BP plc. Current Price: $36.18 Target Price: $51.21 Recommendation: Buy

Transcription

1 BP plc NYSE: BP Current Price: $36.18 Target Price: $51.21 Recommendation: Buy Investment Thesis BP is one of the largest integrated oil and gas companies in the world, with an estimated global market share of 3% of oil and gas production and 4% of refining capacity in the major global markets in which it operates in. Although both the global demand and price of crude oil are still uncertain for 2009, I believe that BP s corporate strategy and operating efficiencies give them a competitive advantage in this current economic state. Given these advantages, I feel that BP will generate above-average returns, when compared to its industry, over the next two years. Summary Based on my analysis, I have assigned BP a 12-month price target of $ Below are key assumptions which support my valuation: Production from US refineries is forecasted to grow between million barrels per day The energy sector is anticipated to grow between 3%- 4% in 2009 BP plans to increase its dividend yield during fiscal year 2009 Operating and profit margins have remained consistent during volatile swings in crude oil prices The integrated oil and gas sector is currently fair valued When using both absolute and comparative multiples, BP is undervalued Both DCF models yielded a target price 32%-49% higher than the current share price, suggesting BP s intrinsic value is greater than its current value Analyst Information Analyst Luke A. DiTomas Fisher College of Business The Ohio State University Columbus, OH Contact Information Phone: (216) DiTomas.1@osu.edu Updated: March 10, 2009 Stock Information Sector: Energy Industry: Integrated Oil and Gas 52 Week Range: $33.70 $77.69 Beta: Revenue Breakdown Other Businesses and Corporate, 1.21% Refining and Marketing, 77.14% Exploration and Production, 21.64% Share Price vs. Volume Share Price $80.00 $70.00 $60.00 $50.00 $40.00 $30.00 $20.00 March-08 April-08 May-08 June-08 July-08 August-08 September-08 October-08 November-08 December-08 January-09 February-09 March-09 $ o Volume 210, , , ,000 90,000 60,000 30,000 0 $ Million Financial Highlights Revenue 365, , ,602 Growth 26.6% 6.8% 10.9% EBITDA Growth 40.6% 11.2% -8.7% Operating Income 35,239 32,352 35,158 Growth 8.9% -8.0% 2.3% Profit for the Year 21,666 21,169 22,286 Diluted EPS $8.17 $5.75 $6.72

2 TABLE OF CONTENTS I. Company Profile... 1 Company Overview... 1 Business Segments... 1 Brands... 2 II. Sector Analysis... 3 Overview... 3 Macroeconomic Drivers... 3 Outlook... 4 III. Industry Analysis... 5 Overview... 5 Background... 5 Current Life Cycle... 6 Macroeconomic Drivers... 6 Recent Performance... 8 Competition... 9 Valuation Outlook IV. Company Analysis Strategy Competitive Advantage Financial Analysis Equity Valuation: Multiples Equity Valuation: Discounted Cash Flow V Equity Valuation: Discounted Cash Flow V V. Summary Strengths and Opportunities Weaknesses and Threats Conclusion VI. Appendix 1: BP plc Financial Statements From 20-F VII. Appendix 2: Discounted Cash Flow Models DCF V DCF V

3 TABLE OF EXHIBITS Exhibit 1: Exploration and Production Financials 1 Exhibit 2: Refining and Marketing Financials 1 Exhibit 3: BP Alternative Energy Financials 2 Exhibit 4: Crude Oil Supply as a % of Production 3 Exhibit 5: Crude Oil Inventories vs. Production 3 Exhibit 6: Regression Analysis 4 Exhibit 7: Products and Service Segmentation 5 Exhibit 8: OPEC Spare Capacity may Lead to Rising Oil Prices 6 Exhibit 9: World Consumption vs. Non-OPEC Production 7 Exhibit 10: Global Oil Cost Curves 8 Exhibit 11: Industry Profitability Analysis 8 Exhibit 12: Industry Multiple Valuation 10 Exhibit 13: 10-Year Absolute Multiples Valuation of Industry 10 Exhibit 14: 10-Year Multiples Valuation of Industry vs. Sector 11 Exhibit 15: 10-Year Multiples Valuation of Industry vs. S&P Exhibit 16: Margin Analysis Income Statement 14 Exhibit 17: Dupont Analysis 14 Exhibit 18: Interest Coverage Multiples 14 Exhibit 19: 10-Year Multiples Valuation of BP 14 Exhibit 20: 10-Year Multiples Valuation of BP vs. Sector 15 Exhibit 21: 10-Year Multiples Valuation of BP vs. S&P Exhibit 22: Share Price Sensitivity Analysis- DCF V1 16 Exhibit 23: Share Price Sensitivity Analysis- DCF V2 17 Exhibit 24: BP Gas Station 18

