Chevron, Procter & Gamble Still in Favor

 | Jun 04, 2013 | 10:00 AM EDT
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This is the final installment of updates on earlier recommendations. While the market is up strongly over the first five months of the year, many of the companies we've recommended are still attractive, even as they have performed at or above the market.

The three stocks we discuss today are Chevron (CVX), Procter & Gamble (PG) and Dell (DELL). We are pleased that today's group of stocks are trading higher and maintain a strong, conviction for the future. We look for additional gains in both Chevron and Procter & Gamble. In the Dell case, the stock is up sharply for the year, and we think the majority of the investment case has played out. Thus, we think it makes sense for investors here to move on.

We last wrote about Chevron (CVX) a year ago, when the stock was trading around $100. Since then, crude prices have gyrated some, but the company's operating performance has been very consistent, with earnings reports slightly better than expectations.

One key development is the growing confidence in CVX's exploration and production profile for the next five years. Important projects, such as oil in the ultra-deep waters of the Gulf of Mexico and natural gas in offshore Australia, are proceeding well. The company has reiterated its expectation for accelerating production growth beginning in 2014.

In comparison to its Big Oil competitors, CVX has superior growth in its profit and resource profile over the next few years and trades at a lower valuation even as its returns on capital are higher. With a dividend yield of 3.2% and a modest price-to-earnings ratio of just 10.0x this year's earnings estimate, we think CVX has more upside potential, and will benefit from improving economic conditions. We think the stock isn't fully valued until $140.

Procter & Gamble has frequently been in the news since we spoke about it at the end of last year and the stock is up nicely for the year. In April, the company reported its first disappointing quarter since announcing a major restructuring a year prior. Combined with the short leash CEO Bob McDonald was on from prior missteps, and the pressure from activist Bill Ackman of Pershing Square, PG's board finally said "enough." McDonald is now gone, replaced by former CEO A.G. Lafley, who successfully led a previous operating recovery at PG.

While more changes are likely, what will not change are the key strategies put in place during the restructuring. These strategies include cutting costs by at least $10 billion, increasing the pace and value of product innovation, focusing on the biggest and most important product/market combinations and increasing shareholder rewards via dividends and repurchases. While the strategy is the same, we believe there will be a greater urgency in its execution.

It will take a little time for Lafley to gain traction, and there may be some earnings slippage this year, but the company is moving in a much better direction. While PG stock is no longer cheap at 17.7x fiscal 2014 earnings, it has a healthy 3.1% dividend yield. With a great focus and urgency on driving revenue and earnings growth and enhancing shareholder value, PG should generate stock gains over the balance of the year. We peg full value for PG stock in the high $80s/low 90s. If Lafley is successful in his return to PG, we believe that value will climb over time.

The saga for control of Dell continues, in the wake of the bid by Michael Dell and Silver Lake Partners to take the company private for $13.65/share. We last wrote about the stock at this price just after the bid was announced. Money manager Southeastern Asset Management vehemently objected to the board's process and the price.

During the "go-shop" period that followed, both Blackstone and Carl Icahn expressed interest, though Blackstone subsequently dropped out. Based on Blackstone's preliminary bid, we had originally thought that a better stock and cash offer by them or Michael Dell's Group was in the offing. With their exit, the dynamic of the process changed and was less favorable.

Southeastern and Icahn have joined forces recently to contest the company's proxy filing and to offer a leveraged recapitalization alternative that theoretically generates a superior offer. While the drama was developing, fundamentals for DELL's end-user computing business have significantly weakened, and the on-going strategic shift from PCs to enterprise solutions will take time.

We are somewhat skeptical about the most recent quarter's very weak earnings and DELL's change in strategy that seems be focusing on recapturing market share and investing in the future with little regard to current earnings. Whether it understates current earnings, this is the earnings and cash flow that investors face in making their decision between the $13.65 takeover price and the Icahn/Southeastern bid.

Although we agree with the case for DELL's value being materially higher than the current bid, the reality is that an auction was held and this was the best bid that was solicited. While the opposition group may yet prevail when the shareholder vote is taken in July, the risk/reward is probably not attractive. We think that risk-adverse investors should probably move on.



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