Chevron: Hold This “Dividend Aristocrat”

chevron-cvxChevron (NYSE: CVX), one of the largest integrated oil and gas companies in the world, has earned the title of a “Dividend Aristocrat” by increasing its dividends for 28 straight years. But as the stock price is vulnerable in the near future, I’m rating it a “hold” instead of a “buy”. First, let’s look at why I think current investors should continue to hold the stock.

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At Chevron’s presentation to analysts in March, senior management announced its commitment to continue to increase dividends. At the stock’s latest closing price of $128.47, the current dividend of  $4.28 translates to a yield of 3.33%, better than fellow Dow oil giant ExxonMobil’s (NYSE: XOM) 2.71%, although not as rich as that of some of its rivals, like France’s Total (NYSE: TOT) at 4.86% or Royal Dutch Shell’s 4.59% (NYSE: RDS-A).

CVX has a long-term dividend growth rate of more than 10 percent a year, a number it outdid last year with a hike 11 percent to $4.00 (this year’s was just 7 percent, however). The company accomplished that by increasing its payout ratio to 42 percent, slightly above its long-term median ratio of 35 percent.  In view of the fact that management has been willing to stretch to as high a ratio of 180 percent, it’s not unreasonable to expect the company to rely on a higher ratio than its current one in order continue to reward investors.

The question is, could it afford to?  The answer appears to be yes.  Despite negative free cash flow of some $5 billion last year, the company has $16 billion in cash on hand, alone enough to pay dividends for two years.  In addition, operating cash flow is expected to increase by $7 billion a year to $50 billion by 2017, due an increase in production, the result of its $130 billion in capital investments over the last five years. That, and a flattening of capital investments, is projected to turn CVX free cash flow positive by 2015 and for the company to achieve free cash flow of as much as $14 billion by 2017.

So why aren’t I more bullish on CVX? It’s a matter of valuations that generate some uncertainty for the stock price, and the right price to start a position. To me, the shares are a bit overvalued and subject to a possible decline beyond the recent 3.3 precent fall off the all-time of $132.98 it hit on July 6.

Two key valuation metrics indicate the current price is vulnerable. First, there’s Chevron’s PE of 12.5, which is higher than its median of 9.3 over the last 13 years. Then there’s the PEG, which compares a company’s estimated PE and earnings for next year (in this case, 2015), to its estimated earnings growth rate over the next five years.

For stocks like CVX, I add the dividend yield to the growth rate estimate; the purpose is to compare all stocks to each other on the basis of what investors are paying for future growth plus dividends.  For my money, I look for a dividend-adjusted PEG of below 1.2 for a buy, and between 1.2 and 1.3 for a hold.  Chevron’s adjusted PEG is 1.33, which – ignoring the company’s other positive factors – is just across the line into sell recommendation territory.

The Wall Street consensus for Chevron’s future earnings growth rate per year for the next five years is 5.25 percent. To translate that into a PEG of 1.2, the price has to fall to just under $116, and a more modest trailing 12-month PE of 10.5. Could the stock price retreat to that level in the near future? It’s possible, since that’s where it was in mid-April, and the fact that the stock plunged 16 points in one month, from January to February, to its low of the year at $107 and change.

That being said, the stock appears to have entered at least a short-term downtrend triggered by a combination of a decline in the price of crude oil from its April relative high of $110 a barrel to just under $102, and  management’s advisory on July 10 that it expected second-quarter production to decline.  Technical support for the stock is strong at around $125.

Another factor that could change the PE is an increase in Wall Street’s projections for Chevron’s earnings growth rate. At the current price, an increase in the current estimate from 5.25 percent to 6.77 percent would also lower the PEG to 1.2, and raising my recommendation to a buy.

The picture could change – for the good or bad – when Chevron announces its second-quarter earnings on August 1. At least till then, I have sufficient confidence in management and CVX’s dividend to be comfortable with a long-term hold.

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