BP, Shell Closing Valuation Gap With Exxon

Since its inception in late 1999 Exxon Mobil has always garnered the highest valuation in equity markets of the three supermajors, topping European rivals BP and Royal Dutch/Shell based largely on its superiority in asset management and delivering top financial returns. But is Exxon's reign as the most expensive supermajor about to come to an end? Analysts at UBS Warburg believe it is. Based to recent market valuations, Exxon is trading at a 7.3% premium to BP, a 12.3% premium to Royal Dutch Petroleum, and a 17.3% premium to Shell Transport and Trading. "Our analysis suggests that this wide differential is unjustified. The financial momentum and long-term investment opportunities we see for these companies are very similar. With so little other than short-term perception between them, there is a case for applying the same multiple to all of them," a recent report from UBS states. Although BP leads the group in terms of "operational momentum," UBS believes that both BP and Shell should narrow the valuation gap over the next five years. The bank is so convinced of Shell's ability to close the gap that it upgraded its ratings of Royal Dutch and Shell Transport and Trading to "buy" from "hold" last Wednesday. UBS' ratings on Exxon and BP remain a "hold." BP's greatest asset in closing the valuation gap with Exxon is its aggressive volume growth projections. At 5.5% per annum between 2000 and 2005, BP has the most aggressive volume growth target of the three supermajors. Unfortunately, the company also has a spotty record of delivering on its growth targets. However, UBS forecasts that BP will miss its target by a narrow margin, delivering 5.2% annual growth during this period. This would still leave BP ahead of the other two in terms of growth. UBS sees Shell and Exxon delivering annual upstream growth of 2.8% and 3.1%, respectively. "BP's greater volume growth appears to be largely [capital expenditure] related," UBS states. Indeed, BP was the quickest to increase its capital budget in the aftermath of the oil price collapse in 1998, while both Shell and Exxon remained cautious, only upping spending in 2001. While output is expected to be flat for Shell this year, volume growth should resume at a hearty pace of 4%-5% in 2003-2004. However, another key driver to restoring operational and financial momentum will be a recovery in Shell's downstream operations, which have lagged behind Exxon and BP in recent years, particularly in the US. A rash of downstream deals aimed at both growth and cost reduction at Shell over the past year, including the US acquisitions of Pennzoil and Texaco's stakes in the Equilon and Motiva joint ventures, as well as the purchase of Germany's DEA, promise to reinvigorate Shell's downstream performance. Combined with its active share repurchase program -- which only began last year -- UBS believes Shell could deliver compound earnings-per-share growth in line with the other two supermajors. As for Exxon, the US company remains a paradigm for key financial benchmarks. It offers the fastest earnings-per-share growth between 2002 and 2006 at nearly 6%, and it boasts the highest return on average capital employed in the sector -- estimated at 19.3% in 2003. However, UBS says Exxon's current valuation implies a "structurally higher growth rate" over the long term despite its lower rate of cash flow generation for the period. "Given the similarity of long-term investment options between the three companies, we believe that is an unlikely outcome," UBS states. Other factors contribute to the Exxon premium as well. More than half of its shares outstanding are held by private individuals, making the US market structurally short of the stock. In addition, US investors looking for a blue-chip oil stock immediately turn to Exxon, whereas in Europe there is more competition with BP, Shell, and Total Fina Elf. Paul Merolli