Is BP a good buy?

I've been thinking about whether BP is a good buy or not for a while. Let's look at this company and try to come to some kind of conclusion.

Let's start with fundamental factors.

Using 2009's balance sheet and most recent quarterly data:

1. Balance Sheet - Their cash and liquid assets are about 1/2 of their liabilities and about even with debt. This means if BP were liquidated today it would not be able to meet all of it's liabilities and might not meet it's credit obligations. Their net cash figures are negative. If these values are positive you can measure the discount or premium pay for acquisition. Since these are both negative or near negative the premiums/discounts are not applicable. Their balance sheet is poor and operations must be robust to meet their obligations. We will look at that next.

2. Free Cash Flow - Using Operating Cash Flow Minus Capex gives us Free Cash Flow. Free Cash Flow for BP has been erratic over the past 3 years coming to 6 billion (.33 per share), 14 billion (.74 per share) and -6 billion (negative .31 per share). Over the past 4 quarters it has been 3 billion, 1.6 billion, 3 billion and 1.5 billion. So they have shown consistent profitability over the past 2 years. However we must compare this number to the market. Using 2009's FCF per share of $0.33 and dividing it by the market price of $31.49 gives a FCF yield of 1%. 1% is pretty much a terrible return, especially with CD's yielding 4% in some banks which are essentially risk free thanks to good old FDIC. Couple this poor FCF return with the fact that BP has had negative financing cash flow for the past 3 years and this number is even more disappointing.

3. Dividends - We can calculate the dividend yield as the Dividend per share divided by the market price. BP's quarterly dividend is 84 cents, so 0.84 * 4 / 31.49 gives 11%. This is a much better return than 1%. However, the FCF analysis begs the question is this level of return sustainable into the future? Obviously dividend policy does not follow economic results for BP as they have been paying higher dividends upwards of 4 times higher than FCF for the past 3 years.

So looking at these metrics gives us an idea of what type of investment we are buying in BP. 1) we are not getting a discount on assets and in fact are assuming liabilities 2) we are not getting a competitive FCF return, we should at least make savings account returns in any investment 3) BP’s dividend policy is suspect even though the return is satisfying

Let’s now consider BP’s oil drama. BP is considering cutting its dividend policy which would instantly erode the high return on dividends. Estimates of BP’s cost of the oil spill have been anywhere from 1-3 Billion dollars. This is not such a large number considering their cash at the moment is around 8 billion. Even if we assume the cost of the oil spill is their entire cash reserves they could manage by issuing debt to help pay for the cost but it will certainly make the firm riskier. This is a plausible scenario as I’ve read that the government might be seeking $10 billion in damages from BP under new regulations. However, this is probably unlikely.

While the oil spill is terrible to both BP and the Gulf, it hasn’t devalued BP to the point where I would consider buying it yet based on these metrics. I think the biggest concern for me with BP though is their abysmal FCF return. 1% is laughable. One should buy at a margin of safety and 1% is no margin at all. Assuming BP keeps 2009 FCF, it would have to trade at around $3 to reach a 10% yield. Alternatively it would have to increase it’s FCF by more than eightfold to reach this level. Maybe if it’s price dropped more and it’s FCF increased it would be attractive. I think that with the uncertainty involved in BP’s future operational risks as well as likely regulation and litigation it is very unlikely that its FCF will increase and will probably decrease into the near future.

I would stay away from this and wait until the price drops more.