Dividend Growth Finally Set to Arrive for Total


Entering 2014, Total's (TOT)/(FP) story centers on the ability to deliver long-promised free cash flow growth after the large capital budgets and poor free cash flow of the past few years have kept the company's dividend essentially unchanged since 2008. This recent period of large investments has set Total up to deliver meaningful cash flow growth just as annual capital expenditures begin to fall. Though we think the company's own 2017 free cash flow guidance of $15 billion before dividends is far too optimistic, we do believe Total is about to reach a meaningful inflection point where multiyear dividend growth takes off in 2014.

Annual Dividend Growth Could Average 6% Without Increasing Leverage
Capital expenditures have averaged $31 billion the past three years, very large sums for a company of Total's size: For 2011-13, capex per barrel of oil equivalent produced averaged $33, more than 25% higher than the roughly $25 that is currently the norm for large-cap oil companies. These high levels of spending have been the major reason dividends are largely unchanged since 2008. Total has repeatedly told investors that the first call on any future free cash flow growth will be to increase its dividend. Given our operating outlook for the company, we think Total can increase its dividend by 6% annually over 2014-17.

During 2011-13, operating cash flow averaged $28 billion; with capex averaging $31 billion, Total's $7 billion dividend (EUR 2.36 per share) had to be funded from divestments, given the negative free cash flow. Concerns about how long such practices could fund dividend payments is one of the key reasons Total's stock has underperformed all of the majors since the beginning of 2008 (with the exception of BP (BP), whose stock was clobbered by Macondo in 2010).

However, the peak in Total's investment cycle is finally drawing to an end, and $24 billion-$25 billion annual capex budgets in 2015-17 should be achievable without impairing the company's longer-term growth. At the same time, the company is now well positioned to enjoy meaningful cash flow growth starting in 2014. The recent heavy spending has financed a wave of new oil and gas projects, which we project will increase production to 2.6 million barrels of oil equivalent per day by 2017, roughly 300 thousand boe/d above current levels. Additional cash flow growth from the downstream is also likely, largely from the commissioning of the Jubail complex in Saudi Arabia as well as ongoing restructuring of the European portion of Total's portfolio. We project annual operating cash flow to reach $33 billion and capex to fall to $24 billion in 2017.

One additional cash flow driver must be considered when considering Total's near-term dividend growth: asset sales, a method of portfolio maintenance regularly practiced by all of the majors. We assume Total will divest itself of $3.4 billion of assets in 2014 (the last year free cash flow doesn't cover dividends) and $2 billion annually thereafter, figures we believe are reasonable.

We take our Total cash flow forecast and layer on dividend growth of 5% in 2014 and 8% annually for 2015-17. Such growth would increase the dividend per share to EUR 3.12 by 2017, or a $2.4 billion increase in annual payouts compared with 2013. From the perspective of balance sheet leverage, these increased outlays don't create any financial issues. We believe the company is about to reach a meaningful inflection point, with annual dividend growth for at least the next four years.

Our cash flow projections are well below management's guidance presented in September, when the company discussed reaching 2017 free cash flow levels $6 billion higher than our projections. Although this material variance would imply that our outlook is bearish, we sense that very few investors take management's 2017 targets seriously, given their aggressiveness. If Total falls short of its aggressive 2017 expectations, it should not be a negative for the share price as long as the results are near our more realistic predictions.

Potential 2014 Catalysts to Monitor
Today, we see a few key issues beyond cash flow and dividends that could serve as share catalysts--positive or negative--in the coming year. While this is not a comprehensive list, we think each of these is an important issue for investors to keep tabs on.

Will Total's Big Investments in Exploration Create Value?
Until recently, Total, like many of the majors, was employing a low-risk exploration strategy of "stepping out," or drilling adjacent blocks near oil discoveries already made. This strategy did have a fair amount of success and has netted Total commercially viable oilfields (for example, Pazflor and CLOV in Angola, Moho Nord in Congo, Laggan-Tormore in the United Kingdom). However, step-out exploration has its limitations, namely that the potential number of discoveries is finite and few of the so-called elephant fields are found this way.

Total is now avidly embracing riskier exploration. The company has budgeted $2.8 billion annually for exploration in the coming years (about 10% of total capex), more than a third higher than what it spent in 2010. Much of the increase is to drill more wildcats--exploration wells in unproven acreage where both the risk and rewards are higher. Total has said that its intent is to find elephant-size fields with this change in strategy; to date, the results haven't justified the increased outlays, and we are a bit concerned that Total's exploration budget is getting ahead of its knowledge of the frontier plays it's targeting.

Total has 15 high-impact wells to be drilled during 2014, and drilling results have the potential to be a material share catalyst, especially if results are very good or very bad. Of these 2014 wells, Total's presalt targets in the Kwanza Basin of Angola will be the most closely watched. It is believed that this is the mirror image of the Santos Basin offshore Brazil, where billions of barrels of oil have been discovered. Very little drilling has been done in the African presalt thus far, but it is encouraging that Cobalt's first well there, Lontra #1, was a success, although it found more natural gas and less oil than it hoped. West Africa presalt is clearly a high-cost ($150 million per well), high-risk, but also high-potential wildcat territory.

