Summary
Warren Buffett’s recent decision to significantly increase his interest in Occidental Petroleum has drawn a lot of attention to the company’s shares.
He plainly sees value in their shares and wants to acquire more, regardless of how much he exercises this right.
This is not unexpected given the enormous free cash flow they consistently produce, both under existing booming operational conditions and, more significantly, during 2021.
As they continue to reduce their debt, it supports stronger shareholder returns, enabling them to maximize the value of their enormous free cash flow.
I think that upgrading to a strong buy rating is now warranted in light of their extremely high double-digit free cash flow yield and sound fundamental improvements.
Introduction
Early in the year, it appeared that 2022 offered pretty much everything you could desire from Occidental Petroleum (NYSE:OXY), as my previous piece revealed. This was after the oil and gas industry recovered in 2021. The recent announcement that Warren Buffett was granted permission to grow his already sizable shareholding to as high as 50%, which naturally sparked great attention, cannot be compared to their extremely low dividend yield of only 0.75%. Following this intriguing event, it seems appropriate to offer a follow-up study that covers their recently disclosed data for the second quarter of 2022 and explains why Buffett will not purchase my shares at such a low price, in addition to covering other pertinent topics.
A brief summary and ratings
The table below offers a very succinct executive summary and scores for the major criteria that were evaluated because it is anticipated that many readers are time-constrained. A list of all of my equivalent ratings may be found in this Google Document, along with more details about my rating scheme. For readers who want to learn more about their circumstances, the next section offers a thorough study.
Detailed Evaluation
As oil and gas prices rebounded from the dramatic decline of 2020, they saw their best operating cash flow in recent memory in 2021. This trend continued into 2022, with a first-half result of $8.568 billion. In addition to being almost twice as much as their prior performance during the first half of 2021 ($4.224 billion), it is also quite near to their $10.434 billion full-year results for the same year. According to the management commentary presented below, their small capital investment allowed them to convert $6.878 billion of this into free cash flow, enabling them to meet their net debt objective and start the next stage of their capital allocation strategy.
In the second quarter, we started our $3 billion share repurchase program after achieving our short-term debt reduction goal.
“By the end of this year, we anticipate repurchasing $3 billion worth of shares and bringing down our gross debt to the high teens, taking into account current commodity pricing predictions. We expect to continue distributing capital to shareholders in 2023 through a common dividend that is sustainable at $40 WTI as well as through an active share repurchase program once we have finished the $3 billion share repurchase program and lowered our debt to the high teens.”
Conference Call for Occidental Petroleum’s Q2 of 2022.
They were able to end their deleveraging-focused phase after reaching their net debt objective, as will be covered in more detail below, and start a more balanced phase that includes both additional deleveraging and larger shareholder returns through share buybacks. Although I prefer dividends to share buybacks, it’s encouraging that management plans to increase payouts in 2023 as they transition to the next stage of their capital allocation strategy, which puts an emphasis on shareholder returns rather than deleveraging.
This significant fundamental advancement reportedly piqued Warren Buffett’s interest, and he now appears determined to considerably increase his ownership. Regardless of whether he ultimately carries out this full approval and raises his stake from 20% to 50%, it is clear that he wants to add more shares to Berkshire Hathaway’s (BRK.A) (BRK.B) portfolio. Therefore, given this increased demand for Occidental Petroleum shares, the question arises: Should I sell my shares? In light of the risks associated with an impending recession and the fact that oil prices are still quite robust at the north of $90 per barrel, it may appear rational to sell at this time. Although not necessarily incorrect in terms of the facts, I believe that their shares are sufficiently inexpensive to offset this risk; hence Buffett won’t be receiving my shares (metaphorically speaking).
Their market capitalization is still only around $64b at the moment, despite the fact that their share price has already more than doubled during 2022 as a result of their stellar financial results, which brought it to its highest level since early 2019 before their poorly timed Anadarko acquisition. Given the enormous free cash flow they consistently produce, it still offers extremely attractive value for investors despite being a tremendous value in absolute terms and solidifying its position as a major American oil and gas firm.