4 I. Company Profile 1 COMPANY OVERVIEW Headquartered in London, England, BP plc or British Petroleum operates as an international integrated oil and gas company. They currently employ 96,200 employees, have exploration activities in 23 countries and 17 refineries located around the world. BP products are sold in over 150 countries. They started operations in April 1909, originally known as Anglo-Persian Oil Company. In December 1998, British Petroleum merged with Amoco (formerly Standard Oil of Indiana) forming BPAmoco. The name lasted until 2000 when the company renamed to BP and adopted the tagline "Beyond Petroleum," which still remains in use today. Currently, BP is the second largest publicly traded oil and gas company and fourth largest US refiner. The company is broken down into three separate businesses: Exploration and Production, Refining and Marketing and BP Alternative Energy. BUSINESS SEGMENTS Exploration and Production: Focuses on accessing, finding and developing the largest fields in order to produce and transport oil and natural gas. This segment consists of BP s upstream and midstream activities; o o Upstream Activities: The exploration of oil and natural gas, field development and production. Exhibit 1: Exploration and Production Financials $ Million Total Revenues 89,902 69,376 71,868 Replacement Cost Profit 37,915 27,729 30,953 Total Assets 136, , ,803 Capital Expenditure and Acquisitions 22,227 14,207 13,252 Midstream Activities Responsible for the management of crude oil and natural gas pipelines, processing and export terminals and liquefied natural gas ( LNG ) processing facilities. During 2008, the segment experienced a replacement cost profit* of $38 billion, a 39% increase from The result was primarily driven by higher oil and gas realizations, supported by underlying production growth of 5% and new cost efficiencies also marked the 15 th consecutive year that reserve replacement for the year was greater than 100%. Their continued oil and gas reserve growth provides BP with a foundation for future growth in both production and recovery rates. Refining and Marketing: The role of BP s refining and marketing business is to manufacture and supply more efficient products and services to its customers. During 2008, the segment produced a replacement cost profit of $4.2 billion, an increase of nearly 62% from Despite lower refining margins and adverse foreign exchange effects, the segment was able to significantly increase its profit by restoring the overall availability of its refining $ Million Exhibit 2: Refining and Marketing Financials Total Revenues 320, ,833 71,868 Replacement Cost Profit 4,176 2,621 5,161 Total Assets 75,329 95,311 80,738 Capital Expenditure and Acquisitions 6,634 5,495 3,127 system, reducing operating costs and an ongoing simplification of the business. In total, BP saw its 17 refineries produce, on average, million barrels of oil per day ( MBD ), an increase of * Replacement cost profit reflects the current cost of supplies. The replacement cost profit for the year is determined by excluding from profit inventory holding gains and losses. 1

5 5% from Both the Whiting and Texas City refineries were restored to full operating capacity and are expected to play a crucial role in achieving BP s 2009 goal of a 2.2MBD global average. *BP Alternative Energy: BP is helping to meet the world s growing demand for sustainable and affordable energy by building an alternative energy portfolio with the potential to grow and compete far into the future. In 2008, BP prioritized a $1.4 billion investment into four areas with significant long-term growth potential: o o o o $ Million Exhibit 3: BP Alternative Energy Financials Total Revenues 5,040 3,972 71,868 Replacement Cost Profit (1223) (1209) (841) Total Assets 19,079 20,595 16,315 Capital Expenditure and Acquisitions 1, Wind: Its 274-turbine facility in Cedar Creek, Colorado can produce 432 megawatts (785 megawatts gross) while in operation; it has enough potential total energy generating capacity to supply electricity to six million average American homes. Solar: BP s strategy is to invest in lower-cost manufacturing of solar modules to enable energy from its products to compete with conventional sources of energy. They currently have solar modules installed around the world and continue to support the Solar Cities concept. Biofuels: In 2008, BP announced two strategic partnerships with industry leaders in bioethanol technology. These partnerships should considerably help BP produce biofuel sources that minimize any impact on food supplies while simultaneously developing advanced technologies to greatly improve the efficiency of biofuels. Carbon Capture and Storage ( CCS ): CCS captures the CO 2 emitted during the burning and processing of fossil fuels and transports it safely into deep geological formations such as oil and gas fields. BP is currently looking into technology that will enable low-carbon production of electricity using secure sources of coal and other fossil fuels. BRANDS BP currently operates under six brands which include: BP, Aral, ARCO, Castrol, ampm and Wild Bean Coffee. Ampm is a brand which operates convenience stores in the Western US, whereas Wild Bean Coffee offers affordable and fresh coffee and food within convenient stores. Even though ampm and Wild Bean Coffee and brands under BP, they were not described in detail because they are not associated with BP s core business. BP: BP is the main global brand which appears on production platforms, refineries, ships and corporate offices as well as on solar products, wind farms, research facilities and at retail service stations. Since BP petrol first appeared for sale in Britain in the 1920s, the BP brand has grown to be recognized for quality gasoline, transport fuels, chemicals and other petroleum-based products around the world. Aral: Aral has a significant presence in the German petrol market and has been named Germany s most trusted brand of fuel several years in a row. Aral is also the country s third largest fast food retailer, after McDonald s and Burger King. ARCO: BP acquired the brand in Its name appears on all BP-owned and franchise-operated stations in the Western USA, from the Rocky Mountains to the Pacific Ocean. Since the 1908s, Arco has been known as a source for cleaner fuels, 1 Company 20-F 2

