Imperial Oil Limited (TSX: IMO) is a Calgary-based integrated oil company in Canada, primarily involved in the oil and gas fabrication, petroleum products refining and marketing and chemical business. It is Canada's leading marketers of fuels, lubricants, and a major producer of asphalt. Its operating activities are divided into three segments: a) Upstream (33.45% of sales), b) Downstream (63.62% of sales) and c) Chemicals (2.93% of the sales) according to the FY19 annual report. 

Investment Rationale 

• Gradually lifting coronavirus restrictions are likely to benefit the group: The company is an integrated oil company with operational interests in Upstream, Downstream and Mid-stream activities; however, IMO's majority of revenue comes from the downstream activities, which include refining of crude oil along with distribution and marketing of refined products. Therefore, stable crude oil prices and improve demand offtake of crude oil is expected to benefit IMO. Further, gradually lifting of coronavirus restrictions are also set to drive oil demand which was largely muted in April and May 2020.                                        

• Strong Balance Sheet with ample liquidity: At the end of 1QFY20, the company’s financial position remained strong with long term debt as % of total capital stood at 17.3%, which was significantly below the industry median of 35.7%. Further, the debt to equity ratio stood at 0.22x, significantly below the industry median of 0.79x, implies a lower balance sheet risks against the peers. The company had an industry-leading current ratio of 1.35, whereas peer's average current ratio stood at 1.15. A higher current indicates a strong liquidity position of the company and assesses whether the company has enough cash flow to meet its short-term payables and other liabilities on time.

• Industry Leading Asset Turnover Ratio: The group has industry-leading asset turnover ratio, which measures the efficiency with which a company uses its assets to produce sales. IMO's Asset Turnover ratio stood at 0.16, whereas the industry average asset turnover ratio stood at 0.09, reflect higher efficiency of the management as compared to the competitors. Asset turnover ratio is an important financial ratio used to understand how well the company is utilizing its assets to generate revenue.

• An Income Play: The company has a consistent track record of dividend payment regardless of the economic situation, which reflects its balance sheet strength. At the last closing price of CAD 22.30 (July 16, 2020), the stock was offering a decent dividend yield of 3.95%, which is encouraging from an income investor's standpoint, given the falling interest rate situation. Further, IMO's dividend yield of 3.95% is approximately 7.3 times of the Canada 10 Year Benchmark Bond Yield is at 0.54%.

• Risks Associated to Investment: A second wave of the novel virus would be catastrophic for the oil demand, which in turn would dent the group’s performance. Further, the IMO's cash conversion cycle is significantly higher at 47.4 days, whereas industry median cash conversion days stood at 1.7. The Cash Conversion Cycle (CCC) is a metric that shows the amount of time it takes a company to convert its investments in inventory to cash, the shorter the cash conversion cycle, the better the company is at selling inventories and recovering cash from these sales while paying suppliers.

Financial Highlights: Q1FY20

Source: Company filings

The quarter witnessed a double whammy with the combination of demand reductions brought on by the COVID-19 pandemic and the supply glut resulting from the OPEC+ actions was unprecedented. These resulted in a challenging business environment by the time the quarter ended. Significantly lower global demand had a material impact on crude oil and product prices, which, in turn, impacted the group's reported financial results. However, the group took several steps to reduce spending and modify business plans to adapt to these challenges.

During Q1FY20, the company reported a net loss of CAD 188 million or CAD 0.25 per share on a diluted basis compared to net income of CAD 293 million or CAD 0.38 per share in the same period of 2019. The decline in net profit was primarily driven by a non-cash charge of CAD 301 million. Due to a significant decline in commodity prices at the end of March, inventory revaluation resulted in a loss of CAD 281 million, while remaining CAD 20 million non-cash charges were associated with a goodwill impairment. The group generated cashflow of CAD 423 million from operating activities in the first quarter, compared to CAD 1,003 million in the previous corresponding period. Cash flow was impacted by lower realizations and unfavorable working capital impacts.

Key highlights:

• Upstream production volumes were quite strong at 419,000 barrels of oil equivalent per day driven by the record Q1 production at Kearl.
• The group reported strong results in the Downstream segment as well, including record first-quarter throughput at Strathcona refinery, which continues to demonstrate the value of integration. However, the company reported a loss of CAD188 million in the quarter, driven by non-cash charges on inventory valuation. Excluding this, earnings were positive at CAD 113 million on an adjusted basis.
• On the sales standpoint, petroleum product sales were 462,000 barrels a day in the first quarter, up slightly from the fourth quarter. However, the demand was impacted at the end of the quarter due to COVID-19 pandemic and resulted in lower volumes compared to the group's expectation.
• IMO's Chemical business segment had a solid quarter with earnings of CAD 21 million, stronger than the fourth quarter of 2019. This was due to seasonal volume growth and the absence of turnaround activity.
• The group spend CAD 331 million as capital expenditure during the first quarter, which was lower than the last year. Out of these, ~70% or CAD231 million invested in the upstream segment. Reduced spending compared to last year was mainly due to the ramp down of the Aspen project, as well as completion and start-up of the Kearl supplemental crushers.
• The board of directors declared a dividend of CAD 0.22 per share, unchanged from the prior quarter. The group continued the share buybacks in the first quarter, totaling to CAD 274 million with 9.8 million shares, consistent with Toronto Stock Exchange approved NCIB program.