The $6.878 billion in free cash flow they produced in the first half of 2022 when annualized, provides a staggering 20%+ free cash flow yield on their current market capitalization. It originates from these spectacular operating conditions that are almost certainly going to fade one day, driving their free cash flow lower despite readily leaving their shares looking cheap with tremendous prospects for shareholder returns in the next phase of their capital allocation strategy. Their very strong prospects for shareholder returns, even if oil and gas prices drop to substantially lower levels, are, in my opinion, what makes their shares so desirable and hence too cheap to sell.
As the world’s energy supplies are running low and there is spare capacity to enhance output, the outlook for the oil and gas industry has never been better following the Russian invasion of Ukraine, which put the energy crisis into overdrive. Future forecasts are challenging due to the industry’s intrinsic volatility, but I believe that a return to the softer operating conditions of 2021 provides a solid foundation for a pessimistic scenario. If this happens, even if these flourishing operational conditions entirely disappear, their $6.73 billion in free cash flow from 2021 would still have a very strong free cash flow return of 10% or more on current cost. In my opinion, this makes their shares too cheap to sell because it still leaves impressive room for dividends and share buybacks in 2023 and beyond, especially given that they are about to start deleveraging and unlock the potential of this enormous free cash flow.
Despite also carrying out $451m of share buybacks net of relatively small regular issuances, they were able to make great progress with their deleveraging aim during the first half of 2022 because of their strong cash flow performance. As previously said, their net debt has decreased to only $20.84 billion from its previous level of $26.853 billion at the end of 2021, essentially reaching their aim of $20 billion that they carried into 2022, as per the article I previously cited. Their total debt, or gross debt to use the management’s phrase, is currently $22.202 billion, which is over $5 billion over their revised objective of the “high-teens” they want to reach in the second half of 2022. Given their enormous near $7 billion in free cash flow during the first half and low dividend payments, this should be feasible to achieve.
Unsurprisingly, their huge net debt reduction and stellar financial achievements translated into dramatically lower leverage, with their respective net debt-to-EBITDA and net debt-to-operating cash flow down to 0.94 and 1.12 from their respective prior results of 1.95 and 2.57 at the end of 2021. Aside from the obvious distinction, this means that their net debt-to-EBITDA ratio is now below the very low territory barrier of 1.00, but their net debt-to-operating cash flow is slightly above it and should fall below it during the third quarter as their net debt continues to be reduced.
Even if operating conditions experience a severe downturn in the future, they will be able to keep their leverage under control if they cut another $5 billion from their total debt during the second half of 2022. This added security solidifies their strong fundamental advancements, which supports their capacity to increase dividends and share buybacks in 2023 and therefore maximize the value of their enormous free cash flow.
Finally, when it comes to its liquidity, its cash balance decreased during the first half of 2022 from its prior level of $2.764 billion at the end of 2021 to $1.362 billion. As a result, their current and cash ratios decreased from their prior results of 1.22 and 0.33 to 1.07 and 0.14, respectively. This adjustment, while not entirely desirable, is not abrupt, so their liquidity is still substantial and should continue in the future. Even if central banks continue to tighten monetary policy, their size as a huge firm that is producing enormous free cash flow and further deleveraging improves their access to debt markets, so their future debt maturities are unaffected.
Conclusion
Warren Buffett is set on increasing his position, which is not surprising given the company’s enormous free cash flow, regardless of whether he decides to buy the entire business. They are poised to realize the value of this enormous free cash flow as they enter the next stage of their capital allocation strategy, which I anticipate will raise their stock price. Despite my admiration for Warren Buffett, he won’t be receiving my shares if the free cash flow yield is between a very high 10% and a whopping 20%+. After conducting this analysis, I feel that raising my recommendation to a strong buy is now acceptable in light of their outstanding fundamental advancements and one of the best investors’ glaring recognition of value.
Featured Image : Megapixl © Timonschneider
Author Jowi Kwasu 
