REPYY - Repsol: Rating Upgraded To Buy Yield And Cheap Valuation Too Attractive To Ignore

2023-08-06 02:50:30 ET

Summary

• I recommend a buy due to its attractive FCF/P yield and undervalued position compared to its history.
• The company reported strong execution in the upstream sector and expects improved earnings in the downstream sector.
• Repsol's capital allocation policy, including dividends and share buybacks, is attractive to shareholders, and its focus on renewable energy positions it well for long-term growth.

Overview

My recommendation for Repsol ( OTCQX:REPYY ) is a buy rating, as I believe the FCF/P yield is too attractive to ignore, and the valuation relative to REPYY history does not make sense given that it is a much better business today. Note that I previously rated a hold rating for REPYY due to the lack of certainty in the oil price situation, but I feel the situation seems to be stabilizing as the oil price (Brent) movement seems to be stabilizing (2Q23 vs. 1Q23 based on REPYY 2Q23 presentation).

Business

Repsol S.A., through subsidiaries, explores for and produces crude oil and natural gas, refines petroleum, and transports petroleum products and liquefied petroleum gas ((LPG)). The Company retails gasoline and other products through its chain of gasoline filling stations. Repsol's petroleum reserves are in Spain, Latin America, Asia, North Africa, and others. REPYY has 3 segments, Upstream (54% of EBITDA), Industrial (37% of EBITDA), and Commercial & Renewables (9% of EBITDA).

Recent results & updates

The total adj income reported by REPYY for 2Q23 was €827 million. The upstream sector brought in €410 million in adj income, while the downstream sector brought in €504 million. Overall, 2Q23 showed strong execution in Upstream. Due to an overabundance of middle distillates, benchmark refining margins fell by more than half in 2Q23 (see chart below) and downstream Refining earnings were at extremely low levels. Remember that in the first quarter, earnings from refining grew by 14% sequentially despite a drop in benchmark margin?

Looking forward, as the benchmark margin continue to rise, I expect to see health growth in the downstream segment earnings in 3Q23, thanks to the strong seasonal demand. One key datapoint to note during the call, that points to a strong near-term performance, is management noting a $9-$12/barrel premium in the month of July.

“Still, we see refining margins at healthy levels as exemplified by the diesel spreads that we still have today, and this refining margin that we have experienced over the last 10, 15 years, sorry, days that could be something in between EUR9 a barrel and EUR12 a barrel.” 1H23 earnings call

Capital allocation policy very attractive

A key part of REPYY's equity story is its attractive FCF yield to shareholders. Based on LTM data, REPYY generated €4.2 billion of FCF, representing around 24% FCF/P yield. When compared to peers in the same industry, REPYY has one of the highest yields. REPYY also has a clear capital policy that consists of dividends (historical dividend yield of 5 to 6%) and share buybacks (newly implemented in the 2Q23 earnings). In addition, management has approved a new capital reduction program for 2H23 that will involve the redemption of 60 million shares and the purchase of 50 million additional shares (4% of our outstanding) from the market. This, combined with increased dividends, suggests that yield would be at least in the 10+% range (historical 6% yield + 4+% share buyback).

Renewables energy long-term tailwind

As I mentioned before, the transition to a low-carbon economy will be a hot topic for years to come. As evidenced by its current 2 GW of operational renewable capacity and 1.2 GW of renewable capacity under construction, REPYY has clearly executed well on this. By the end of 2023, I am optimistic that REPYY we will reached or even surpassed its 2.7 GW of installed capacity target. The Frye solar project in Texas, which is scheduled to begin operations this quarter, will be a major contributor to this expansion.

Looking forward, I expect this aspect of REPYY to be a catalyst to long-term valuation support as investors evaluate the long-term sustainability of REPYY business.

Valuation

REPYY currently trades at 2.7x forward EBITDA, which is significantly lower than where it traded previously (an average of 4.8x forward EBITDA). I believe this discount is not justified given REPYY's long-term growth opportunity as it continues to transit towards renewable energy, the continuous premium in refining margin, and a more cost-efficient operating model in the upstream. In the face of these, I expect REPYY to trade at least the same multiple as it did in the past. Using the consensus FY24 EBITDA figure of €9.2 billion and assuming REPYY trades back to 3.7x forward EBITDA (1 standard deviation lower), REPYY's enterprise value will be worth €34 billion, with a market cap of €25.6 billion (48% above current levels). From a per share perspective, it equates to ~€20, and ~USD$22.

Risk

Naturally, given the nature of REPYY business, it is extremely susceptible to oil price movements, which inherently carry risk that are outside of REPYY control, especially in today’s geopolitical environment. The longer term risk is the transition to renewable energy being faster than expected and REPYY, for whatever reason, mis-executed along the way, thereby losing its leading position in the industry.

Summary

I upgraded my rating from a hold to buy for REPYY. The company's strong FCF yield, cheap valuation, and clear capital allocation policy are too hard to ignore. Despite past uncertainties in the oil market, the situation seems to be stabilizing, and Repsol's refining margins and earnings from the downstream sector are expected to improve in the coming quarters. Additionally, Repsol's focus on renewable energy positions it well to benefit from the long-term shift towards a low-carbon economy. Assuming a return to historical multiples, the stock's potential enterprise value and market cap suggest a significant upside for investors.

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