Segment Overview

Upstream: The group produces crude oil and natural gas for sale predominantly into North American markets. Its upstream business strategies guide the company's exploration, development, production, research and gas marketing activities. It has a significant oil and gas resource base and a large inventory of potential projects. The company continues to evaluate opportunities to support long-term growth.

Downstream: The group serves predominantly Canadian markets with refining, logistics and marketing assets. Its business strategies competitively position the company across a range of market conditions. The group owns and operates three refineries in Canada, with aggregate distillation capacity of 423,000 barrels per day. Refining margins are largely driven by differences in commodity prices and are a function of the difference between what a refinery pays for its raw materials (primarily crude oil) and the market prices for the range of products produced (primarily gasoline, heating oil, diesel oil, jet fuel, fuel oil and asphalt).

Chemical: This segment has the lowest contribution in the group's consolidated revenue, but the company maintains a competitive advantage through operational excellence, investment and cost discipline, and integration of its chemical plant in Sarnia with the refinery. The company also benefits from its relationship with ExxonMobil's North American chemical businesses, enabling Imperial to maintain a leadership position in its key market segments.

Stock Performance

1-Year Price Performance (as on July 16, 2020, after the market close). Source: Refinitiv Thomson Reuters).

At the last closing price (July 16, 2020), shares of IMO traded 0.89% lower at CAD 22.30. Over the past year, its shares have registered a 52W High of CAD 37.46 on July 25, 2020 and a 52W Low of CAD 10.27 on March 18, 2020. At the closing price of CAD 22.3, its shares traded approximately 40.5% below its 52W High and approximately 117.4% above its 52W Low. This implies that the stock has recorded a sharp recovery over the past four months.

However, despite a sharp recovery from the March 2020 bottom price level, IMO shares were featuring a negative price return of 39.75% on a YoY basis and traded 35% lower on a YTD basis. The stock generated a return of ~ 41% over the past three months and traded appreciated 10% over the past five trading sessions.

Top-10 Shareholders 

The top 10 shareholders have been highlighted in the table, together hold around 86.29% stake in the company. Exxon Mobil Corp and Artisan Partners Limited Partnership hold the maximum interests in the company at 70.53% and 4.17%, respectively. Further, five out of top-10 shareholders have increased their stake in the company over the last six months, with Fidelity Investments Canada ULC , and Artisan Partners Limited Partnership is among the top investors in the company which have increased their stakes by 11.97 million and 3.62 million, respectively. The institutional ownership in the IMO stood at 22.93%, and ownership of the strategic entities stood at 70.54%, respectively

Source: Refinitiv, Thomson Reuters

Valuation Methodology (Illustrative): EV to Sales Based Valuation Metrics

Note: All forecasted figures have been taken from the Refinitiv (Thomson Reuters).

Stock Recommendation

The combination of demand reductions brought on by the COVID-19 pandemic and the supply glut resulting from the OPEC+ actions was truly unprecedented and had a significant weigh on the group's performance. However, oil and its derivative had recovered strongly after lockdown restriction eased out, which is expected to benefit the company in the next few quarters, however, to further attain pre-COVID-19 demand would take some time. The group has a strong balance sheet with ample liquidity, including a cash balance of CAD 1.4 billion. The current liquidity position seems to be enough to help the group navigate through the current challenging conditions.

As the company has operational interests in the upstream activities, the recent recovery in the oil prices since April 21, 2020, is also expected to benefit IMO. Oil price recovered sharply after hitting a multiyear low in April 2020 and easing lockdown restrictions across the world after approximately two months of stringent restriction on travel and economic activities, also bringing back oil demand in the market.

Further, the company is offering a lucrative dividend yield of 3.95%, with a consistent track record of dividend payment regardless of the economic situations. A higher yield amid falling interest rate environment making IMO stock a lucrative bet from an income investor's standpoint.

Also, its shares have recorded a sharp recovery from March 18, 2020 bottom and outperformed the benchmark indices and sector over the past the 3-Months, and in the last five trading sessions as well, which implies a relative strength in the IMO's shares.

Therefore, based on the above rationale and valuation done using the above methodology, we have given a "Buy" recommendation at the closing price of CAD 22.30 (on July 16th, 2020), with lower double-digit upside potential. We have considered Cenovus Energy Inc (TSX: CVE), Husky Energy Inc (TSX: HSE) and Suncor Energy Inc (TSX: SU) etc., as a peer group.

*Recommendation is valid at July 17, 2020 price as well.

*Please be aware that dividends are variable and not guaranteed.

Disclaimer

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