6 or blends of gasoline which give off less pollution by keeping the car and truck engines they pass through cleaner. Castrol: BP acquired the brand in 2002 to help grow its lubricants business. Castrol is known for producing motor oils for automobiles and motorbikes, but the company makes lubricants for every conceivable application on land, sea or air. They continue to work collaboratively with VW, Audi, BMW, Komatsu and others. II. Sector Analysis 2 OVERVIEW BP is part of the energy sector; companies within this sector include integrated oil and gas companies, and pure-play companies in various areas which include: exploration and production, refining and marketing, transportation and pipeline services and oilfield services and drilling. The sector is unique in the fact that even though there are different industries within the sector, each industry is geared towards the production and refinement of crude oil. Historically, the energy sector has been cyclical in that it has experienced a number of boom and bust periods. In recent years, 1996 present, the sector has experienced stronger-than-expected demand growth due to the increased global need for energy. Prior to the upswing in energy demand, oil and gas companies emphasized return on investment ( ROI ), rather than production and reserve growth. Furthermore, oil and natural gas prices were much lower than historical averages, which placed a burden on these companies to keep supply levels up. As seen in the graphs, when the energy sector began to rebound in the late 1990s, supplies dropped below the historical average (represented by the green lineexhibit 4) and production volume increased as companies tried to replenish both their reserves and supplies. Companies then shifted their strategy to focus on reserve replenishment and production capacity, rather than ROI. Due to these changes, it is projected that the energy sector will shift to a more defensive sector in order to position itself for the anticipated higher levels of energy needed in the coming years. Inveotories Exhibit 4: Crude Oil Supply as a % of Production Exhibit 5: Crude Oil Inventories vs. Production March-94 September-94 March-95 September-95 March-96 October-96 April-97 October-97 April-98 October-98 May-99 November-99 May-00 November-00 June-01 December-01 June-02 December-02 June-03 January-04 July-04 January-05 July-05 January-06 August-06 February-07 August-07 February-08 August-08 Crude Oil Inventories International Crude Oil Production 80,000 75,000 70,000 65,000 60,000 55,000 50,000 Production MACROECONOMIC DRIVERS After performing a regression analysis, the two main macroeconomic factors that drive the S&P 500 energy sector are crude oil prices and US Gross Domestic Product ( GDP ) growth. A linear regression was performed using weekly averages of crude oil prices and quarterly GDP data from March March The regression returned an R 2 of.899, and each independent variable 2 Credit Suisse Research Report 3

7 returned a t-score above two, meaning this regression can explain 89.9% of the variance from S&P 500 energy sector returns. Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 523 Exhibit 6: Regression Analysis ANOVA df SS MS F Significance F Regression E 260 Residual Total Coefficients Standard Error t Stat P value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept E Crude Oil ($/Barrell) E US Gross Domestic Product E After careful analysis, the results of the regression were what I expected. First, the very strong correlation between crude oil prices and sector returns was expected. Production costs essentially remain unchanged when fluctuations in crude oil prices occur, whereas revenue numbers do change with price fluctuations, giving way for changes in operating profit. Furthermore, in regards to GDP and sector performance, the results were also what I expected. GDP growth in a very important factor in the energy sector because in a separate regression, it was determined that GDP growth explains 93% of the change in demand for petroleum based products. This growth can be attributed to increases in consumer spending and personal/business travel. OUTLOOK Based on economists predictions, US real GDP is expected to decline by 2.7% in 2009, which is 3.3% increase when compared to fourth quarter This increase is expected to trigger an increased demand for petroleum based products, but crude oil prices are only expected to see modest growth because recent lower global oil demand has caused an increase to the oil surplus. Given the above mention regression analysis, the energy sector is expected to follow GDP growth and see 3-4% growth in

8 III. Industry Analysis 3 OVERVIEW BP is part of the integrated oil and gas industry within the energy sector. This industry is responsible for the refinement of crude oil into different petroleum based products including: gasoline, diesel fuel, jet flue, petroleum coke, still gases, LPG, asphalt and residential fuel oil. The two most important products refined from crude oil are gasoline and diesel fuel, which account for 46% and 23% of refinery production. Exhibit 7: Products and Service Segmentation Gasoline- 46.0% Diesel Fuel- 23.0% Jet Fuel- 8.0% Other- 4.8% Petroleum Coke- 4.5% Still Gases- 4.0% Residual Fuel Oil- 3.7% LPG- 3.5% Asphalt- 2.5% Nearly 70% of the output of this industry is absorbed by road users. This is compromised of gasoline, which is consumed by individuals, and diesel fuel, which is mainly used in commercial transport; a small portion of diesel fuel consumption is attributed to individuals. In the United States, the average number of miles driven was down 10% in The current downturn in our economy has decreased consumer spending, which has impacted the output of the automotive industry. Due to these reasons, both gasoline and diesel fuel consumption have fallen 14% in the last year. The aviation industry absorbs 9% of the industry s production. The importance of this market to the industry s performance has declined in recent years due to heightened concerns over terrorist attacks on airplanes, lower ticket sales and the impact higher fuel prices have on the aviation industry. However, US refinery output to this industry remained somewhat constant in 2008, mainly because imports bared the brunt of the decline in demand. BACKGROUND The modern petroleum industry was started in 1859, as this was the year that the first person was able to drill successfully for oil. Crude oil was first refined into kerosene and used as fuel for lighting devices, but Thomas Edison s invention of the electric light but a decline on the commodity. The emergence of the automobile industry in the early 1900s created a market for gasoline, which had originally been a waste product of the industry. As the automotive and energy markets grew, so did the oil and gas industry. Today, the United States is responsible for 8% of the total world production of oil, where as in 1934 its production accounted for 60% of the world total. Furthermore, crude oil, natural gas and coal account for 88% of the world s energy needs. 3 IBIS Industry Report 5

