TotalEnergies: Undervalued Vs. Peers; Upside potential (NYSE: TTE)

HJBC

Thesis

I recently posted a negative article on Exxon Mobil (XOM) as I believe the price of oil will likely drop significantly by year end. However, my sell recommendation on XOM was heavily influenced by the parent of the company valuation against European industry peers, where I believe valuations still imply significant upside even with oil price NYSE: TTE). TotalEnergies trades at a discount of around 70% to 100% to US oil majors and is valued at a one-year forward P/E of

About TotalEnergies

TotalEnergies is a European oil major, headquartered in Paris, France. Approximately 80% of the company’s assets are invested in oil exploration and production and approximately 20% in refining and marketing. From a revenue perspective, however, Refining-Chemicals accounts for almost 40% of revenue, Marketing and Services around 40%, Integrated Gas and Renewables around 10% and Exploration- Produce the rest. In 2021, as part of a major rebranding effort in regards to the company’s Net-Zero ambitions, Total SE was rebranded as TotalEnergies. Total aims to accelerate the company’s green power push and add around 10 GW of renewable energy capacity to its portfolio. At the same time, Total acquired a 20% stake in Adani Green Energy, one of the largest solar developers in the world.

In my view, TotalEnergies is well positioned to successfully transition to a low-carbon energy portfolio, while maintaining significant exposure to the oil and gas industry. My judgment is anchored on the company’s track record for investing wisely in renewable energy projects and maintaining a strong cash flow profile from the company’s E&P business, which has an estimated pre-dividend breakeven price for oil about $20/barrel. Notably, CEO Patrick Pouyanne has not spoken about green energy transition as aggressively as, say, Bernard Looney of BP (BP). This indicates to me that TotalEnergies has not moved to an ideological capital allocation framework, but is still concerned with return on investment and creating shareholder value.

TotalEnergies activity

Presentation to investors of TotalEnergies

Extremely bullish performance

TTE stock has strongly outperformed the market over the past 12 months as the rapid appreciation in oil prices has supported the company’s operations. For information, TTE is up around 10% against -7% for the CAC index. Energy price inflation pushed Total’s revenue for the past 12 months to $294 billion (up 59% from the prior period) and profits to $33.5 billion (up up approximately 50%, respectively), based on a margin of 11.4%. With oil prices still high, profitability should remain strong. In fact, analysts expect Total to deliver record numbers in Q2 2022, which should be supported by record refining volumes and margins. That said, the thesis of investing in oil and gas companies is deeply rooted in the price of oil.

Evolution of the TotalEnergies share price

Looking for Alpha

Attractive despite falling oil

This week, Edward Morse, the global head of commodity strategy at Citi with half a century of experience, shared the view that oil (benchmark WTI) could fall to $60 a barrel, if the economy world was to sink into a recession. Although I see the price of oil falling to around $60/barrel by the end of the year, driven by the prospect of a recession, the rising cost of capital and falling asset prices, I am always positive on Total. My favorable outlook for Total is driven by relative undervaluation against its US peers and absolute undervaluation based on multiples and EPS estimates. For reference, TTE is trading at a one-year forward P/E of x3.6, an EV/Revenue of x0.5 and a P/B of around x1. XOM is trading at a one-year forward P/E of around x7, an EV/Income of x0.95 and a P/B of around x2. This is about a 100% bonus! Notably, both companies share equally in windfall earnings/contractions due to oil price volatility.

Valuation of residual profits

Now let’s look at the valuation. What might be the fair value per share of the company’s shares? To answer the question, I built a residual income framework and anchor on the following assumptions:

  • To forecast EPS, I rely on analyst consensus forecasts available on the Bloomberg Terminal through 2025. In my view, any estimate beyond 2025 is too speculative to be included in a valuation framework. But for 2-3 years, analyst consensus is usually pretty accurate. That said, EPS are estimated at $11.18, $10.11 and $8.30 for 2022, 2023 and 2024 respectively.
  • To estimate the cost of capital, I use the WACC framework. I model a three-year regression against the CAC 40 to find the stock’s beta. For the risk-free rate, I used the yield on 10-year U.S. Treasuries as of July 15, 2022. My calculation indicates a fair required return of 9%.
  • To calculate TTE’s tax rate, I extrapolate the 3-year average effective tax rate from 2019, 2020, and 2021.
  • For the terminal growth rate, I apply 0 percentage points to reflect the balance of a secular decline for oil and gas activities and the transition to green energy.

Based on the assumptions above, my calculation returns a benchmark target price for TTE of $71.52/share, implying a significant upside of around 55%.

TTE Valuation Residual result

Consensus of analysts; Author’s calculations

I understand that investors may have different assumptions regarding required TTE return and terminal business growth. Thus, I am also attaching a sensitivity table to test different hypotheses. For reference, red cells imply overvaluation relative to the current market price, and green cells imply undervaluation.

Sensitivity table TTE valuation

Consensus of analysts; Author’s calculations

Risks for my thesis

My thesis is linked to the implication that there are no structural differences between the European and American oil majors. This, however, is not necessarily true since the respective regulatory exposure is somewhat different. Arguably, the European Union is slightly more aggressive when it comes to the green energy push and US stocks are generally trading at a premium. Nevertheless, a relative valuation gap of 100% is not justified, in my view. Also, investors should note that I assume a sustainable oil price of around $60/barrel. While this may sound bearish to some readers, others might argue that the fair value of oil is much lower. As the covid-19 induced selloff in 2020 has shown, oil can even trade at negative price levels. If Oil were to break significantly below $60/share and not recover in a reasonable amount of time, TotalEnergies’ bullish thesis would be shattered.

Conclusion

TotalEnergies stock is undervalued. The argument is easy to prove if you consider a relative multiple valuation against Exxon Mobil, which trades at around 100% premium to TTE. This discount is not justified, in my opinion, because the European and American oil majors equally share the exposure to the price of oil. Additionally, I believe TotalEnergies is well positioned to generate sustainable value, given the company’s diversified energy strategy. That said, I see over 50% upside supported by residual earnings valuation. My base target price is $71.52/share.

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