Eni’s Third Quarter Results: Balance Sheet Improved and Conservatively Managed (NYSE:E)

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SimonSkafar

Italian multinational energy company, Eni SpA (New York Stock Exchange:E) is one of the stars of the energy market. The company has been a winner during the stock market crash, rewarding investors after years of underperformance. Future profitability is likely and bearable, given the outflow of capital and the renewed discipline of capital throughout the industry. Rather than being subject to a boom-and-bust trend, investors in energy stocks, and Eni in particular, are likely to enjoy softer performance profiles.

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

Source: Google Finance

Source: Google Finance

However, in the wake of the Russian 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 nearly 15%, while the FTSE MIB is down over 15% and the S&P 500 is down nearly 21%.

Source: Google Finance

Source: Google Finance

Oil & Gas profitability is sustainable

In the wake of the Great Recession, energy markets have destroyed investor capital with utter abandon. In the last decade, the MSCI World Energy Index it has returned just 4.39% annually, compared to 9.52% for the MSCI World and 8.54% for the MSCI ACWI. That pattern of underperformance dates back to 2006.

Source: MSCI World Energy Index

Source: MSCI World Energy Index

However, in 2021, the MSCI World Energy Index grew 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 down 20.81%.

While “inflation” is a decent explanation for what’s going on, the sustainability of industry profitability in a boom has never been a given. High returns typically attract capital, and managers are tempted to increase their asset base and expand production to maximize their returns. Unfortunately, what is rational at the micro level is irrational at the macro level, and managers’ decision to expand capital spending leads to an oversupply of oil and gas, and from there, to the bursting of the bubble. Capital, once attracted to industry, is now repelled by it and exists to the point where profitability returns to industry. This phenomenon has been described by Marathon Asset Management as the “cycle of capital”, 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, with low asset growth companies enjoying higher abnormal returns than high asset growth companies. Thus, the poor returns in the energy industry after the Great Recession are a function of the asset growth effect. For investors, the question is: will yields plummet as they have historically?

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Although OPEC+’s decision to symbolically cut production despite urging by President Joe Biden to expand it, it has been explained as support for russiathere are strong economic reasons to say no to the US: demand has been slow, especially from a China that remains committed to a zero Covid policy, which the Chinese government has described as a “policy of greater benevolence 大仁政”. The expansion of production would reduce prices without increasing Chinese demand. OPEC+ has also had to weigh the consequences of going against Russia and Russia having an independent oil policy that would hurt its interests. Ultimately, a policy to go against Russia would not succeed because there is not enough capacity available to compensate for the loss of Russian oil.

We are therefore at a unique time when high oil prices are unlikely to be offset by an expansion in production and the kind of capital destruction that invariably follows.

Furthermore, there has been, in the last 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 their positions in profitable energy companies, for ESG reasons. activist Investor, Engine #1has worked to reduce the company’s carbon footprint, since winning board seats last year.

While the Russo-Ukrainian war has forced Europe to invest in fossil fuel solutions in the interim, in the long run the road is away from fossil fuels. So what we have is a situation where profitability is increasing, but capital is still flowing out and will in the future. Last year, New builds found thatwhile the main gains from majors 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 just 1% between 2017 and 2021, their total market capitalization fell 20%.

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Source: New Constructions

Source: New Constructions

Driving the exit from fossil fuels is the belief that oil and gas are headed for Armageddon. However, as Cop 27 convenes, it has become increasingly clear that the world will not be able to meet its 1.5°C temperature rise target, with the UN chief warning that the world is on track. . “highway to climate hell”. This failure has been driven by a misunderstanding of the pervasiveness 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. While that’s a big drop, spread over several decades, it shows how the world is characterized by what that Vaclav Smil has called “energy inertia” instead of the much-touted quick transition. For its part, natural gas has gone from 16.2% in 2017 to 23.2% in 2019. That is, oil & gas has gone from 60.3% of world 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 exits amid energy inertia and a growing sense of capital discipline within the industry means profitability is sustainable. The industry is finally behaving rationally. The reliance of the United States on the use of strategic reserves to discourage the price of oil is a sign of the limited options The West has to reduce the price of oil. If demand recovers, given the scarcity of investment, prices will rise.

Eni’s solid profitability

Eni’s own numbers reflect the industry-wide trend towards higher profitability. Between 2017 and 2021, revenue increased from $70.98 billion in 2017 to $77.77 billion in 2021. This gives us a measly 5-year revenue compound annual growth rate (or CAGR) of 1.85%. According to Credit Suisse The base rate book28.8% of companies achieved a similar growth rate between 1950 and 2015. In the nine months of the year, revenue grew to almost $102 billion, compared to $50.693 billion in the same period last year.

Source: Credit Suisse

Source: Credit Suisse

Eni’s gross profitability decreased from 0.169 in 2017 to 0.16 in 2021, showing some deterioration in the attractiveness of the company, largely due to asset growth in 2021. Gross profitability decreased further in the nine months of 2022, at 0.155. This remains well below 0.33 threshold that Robert Novy-Marx discovered made an action attractive.

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The company has made great strides to improve its balance sheet strength, which is important, not only in terms of reducing business risk, but also to better position the company from a capital cycle standpoint, for returns. futures.

Source: Eni Investor Presentation;  November 2022

Source: Eni Investor Presentation; November 2022

Operating margin increased from 11.3% in 2017 to 15.9%, suggesting improvements in value creation. According to The Base Rate Book, the average operating margins for the energy sector, between 1950 and 2015, were 12.1%, while the average operating margins were 11.6%.

Source: Credit Suisse

Source: Credit Suisse

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

Source: Credit Suisse

Source: Credit Suisse

Eni increased free cash flow (or FCF) of €6 billion in 2017 to 7,600 million euros in 2021. In the nine months of the year, the FCF already reaches 7,438 million euros. Eni believes that it will be able to increase the 4-year cumulative FCF from €5.582 billion in 2021 to €25 billion 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 remunerate Eni shareholders, with some of the highest remuneration returns in the industry.

Source: Eni Investor Presentation;  November 2022

Source: Eni Investor Presentation; November 2022

Eni’s return on invested capital (or ROIC) has decreased from 11.6% in 2017 to 10.4% in 2021. However, it is still top-tier.

Valuation

Eni has a P/E 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 a FCF yield (FCF/enterprise value) of around 11, two %. This is in comparison to the mean FHR performance of 1.5% of the 2,000 largest companies in the United States, as measured by New Constructs. That suggests future stock market performance will outperform 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 and future profitability will grow exponentially. sustainable. In addition, the relative undervaluation should result in mean reversion and an increase in the share price. The company has been conservatively managed and, given the likelihood of high oil and gas prices in the long term, the likelihood of future profitability is very high.

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