9 CURRENT LIFE CYCLE The integrated oil and gas industry is in the mature phase of the product life cycle. The reasoning for this can be attributed to these four statements: o o o o The total number of enterprises and individual establishments has peaked due to the considerable rationalization seen in the industry since the 1980s. Total industry revenue tends to increase at a slower pace than the economy as a whole. The industry is dominated by supermajors international integrated oil and gas companies. The six largest companies produced over $1.8 trillion in revenue in The products that this industry produces are well established, and demand for them moves in respect to GDP growth. However, these companies are beginning to establish/grow their alternative energy businesses. MACROECONOMIC DRIVERS After running a simple regression between annual change in crude oil prices vs. average annual revenue growth for the six largest oil and natural gas companies, R 2 was.969, meaning annual changes in crude oil prices explain 96.9% of changes in annual revenue for the six companies. Given such a high correlation, I found it necessary to examine what factors affect the price of crude oil. When trying to predict crude oil prices, there are additional outside factors that must be considered. It is important to note that oil markets do not act entirely like other commodity markets because a market premium may be attached for various reasons. For example, a political concern in countries such as Iran and Nigeria and the reliability of their oil supply. In addition, the management of spare crude oil supplies by a cartel of nations, Organization of Petroleum Exporting Countries ( OPEC ) or National Oil Companies ( NOCs ). These organizations have less incentive to increase production than publicly traded oil and gas firms. The graph represents that falling OPEC spare capacity can lead to increases in crude oil prices. Exhibit 8: OPEC Spare Capacity may Lead to Rising Oil Prices One of the main factors that affect crude oil prices in supply and demand. Crude oil prices increased consistently from mid because oil suppliers struggled to meet the higher-thanexpected increases in global demand, particularly from emerging countries. As mentioned earlier, the main problem for this was oil and gas companies emphasizing ROI rather than production and reserve growth. 6

10 Furthermore, another factor affecting supply and demand of crude oil is the global demand due to the industrialization of Asia, the Middle East, Latin America and other emerging countries. In many industrialized countries, outsourcing is becoming a popular strategy because of rising labor and equipment costs. As a result of these corporate strategies, strong economic growth is expected in these countries and an anticipated increased demand in crude oil by.5mbd in Another country expected to play a large role in crude oil demand in 2009 is China. Their GDP is expected to grow by 9% in 2009, with an increase in demand for oil by 5% to around 9MBD. Even with expected increases in crude oil demand by a number of countries, world consumption is projected to fall by 1.2MBD. The overall global economy is expected to remain weak in 2009, with global GDP assumed to decline by.1% during the year. Even with this estimate, production from US refiners is expected to increase by.5-.75mbd; the reason for this is the before mentioned shift in corporate strategy to grow both production and reserves. When compared to 2007, global production remained the same in All these figures are shown in the graph below. Exhibit 9: World Consumption vs Non-OPEC Production (Change from Previous Year) Due to the anticipated decrease in crude oil demand, the oil supply is also going to be affected. The supply is anticipated to grow by 150 million barrels in 2009, which is a decrease when compared to 2008, which experienced supply growth of 330 million barrels; that increase was the result of longer-than-expected delays in key projects, larger-than-expected decline rates in mature production basins, and supply disruptions in the Gulf of Mexico and Central Asia. However, the overall increase in oil supply can be beneficial to oil companies. The graph below represents the 2008 cost curve and the expected 2009 cost curve. During periods of increased supply, oil companies experience additional operational cost cuts and capital expenditures ( CAPEX ) reductions. In regards to BP, they are expected to reduce operating costs by $2 billion in Companies also reduce these costs by eliminating EOR projects; projects which are unprofitable if oil is above a certain $ per barrel average for an assigned period. In addition to reducing spending in EOR projects, mature projects will have marginal CAPEX reduced, which helps reduce costs. 7

11 Exhibit 10: Global Oil Cost Curves Even though the demand for crude oil is expected to decline in 2009, there is still a growing demand in many emerging countries. Furthermore, an increase in supply is not necessary a bad thing as oil companies are able to imply another round of cost cutting and eventually operate more efficiently. After careful analysis of the effects supply and demand have on crude oil prices, my analysis estimates crude oil prices to average $60 per barrel in RECENT PERFORMANCE In order to analyze the integrated oil and gas industry, I first made the assumption that the six largest companies in the industry, which are known as the supermajors would best represent the industry as a whole. Exhibit 11: Industry Profitability Analysis Price Equity Enterprise Total Debt/ Total Debt/ LTM 3-yr. Revenue Company Ticker 03/06/09 Value Value [1] Total Debt EBITDA Capital Revenue CAGR BP plc LSE:BP. $35.01 $109,325.6 $135,138.6 $33, x 23.3% $361, % Chevron Corp. NYSE:CVX , , , x 7.1% 255, % ConocoPhillips NYSE:COP , , , x 34.4% 225, % Exxon Mobil Corp. NYSE:XOM , , , x 2.9% 466, % Royal Dutch Shell plc LSE:RDSA , , , x 15.3% 458, % Total SA ENXTPA:FP , , , x 23.0% 202, % Mean 0.5x 17.6% 12.5% Median 0.5x 19.1% 11.9% LTM Gross LTM LTM EBITDA LTM LTM EBIT EPS LT EPS Company Margin EBITDA Margin EBIT Margin LTM 2009E 2010E CAGR [2] BP plc 16.2% $46, % $35, % $8.17 $5.74 $ % Chevron Corp. 28.5% 49, % 40, % % ConocoPhillips 26.8% 40, % 31, % (11.16) % Exxon Mobil Corp. 38.4% 96, % 84, % % Royal Dutch Shell plc 13.7% 64, % 51, % % Total SA 30.8% 39, % 32, % (0.1%) Mean 25.7% 17.5% 14.1% 5.7% Median 27.6% 18.7% 14.9% 6.4% 2008 was a very profitable year for the integrated oil and gas industry. Revenue growth for the industry was 28.6% in 2008, compared to a 3-year revenue compound annual growth rate ( CAGR ) of 12.5%. Crude oil prices have increased since 2004, with a major increase coming in the middle of 2008 when it reached $ on July 11, In regards to earnings before interest expense, taxes, depreciation and amortization ( EBITDA ), the average margin in 2008 was 17.5%, which is consistent when compared to recent years. In regards to earnings before interest expense and taxes ( EBIT ) margin, it was 14.1% for the year which is also in line with previous year s margins. Consistency in margins is a typical characteristic 8

