Eni Q3 results: Prudent management, improved balance sheet (NYSE:E)

SimonSkafar

Italian multinational energy company, Eni SpA (NYSE:E) is one of the stars of the energy market. The company was a winner in the stock market crash, rewarding investors after years of underperformance. Future profitability is probable and sustainable, given capital outflow and renewed capital discipline across the sector. Rather than being subject to a boom and bust trend, investors in energy stocks, and Eni in particular, should benefit from smoother return profiles.

Over the past five years, Eni has been a terrible investment proposition for investors, with the share price down 0.99% over that time, while the FTSE MIB (the benchmark for the Borsa Italiana) rose 4.13% and the S&P 500 rose 47.42%. .

Source: Google Finance

Source: Google Finance

Nevertheless, following Russia’s invasion of Ukraine and post-pandemic supply chain dislocations, oil and gas prices have taken off, and with them, energy stocks. Year-to-date, Eni is up almost 15%, while the FTSE MIB is down more than 15% and the S&P 500 is down almost 21%.

Source: Google Finance

Source: Google Finance

The profitability of oil and gas is sustainable

In the wake of the Great Recession, energy markets destroyed investor capital with wild abandon. Over the past decade, the MSCI World Energy Index has returned just 4.39% annually, compared to 9.52% for the MSCI World and 8.54% for the MSCI ACWI. This trend of underperformance dates back to 2006.

Source: MSCI World Energy Index

Source: MSCI World Energy Index

However, in 2021, the MSCI World Energy Index rose by 41.77% compared to 22.35% for the MSCI World and 19.04% for the MSCI ACWI. Year-to-date, the MSCI World Energy Index is up 47.91%, while the MSCI World Index is down 19.74% and the MSCI ACWI is down 20.81% .

While “inflation” is a decent explanation for what is happening, the sustainability of the industry’s profitability in the event of a boom has never been given. High yields typically attract capital, with managers tempted to grow their asset base and increase production to maximize their returns. Unfortunately, what is rational at the micro level turns out to be irrational at the macro level, and managers’ decision to increase capex leads to oversupply of oil and gas, and hence to a bursting of the bubble. Capital, once attracted to industry, is now repelled by it and exists to a point where profitability accrues to industry. This phenomenon has been described by Marathon Asset Management as the “capital cycle”, and in the academic literature it is described by the asset growth effect. The asset growth effect refers to the inverse relationship between asset growth and future abnormal returns, whereby firms with low asset growth enjoy higher abnormal returns than firms with high asset growth. Thus, the low returns of the energy sector after the Great Recession are a function of the asset growth effect. For investors, the question is: will yields fall as they have in the past?

While OPEC+’s decision to symbolically cut production despite calls from President Joe Biden to expand it, has been explained as support for Russia, there are strong economic reasons to say no to the United States: Demand has been sluggish, particularly from a China that remains committed to a zero Covid policy, which the Chinese government has called a “policy of greatest benevolence 大仁政”. Expanding production would reduce prices without increasing Chinese demand. OPEC+ also had to weigh the consequences of going against Russia and making Russia have an independent oil policy that would harm its interests. Finally, a policy going against Russia would not succeed because there is not enough capacity available to compensate for the loss of Russian oil.

Thus, we are at a unique moment when high oil prices are unlikely to be met by expanding production and the type of capital destruction that invariably follows.

Additionally, there has been, over the past decade, pressure from ESG investors for a large divestment from the industry. Last year, Stichting Pensioenfonds ABP, the Dutch pension fund for government employees, sold its positions in profitable energy companies, on ESG grounds. Activist investor Engine No. 1 has worked to reduce the company’s carbon footprint since winning board seats last year.

While the Russian-Ukrainian war has forced Europe to invest in fossil fuel solutions in the interim, the long-term path is far from fossil fuels. So we have a situation where profitability is increasing, but capital is still flowing out, and will in the future. Last year, New Constructs found that while the core revenues of supermajors such as PetroChina (OTCPK:PCCYF) (PTR), China Petroleum (OTCPK:SNPTY, OTCPK:SNPMF)(SNP), Exxon Mobil (XOM ), Chevron (CVX), Royal Dutch Shell (SHEL) (RDS.A), TotalEnergies (TTE), BP (BP), ConocoPhillips (COP) and Eni (E) fell only 1% between 2017 and 2021 , their total market capitalization fell by around 20%.