Vaca Muerta Could Be High-Return Growth Option
Long Argentina's largest natural gas producer (with the exception of the national oil company), Total found itself perfectly positioned to benefit from the opening of the Vaca Muerta shale play. Early appraisal results on the company's acreage have been so promising (thick gas pays, which in many cases make lower-cost vertical drilling a viable option) that a fifth rig was added to its drilling program in 2013. Total now hopes this play will become larger than (and have superior economics to) its Utica joint venture with Chesapeake CHK, where Total is hoping to increase production to 100 mboe/d by 2020. This implies that Vaca Muerta could be a nice source of growth if Total's management is right.

Beyond this play's promising geology and Total's large acreage position, two important factors should offer high returns for near-term development drilling. First, to encourage gas drilling, the Argentine government will pay $7.50 per thousand cubic feet on incremental production above current output levels. Second, existing gas infrastructure in the region has spare capacity readily available, so at least in the near term, large midstream investments won't be necessary to get Vaca Muerta gas to market. Increasing Vaca Muerta disclosures and more clarity on production potential should be forthcoming in 2014.

Ichthys LNG Progress Uncertain
Liquefied natural gas projects in Australia seem to generate only negative news, and the $34 billion Ichthys LNG project (in which Total has a 30% stake) is no exception, as murmurs surfaced during 2013 that it is bound to be the next Gorgon and run billions of dollars over budget. Total says that has not happened and the project remains largely on track. We're a bit skeptical that this is entirely true, although it seems possible that a Gorgon-style cost blowout can be avoided. Given Ichthys' massive budget and the fact that Total is responsible for 30% of it, keeping costs under control is critical. This project is set to start up in late 2016, so multiple updates should be provided during the coming year.

Closing Refining Capacity in France
European refining and chemicals remains a really bad business to be in, as returns on capital and margins are very weak. Given the huge cost advantage that many North American refiners enjoy via crude price differentials as well as new low-cost capacity being commissioned in Asia (like Jubail), European refiners will continue to reside at the high end of the global cost curve for the foreseeable future.

As such, a key issue to monitor is how events play out when Total attempts to close another French refinery. When the firm closed its Dunkirk refinery in 2010, it cut a deal with then-President Nicolas Sarkozy, agreeing not to close another refinery for five years. This moratorium lapses in late 2014, and our understanding is it's all but certain that Total will move to close another of its five remaining refineries as quickly as possible. Shuttering an uneconomic industrial operation in France is far from easy, however, and the unions representing Total's employees surely know this move is forthcoming. If Dunkirk is any guide, a pitched fight will ensue, as will legal challenges and government intervention. The outcome of this next confrontation will go a long way toward determining the pace at which Total can shutter additional refining capacity in France. Our sense is that another deal will be cut with the government and unions that prevents the next closure for a period of a few years. Try as it might, Total will probably have low-return refining operations in Europe for some time to come.

Progress of Jubail's Startup
This will be the first year that Jubail, a 400 mb/d refining and chemical complex in Saudi Arabia, contributes to Total's R&C results (Total owns 37.5%, Saudi Aramco holds the rest). The $14 billion facility possesses a few operational advantages: The refinery is among the most complex in the world, has access to low-cost feedstock from the Manifa heavy oil field, and has low operating costs thanks largely to natural gas prices that are set at $0.75/mcf in Saudi Arabia for industrial users. A final positive is that the corporate tax rate in Saudi Arabia is 25%. Although the information isn't available to precisely forecast Jubail's profitability, it seems reasonable from the above information that this asset could net Total $300 million-$400 million of annual profits when fully operational.

However, large new refineries often experience operating issues in their first year, as Saudi Aramco experienced firsthand in 2012 when Motiva (its joint venture with Shell (RDS.A)/(RDS.B)) commissioned an upgraded refinery in Port Arthur, Texas. Within a month, this refinery was shut down because its new crude-distillation unit experienced corrosion and large amounts of it had to be replaced. More problems have since surfaced, and an asset that Shell's investors expected to become a source of downstream cash flows has been anything but. This isn't to say that Jubail is destined for such a fate, but investors should keep tabs on how reliably the refinery operates during the next few quarters.

Total Is Our Preferred European Major
From a valuation perspective, Total's 0.97 price/fair value ratio doesn't look much cheaper than those of the other European supermajors. That said, the company is further along than Shell (P/FV 1.04) in getting its portfolio in order and doesn't have the legal issues that BP (P/FV 1.02) must grapple with. Of the group, we think Total currently offers the best combination of valuation and a key catalyst in the form of near-term dividend and cash flow growth.


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