12 of a mature industry. Both EBITDA and EBIT growth rates for the year were significant when compared to previous years, 29.4% and 52.2% respectably. The growth in 2008 is a direct result of revenue increases seen in the same period. Every company in the group reported very strong earnings per share ( EPS ) numbers; with the acceptation of ConocoPhillips- they had a $35billion write-down in the fourth quarter Much like EBITDA and EBIT growth, EPS growth is directly attributed to increases in crude oil prices. The average last twelve months ( LTM ) EPS CAGR average for the industry was 5.5%. COMPETITION Integrated oil and gas companies compete on the premise of who can operate in the most efficient manner. Given 70% of refinement is gasoline, operating efficiency is the most important factor to success in this industry because price per gallon of gasoline is a much larger determinate of where a consumer purchases gasoline, rather than the brand of gasoline. Companies distinguish themselves by distributing dividends, reserve replenishment and production capacity. Intensity of Rivalry: HIGH o Heightened government control has restricted access to new upstream resources. o Oil and gas and facing growing competition from other fuel sources. o Increasing difficulties in extracting the remainder of the world s oil will lead companies. to strive for greater efficiencies- hence increasing rivalry. o Increasing security of supply and transport costs has pushed companies to build plants closer to major demand centers. Threat of Entry: LOW o High start-up costs. o Economies of scale. o Multiple permits and licenses needed for exploration of oil. o Large amount of vertical integration to support downstream businesses. o Oil exploration requires large amounts of cast reinvested in the business each year. Supplier Bargaining Power: MODERATE o Foreign governments require permits and licenses in order to conduct drilling/extraction. o Facilities need specialized parts and equipment to ensure proper functioning. o Vertical integration has reduced the reliance of input suppliers. Buyer Bargaining Power: LOW o Commodity traders effect oil prices, shifting price power away from buyers. o Demand by foreign countries is expected to increase. o Oil is one of the main commodities that drives the US/Global economy. Substitutes: LOW MODERATE o Although there is movement towards alternative energies, there hasn t been a sustainable. Energy source which could be a true substitute oil. o Oil is one of the main commodities that drives the US/Global economy. 9

13 VALUATION 4 The first valuation metric I used was multiples compared to enterprise value. The industry has had very constant multiples for each category as seen in the chart below. When compared to past values however, there was a difference. In regards to Enterprise Value to LTM Revenue, the average for 2008 was.45x, vs. the 2007 average of.88x. This does not mean the industry is undervalued though; revenues for the industry increased on average 40% in 2008, which would significantly alter the multiple value. The same is seen in Enterprise Value to LTM EBITDA and Enterprise Value to LTM EBIT as the 2008 averages are much lower than the 2007 averages. What is important here is that the market has adjusted and the multiples are now constant for the industry. Absolute Valuation Exhibit 12: Industry Multiple Valuation Enterprise Value to LTM Company Revenue EBITDA EBIT BP plc 0.37x 2.9x 3.8x Chevron Corp. 0.46x 2.3x 2.9x ConocoPhillips 0.36x 2.0x 2.6x Exxon Mobil Corp. 0.64x 3.1x 3.5x Royal Dutch Shell plc 0.30x 2.1x 2.7x Total SA 0.58x 2.9x 3.6x Mean 0.45x 2.56x 3.19x Median 0.42x 2.61x 3.22x The second valuation metric I used was another absolute and comparative multiples analysis. The chart below uses 10-year averages to calculate the multiples. In absolute terms, the industry is currently undervalued; the currently multiples are, on average, 29.78% lower than the 10-year averages. Exhibit 13: 10-Year Absolute Multiples Valuation of Industry High Low Mean Current Percent From Mean Valuation Opinion P/Forward E % Fair Value P/S % Undervalued P/B % Undervalued P/EBITDA % Undervalued P/CF % Undervalued P/E/G ratio % Fair Value ROE % Fair Value Furthermore, when the industry is compared to the sector as seen in the chart below, the industry is currently valued appropriately. The absolute valuation is returning the sector as undervalued because of recent years having very high multiples, which may be skewing the averages. As seen in both valuation techniques, the market is still adjusting after 2008 being such a highly profitable year, and the industry is moving towards its fair value. 4 StockVal 10

