6 above FCF breakeven for most of Q3 and Q4. That is the difference between $41 and $35 per barrel. I used $35 on the low end since Marathon Oil said it expects that Q4 FCF breakeven will be at $35.
Now the company also says it expects to produce 190,000 barrels of oil per day (bopd) for the second half. That means that the daily FCF generation will be $1.14 million. And since there will be 182 days in the second half, and total H2 (second half 2020) FCF will be $207.5 million. That implies $415 million on an annualized run-rate basis.
Here is why that is important. MRO stock presently has a market capitalization of $4.5 billion. That means the prospective FCF yield is 9.2%. This is probably twice as high as it would normally be with that kind of FCF generation.
How High Could MRO Stock Fly
I expect that over the next year, the price of oil will rise mainly due to a reduction of the damage from the Covid-19 pandemic on economic activity. This includes the assumption that a vaccine becomes available in early 2021 which is effective and becomes widely available.
Here is what I forecast. If the price of oil averages $50, and Marathon continues to make 190,000 bopd, FCF generation should be $2.85 million per day. That implies FCF of $1.0374 billion in 2021.
I also assume that MRO stock would rise to the point where the FCF yield would be 6% on average. Therefore, using a little bit of algebra, we can estimate the MOR stock will have a market cap of $17.29 billion. Take $1.0374 billion and divide it by 6.0%. The result of $17.29 billion is 3.617 times the present price.
That implies that MRO stock would rise to $21.41 per share.
This shows the tremendous operating leverage that Marathon Oil has. For example, if the price of oil rises just 19% (i.e., from $42 per barrel to $50), it leads to a 262% increase in the price of MRO stock. That is a lot of leverage.
What To Do With Marathon Oil Stock
I can tell you that this is now one of my own personal core holdings. That is because of its implied massive operating leverage to the price of oil.
By the way, this works on the downside too. A lower oil price leads to a much more heavy FCF loss. But from my standpoint, that will likely normally just be a temporary phenomenon. To someone like me, who is a continuous buyer, it is actually preferable.
One more point. Marathon Oil is likely to restore its dividend once it has one or two quarters of positive free cash flow. It used to pay 5 cents per quarter up until Q1 (i.e., it quite in Q2). According to Seeking Alpha the average dividend yield over the past four years up until then was 1.59%.
So, let’s say it returns the dividend in Q4 2020 or Q1 2021. And just to be conservative, let’s say it lowers the quarterly dividend to 3 cents per share per quarter from 5 cents. That implies a target price of $7.55 per share, i.e., 12 cents divided by 1.59%. That implies a minimum gain of 27.5% for MRO stock. And, if we want to expand out the forecast, a return to 20 cents per share annually divided by 1.59% yields a price target of $12.58 per share.
So now we have three target prices. The high-end price is $21.41 based on FCF estimates for next year. The middle price is $12.58, based on a return of the prior dividend and the prior dividend yield. And the low-end price is $7.55, based on a 40% reduction in the dividend and the same dividend yield.
The average of these three is $13.85 per share for some time during 2021. That is 142% higher than today’s price. All based on the company’s FCF operating leverage and a return of the dividend. That’s why I am buying it myself.
As of this writing, Mark Hake, CFA holds a position in MRO stock and he intends to buy moreMRO stock. He runs the Total Yield Value Guide which you can review here.