Source: New Builds

Source: New Builds

Driving the exit from fossil fuels is the belief that oil and gas are headed for an Armageddon. However, as COP 27 convenes it has become increasingly clear that the world will not be able to meet its 1.5C temperature rise target, with the UN chief warning that the world is on the “highway to climate hell”. This failure was motivated by a misunderstanding of the ubiquity and importance of oil and gas. Data from the International Energy Agency shows that oil accounted for 44.3% of the world’s primary energy supply in 2017, falling to 30.9% in 2019. Although this is a strong decline, spread over several decades, shows how the world is characterized by what Vaclav Smil called “energy inertia” rather than the vaunted rapid transition. Meanwhile, natural gas fell from 16.2% in 2017 to 23.2% in 2019. This means that oil and gas fell from 60.3% of the world’s primary energy in 2017 to 54, 1% in 2019. Oil 1 gas demand remains stubbornly high, despite decades of effort and a widespread narrative that the industry is on its last legs.

Source: International Energy Agency

Source: International Energy Agency

Capital is flowing out amid energy inertia, and a growing sense of capital discipline within the industry means that profitability is sustainable. Industry is finally behaving rationally. The reliance of the United States on the use of strategic reserves to mitigate the price of oil is a signal of the limited options available to the West to reduce the price of oil. If demand rebounds, given the shortage of investment, prices will rise.

Eni’s solid profitability

Eni’s own figures reflect the industry-wide drift towards greater profitability. Between 2017 and 2021, revenue grew from $70.98 billion in 2017 to $77.77 billion in 2021. This gives us a meager 5-year compound annual revenue growth rate (or CAGR) of 1. 85%. According to Credit Suisse’s The Base Rate Book, 28.8% of companies achieved a similar growth rate between 1950 and 2015. In the nine months of the year, revenue reached nearly $102 billion, compared to $50.693 billion. billion for the same period last year.

Source: Credit Suisse

Source: Credit Suisse

Eni’s gross profitability fell from 0.169 in 2017 to 0.16 in 2021, showing some deterioration in the company’s attractiveness, largely due to asset growth in 2021. Gross profitability has further declined over the nine months of 2022, to 0.155. This remains well below the 0.33 threshold that Robert Novy-Marx said made a stock attractive.

The company has made tremendous progress in improving the strength of its balance sheet, which is important, not only in terms of reducing business risk, but in order to better position the company from a cycle point of view. capital, for future returns.

Source: Eni Investor Presentation;  November 2022

Source: Eni Investor Presentation; November 2022

The operating margin fell from 11.3% in 2017 to 15.9%, suggesting an improvement in value creation. According to The Base Rate Book, median operating margins in the energy industry, between 1950 and 2015, were 12.1%, while average operating margins were 11.6%.

Source: Credit Suisse

Source: Credit Suisse

Net income grew from $3.374 billion in 2017 to $5.821 billion in 2021, giving a 5-year net income CAGR of 11.52%. This gives us a base rate of 20.3% of businesses. For the nine months of the year, net income reached $13.26, compared to more than $2.3 billion for the same period last year.

Source: Credit Suisse

Source: Credit Suisse

Eni has increased free cash flow (or FCF) from €6 billion in 2017 to €7.6 billion in 2021. In the nine months of the year, FCF has already reached €7.438 billion. euros. Eni estimates that it can increase the cumulative FCF over 4 years from 5.582 billion euros in 2021 to 25 billion euros for the period 2022-2025.

Source: Eni Investor Presentation;  November 2022

Source: Eni Investor Presentation; November 2022

The company’s FCF has been used to compensate Eni shareholders, at some of the highest compensation yields in the industry.

Source: Eni Investor Presentation;  November 2022

Source: Eni Investor Presentation; November 2022

Eni’s return on invested capital (or ROIC) has increased from 11.6% in 2017 to 10.4% in 2021. Nevertheless, it remains number one.

Evaluation

Eni has a price/earnings multiple of 3.06, compared to 11.28 for the FTSE MIB and 20.01 for the S&P 500. In addition, the company has an FCF yield (FCF/enterprise value) of around 11 .2%. This is in comparison to the average FCF return of 1.5% of the largest 2,000 companies in the United States, as measured by New Constructs. This suggests that the future performance of stock markets will be higher than that of US markets.

Conclusion

While Eni’s numbers are not sensational, industry-wide trends lead us to believe that as a rising tide lifts all boats, Eni will benefit from industry-wide trends. industry and that future profitability will increase sustainably. Moreover, a relative undervaluation should result in a reversion to the mean and a rise in the stock price. The company has been managed conservatively and, given the likelihood of high oil and gas prices over the long term, the chances of future profitability are very high.

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