14 In comparing the industry vs. the S&P 500, the industry is currently fairvalued, which suppors my thought that the market is adjusting and valuing the industry correctly. Industry vs. Sector Valuation Exhibit 14: 10-Year Multiples Valuation of Industry vs. Sector High Low Mean Current Percent From Mean Valuation Opinion P/Forward E % Fair Value P/S % Undervalued P/B % Fair Value P/EBITDA % Fair Value P/CF % Fair Value P/E/G ratio % Fair Value ROE % Undervalued Industry vs. S&P500 Valuation Exhibit 15: 10-Year Multiples Valuation of Industry vs. S&P 500 High Low Mean Current Percent From Mean Valuation Opinion P/Forward E % Overvalued P/S % Fair Value P/B % Fair Value P/EBITDA % Fair Value P/CF % Fair Value P/E/G ratio % Fair Value ROE % Fair Value OUTLOOK The financial performance of this industry will continue to rely on the price of crude oil and the demand for petroleum based products. Revenues are forecasted to drop by 40% in 2009, but EPS estimates for 2009 are 30% lower than Overall global demand is forecasted to decline in 2009 with production figures seeing slight increases. The outlook for 2009 isn t all bad though; companies will continue to cut costs and operate more efficiently going forward. Also, reserve growth is expected to grow as companies begin to position themselves for an upswing in demand. Oil is expected to average $60 per barrel, there is however the potential for political events or natural disasters to give rise to sharp and substantial, if short-term, movements in oil. 11

15 IV. Company Analysis 5 STRATEGY BP s corporate growth strategy and priority for the future is to focus on expanding its portfolio by adding new acreage, pursuing aggressive exploration programs, investing in organic growth, and making selective acquisitions. Specifically, the company seeks to grow its upstream business by leveraging its geographical diversity and investing in areas of resource opportunity. BP will also focus on technology and innovation as a means to discover new income streams including oil sands production, gas to liquids conversion, and alternative energy sources. BP pursues a cost-leadership business strategy. Due to the inherent nature of the energy business, BP looks to increase margins by optimizing its cost structure and minimizing waste. In short, BP s homogenous products necessitate a cost-leadership strategy. Indeed, consumers don t choose BP due to any differentiation in the product. One of the primary ways BP is able to pursue a costleadership strategy is by being vertically integrated, which allows for considerable economies of scale. COMPETITIVE ADVANTAGE BP currently has a competitive advantage in its upstream activities because of a recent restructuring of the business segment. 18-months ago, BP noticed potential to improve their already very efficient exploration and production business. The restructuring of the business proved to be very affective as they were the only supermajor to meet their 2008 guidance estimates for production growth. BP was also able to hold production costs the same as 2007, even with the 5% increase in production. Furthermore, the industry average for the profit per refined barrel of oil is $3.50-$4.00; BP s 2008 average was $7.00. Also, BP is expected to see operating costs fall by $2 billion in 2009 due to the recent restructuring. Given how even more efficient the business segment now operates, BP sees continued production growth through 2013, and could continue that growth through 2020 if necessary. In my opinion, BP is the most well-position integrated oil and gas company in the industry and has the most potential for above average returns in the next two years As mentioned above, BP s strategy has always been one of continued innovation and growth. This has lead to another competitive advantage in their production of acetic acid known as CATIVA. Acetic acid is an important commodity that is used as a feedstock for a range of chemicals including paints, adhesives and coatings. BP originally used technology licensed to them by Monsanto; in 1986 they acquired the rights to Monsanto's methanol carbonylation technology which allowed them to further develop and eventually create the CATIVA process. Compared with the basic carbonylation process, CATIVA delivers a 50% savings in conversion costs and reduces the capital cost of building a new 500,000 tonnes per annum (tpa) plant by 30%. In addition, BP's process is also very energy efficient, emitting virtually zero pollutants into the atmosphere. The acquisition was completed over 20 years and BP continues to dominate the market, holding a 25% market share. Given BP s before-mentioned strategy, they only continue to improve upon an already successful process and will continue to be the industry leader. To conclude, BP s last competitive advantage is in their Alternative Energy business. In the beginning of 2008, CEO Tony Hayward pledged to invest in a focused and disciplined way in areas where we believe we can create the greatest competitive advantage. Given this strategy, BP had an

16 extremely successful year in the progression of this business segment. They saw solar sales increase by 40%, as well as optimizing manufacturing costs. Furthermore, they now have the third largest wind farm in the country, and also entered into a joint venture with Tropical BioEnergia S.A. which created the single largest investment into biofuel technology. After reading about other companies in the industry and their approach to alternative energy, I feel that BP currently has the most wellpositioned portfolio of investments, and its portfolio has the largest potential for growth in 2009 and beyond. FINANCIAL ANALYSIS Return on Equity: (Net Income/Shareholder s Equity): Measures the amount of net income returned as a percentage of shareholder s equity. Shareholders are particularly interested in this as it is revealing how much profit a company is generating with the money that they have invested. BP s ROE of 23.5% is currently best in the industry. Even with BP additional debt in recent years, the company has been able to keep ROE constant because of additional operating efficiencies. Return on Assets: (Net Income/Total Assets): Measures how profitable a company is relative to its total assets. This is an important metric because it allows shareholders to see how efficient the company is at using its assets to generate revenues. The continued increase can be attributed to BP s focus on improving capacity and production of its fixed assets. Profit Margin: (EBIT/Sales): Measures how much out of every dollar of sales a company keeps in earnings. A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors. Continued improvement in this metric is not surprising as BP just finished restructuring its upstream actives to be more profitable and is currently in the process of doing the same to its downstream activities. Asset Turnover: (Sales/Assets): Measures the amount of sales generated for every dollar's worth of assets. It is calculated by dividing sales in dollars by assets in dollars. The ratio is used to gauge a firm's efficiency at using its assets in generating sales or revenue. The metric has seen slight improvement in recent years which is because of management s goal of increasing overall production from existing assets. Leverage Multiplier: (Total Assets/Total Stockholders Equity) Measures how a company uses debt to finance its assets. BP s leverage multiplier is above the industry median, but only by a slight margin. As seen in the interest coverage exhibit, BP is generating significantly more in EBIT than it is paying in interest. The decrease in the interest coverage multiple over the past few years is due to BP s growth strategy and additional debt to finance acquisitions/joint ventures. Margin Analysis: As seen in the table below, BP has seen improvement in each metric in recent years. This is attributed to BP s continual improvement in operating efficiencies. The most significant change was seen in the SG&A margin, as it decreased over 47% since In sum, BP s capital structure is very sound and has performed extremely well with the recent changes in crude oil prices. If necessary, the company is in a position to take-on additional debt to aid in its growth strategy and can remain profitable. 6 Company 20-F 13

17 Exhibit 16: Margin Analysis Income Statement Gross Margin % 23.03% 23.29% 21.75% 19.48% 18.87% 18.29% SG&A Margin % 7.64% 6.65% 5.67% 5.26% 5.18% 4.02% EBITDA Margin % 15.06% 16.15% 15.35% 12.64% 13.15% 13.84% EBIT Margin % 10.17% 11.87% 12.14% 10.40% 9.71% 11.08% Earnings from Cont. Ops Margin % 7.58% 9.20% 9.11% 8.40% 7.33% 7.61% Net Income Margin % 7.54% 8.88% 9.19% 8.39% 7.33% 7.61% Exhibit 17: Dupont Analysis BP Industry Median BP BP BP BP-2004 BP ROE 23.5% 20.4% 23.38% 27.20% 27.9% 24.2% 18.1% ROA 9.3% 9.0% 7.61% 8.14% 9.1% 7.7% 6.3% Profit Margin 11.1% 3.4% 9.70% 10.40% 12.1% 11.9% 10.2% Asset Turnover 1.30x 1.90x 1.30x 1.30x 1.20x 1.00x 1.00x Leverage Multiplier 2.52x 2.02x 2.49x 2.55x Exhibit 18: Interest Coverage Multiples EBIT $35,239 $32,352 $35,158 $32,682 $25,746 Interest Expense $1,547 $1,393 $986 $874 $768 Interest Coverage 22.78x 23.22x 35.66x 37.39x 33.52x EQUITY VALUATION: MULTIPLES The first technique I used to value BP was historical multiples. Much like the industry, when compared to its self, BP is currently undervalued. The target multiples I selected were 90% of the 10-year means because I feel the industry will not revert back to 100% of its historical averages during This valuation yielded a share price of $56.99, which is approximately 49% higher than BP s current share price. This upside was expected given the previous valuation of the industry. Absolute Valuation Exhibit 19: 10-Year Multiples Valuation of BP High Low Mean Current #Your Target Multiple *Your Target E, S, B, etc/share Your Target Price (F x G) P/Forward E $38.36 P/S $92.97 P/B $63.74 P/EBITDA $78.56 P/CF $63.62 P/E/G ratio $30.69 ROE $

18 In comparing BP to both the energy sector and S&P 500 is where the valuation differences appear. BP is currently undervalued in the majority of the metrics. As mentioned previously, the industry and sector multiples vs. the S&P 500 yielded a result of the industry being valued correctly when compared to the sector. Stock vs. Sector Valuation Exhibit#: 20: Exhibit#: 10-Year Multiples BP vs. Sector Valuation Multiples of of BP Valuation vs. Energy Sector High Low Mean Current Percent From Mean Valuation Opinion P/Forward E % Undervalued P/S % Undervalued P/B % Fair Value P/EBITDA % Undervalued P/CF % Fair Value P/E/G ratio % Fair Value ROE % Undervalued Stock vs. S&P500 Valuation Exhibit 21: 10-Year Multiples Valuation of BP vs. S&P 500 High Low Mean Current Percent From Mean Valuation Opinion P/Forward E % Fair Value P/S % Undervalued P/B % Fair Value P/EBITDA % Undervalued P/CF % Fair Value P/E/G ratio % Overvalued ROE % Fair Value After analysis of this valuation technique, I determined that BP is undervalued. Both the industry and sector it operates in were determined to be valued appropriately, but that doesn t mean that every stock in the industry and sector are correctly. This valuation gives upside to BP in that its intrinsic value is higher than its current share price. EQUITY VALUATION: DISCOUNTED CASH FLOW V1 In order to find the most accurate intrinsic value of BP, I built two different DCF models. The first model is driven off historical growth rates and margins. In DCF V1, revenue is calculated by forecasting its growth rate for 8 years. Given how correlated revenues are to crude oil prices, it was difficult to predict the revenue growth rate. Due to crude oil prices dropping significantly in fourth quarter 2008, BP revenue numbers are forecasted to drop between 20-25% in Going forward, I laddered revenue growth because oil is expected to gradually increase in the coming years. In 2018E revenue growth is 3.92%; that is the 10 year average enterprise growth rate for the supermajors. The following assumptions are for DCF v1: 15

19 o Cash and Equiv: Calculated as a percentage of sales based on 3-year historical averages and held consistent throughout forecasted years. o Trade and Other Receivables: Calculated based on same set of same assumptions as Cash and Equiv. o Inventories: Calculated based on same set of same assumptions as Cash and Equiv. o Trade and Other Payables: Calculated as a percentage of sales with the % growing each year because of historical trends. o Operating Expenses: Calculated based on same set of same assumptions as Cash and Equiv. o Depreciation: Calculated as a percentage of sales for 2009 based on 3-year historical average, but grew the % in each forecasted year in order to have it trend towards CAPEX. o Operating Margin: Calculated based on assumptions made above. o Tax Rate: Assumed 33% tax rate. o Interest Expense and Income: Calculated based on same set of same assumptions as Cash and Equiv. o Minority Interest: Calculated based on same set of same assumptions as Cash and Equiv. o CAPEX: Calculated based on same set of same assumptions as Cash and Equiv. o Terminal Discount Rate: 11.0%- Discount Rate used in Credit Suisse Research Reports. o Terminal FCF Growth: 3.92%- Average 10-year growth rate of Enterprise Value for supermajors. o Shares Outstanding: Taken from fourth quarter 2008 earnings press release (in ADS terms) 1 ADS share = 6 common shares. o Cash: Taken from fourth quarter 2008 earnings press release. o Debt: Taken from fourth quarter 2008 earnings press release. o Share Price: $ Close price on February 27, After running the model, it returned a target share price of $57.30, an upside of 49.36% compared to the current share prices. I also ran a Exhibit 22: Share Price Sensitivity Analysis- DCF V1 sensitivity analysis using different Share Price Sensitivity Analysis terminal discount and FCF growth rates. My model returned an implied range of values (inside square in exhibit) of $ $78.12, all of which are at least 25% higher than the current price. The DCF value was also very close to the multiples target price of $56.99 Terminal FCF Growth Terminal Discount Rate % 9.5% 11.0% 12.5% 14.0% 2.4% $76.76 $61.78 $52.60 $46.55 $ % $84.59 $65.94 $55.05 $48.10 $ % $95.29 $71.21 $57.30 $49.93 $ % $ $78.12 $61.70 $52.10 $ % $ $87.58 $66.37 $54.74 $47.59 EQUITY VALUATION: DISCOUNTED CASH FLOW V2 Given the amount of uncertainty there is with crude oil prices for 2009, I wanted to build another DCF model which was drive off different metrics than my original DCF. The model runs by first inputting 2008 actual EBITDA. When looking at historical financial statements, average EBITDA growth for BP for the last 10 years is 9.8%. To keep the model on the conservative side, I laddered the growth rate to return to the 10-year average in 2013E. The next metric calculated is Enterprise Value, by inputting EV/EBITDA forecasted multiples. The industry has historically traded between x and like EBITDA growth, I laddered the multiple to return to the historical average in 2013E. The next value calculated in the model is revenue, by entering the forecasted EV/Revenue multiple. Again, the forecasted values were laddered based on 10-year historical averages. The net 16

20 income margin compared to EBIT was very consistent in historical years and was kept the same for the forecasted period. Free cash flow is calculated the same as DCF v1. The following assumptions are the same as DCF V1: Cash and Equiv, Trade and Other Receivables, Inventories, Trade and Other Payables, Depreciation, Interest Expense and Income, Minority Interest, CAPEX, Terminal FCF Growth, Shares Outstanding, Cash, Debt, Share Price. The terminal discount rate used in this model is 13.0%- a 2% premium was attached because with a 5-year forecasted time horizon more emphasis is placed on the terminal value. After running the model, it returned a target share price of $50.81, an upside of 32.46% compared to the current share prices. I also ran a sensitivity analysis using different terminal discount and FCF growth rates. My model returned an implied range of values (inside square in exhibit) of $ $ Terminal FCF Growth Exhibit 23: Share Price Sensitivity Analysis- DCF V2 Share Price Sensitivity Analysis Terminal Discount Rate % 11.5% 13.0% 14.5% 16.0% 2.4% $64.45 $53.98 $46.96 $42.04 $ % $69.00 $56.74 $48.74 $43.24 $ % $74.69 $60.05 $50.81 $44.61 $ % $81.97 $64.08 $53.26 $46.20 $ % $91.63 $69.11 $56.19 $48.04 $42.56 TARGET SHARE PRICE CALCULATION In order to derive my target share price, I took a weight average of the following: o DCF V1-20% o DCF V2-20% o Price/Forward EPS- 20% o ROE- 20% o Price/EBITDA- 20% After considering all the analysis in this report, my target share price for BP is $51.21, which is a 33.5% upside compared to the current stock price. 17

21 V. Summary STRENGTHS AND OPPORTUNITIES BP has several strengths in the current market. Their corporate strategy has given them competitive advantages that will allow BP to be profitable even during poor economic times. Furthermore, BP s Alternative Energy portfolio is one of the best in the industry and may receive a significant amount of funding from the government as President Obama is pushing very hard for our country to focus on alternative energy sources. In terms of valuation, all my techniques returned the same result, BP is currently undervalued. Finally, management has announced that they plan to increase the dividend yield beginning in 2009 as a push to return more money to shareholders through dividends, rather than share repurchases. WEAKNESSES AND THREATS BP is also faced with many threats in the current market. There is the possibility that the economy continues to decline and crude oil prices drop to $20 per barrel. There is also the current issue of OPEC and there production cuts. They agreed to cut production by 4.2MBD by the beginning of this year, but as of January 1, 2009, only 60% of the cuts had been enforced. If OPEC does not follow through with the production cut, which could even further alter the supply and demand curve. CONCLUSION In conclusion, BP is a mature company with a strong balance sheet and very sound corporate strategy. Based on my analysis, I am recommending BP as an immediate buy and assigning a oneyear target share price of $51.21 Exhibit 24: BP Gas Station 18