Occidental Petrolium Corporation

March 8, 2007
 The Occidental Petroleum Corporation (OXY) is an oil and natural gas exploration and

chemical manufacturing company based in Los Angeles, California. The company has oil and

natural gas operations within the United States, as well as the Middle East, North Africa, South

America, and Latin America. Occidental is known as the largest oil producers in Texas and the

largest natural gas producer in California. The company holds a 25% interest in the assets and

liabilities of the Dolphin Project in Qatar. The Dolphin Project has the rights to operate and

produce natural gas within the country, as well as the right to build and own a major gas pipeline

within the Middle East.

Occidental focuses most of its business on oil and natural gas exploration, but also is

heavily involved with manufacturing chlorine and caustic soda. While producing chemicals for

pharmaceuticals, water disinfectants and detergents, Occidental has grown to become a market

leader within the chemical manufacturing industry.

Occidental possesses $38.83 billion in market capitalization, as well as over $5.3 billion

in net income. While striving to increase its revenue, Occidental has managed to decrease the

amount of debt held by $900 million. The company has improved its financial status over the

past several years, leading to an increase of its credit rating to “single A.”

The company is listed within the Independent Oil and Gas industry, competing with

several large corporations such as: China Petroleum and Chemical Corporation, EnCana,

CNOOC, and Suncor Energy. Other close competitors would include Exxon Mobile, Royal

Dutch, Chevron, and Conoco Phillips. The industry has an overall market capitalization of $492

billion, with a net profit margin of 16.5. Within the past week, the industry has taken a dive,

dropping more than five percent. Interestingly, the industry follows the performance of the S&P

500, showing a high correlation with the index.

 The most recent shareholder letter written by Dr. Ray R. Irani, President of Occidental,

was very informative and thought provoking. The letter detailed the company’s operations in

each of its locations throughout the world, giving extensive information about production

statistics. Understandably, Irani is trying to give the shareholder as much information as possible

by providing eight pages of statistics. At the same time, however, the shareholder who is reading

the letter made be overwhelmed by the amount of statistics given. With a large outflow of

statistics and information, the letter is not very personal, and begins to sound mundane after the

first several pages.

Irani does prevent the usage of clichés throughout the letter, with only a few possible

phrases that may seem cliché. Irani explains the increase in capital expenditures over the year

due to “the large number of excellent growth projects in our portfolio.” This would be a good

explanation if Irani provided details about these growth projects. Though much of the letter

provides excellent details and graphics to describe Occidental’s success, the letter fails to provide

comparisons between the company and its industry.

Ray Irani does provide significant details about the company’s vision and strategies for

the future. This includes the plans for further acquisitions throughout South America and the

Middle East. Irani also states that the company will be buying back 30 million shares within the

next few years. Though the letter does provide thorough analysis, it does not mention any

negative impacts on the company or industry. This should make a shareholder precautious about

what is actually happening within the company, since Irani does not discuss any problems.

Another glaring detail is that Occidental relies heavily on the price of oil; without the spike in

prices of oil, the company would not have seen such a prolific rise in earnings. Overall, the letter

should receive a “C+” letter grade. Many details are missing about possible obstacles the
company has faced or will later face, which should lead to questions about how honest

Occidental is being with its shareholders. Since many qualitative and quantitative details are

given about the success of the company, this offsets a potentially lower rated letter.

Compared to its industry, Occidental had a higher implied return on equity. Occidental’s

current ROE is 25.92%, about 4.2% higher than the industry. Much of this is due to their higher

operating profit margin and exceedingly high asset turnover. The implied ROE was calculated

by multiplying together the operating profit margin, tax burden, interest burden, asset turnover,

and total financial leverage. An interesting point to mention is that Occidental has an interest

burden ratio of 1, meaning that it does not pay out any interest before taxes are deducted. After

calculating the DuPont Analysis for Occidental, the company does not show any evidence of

artificially increasing its return on equity. The current implied ROE is identical to the reported

ROE, while the company shows an implied five year average ROE of 28.08%, .01% higher than

its reported counterpart. The company’s high ROE can be justified by the company’s

acquisitions of oil and natural gas facilities in the Middle East and the United States producing

higher profits compared to previous years.

Following the recommendations of Warren Buffett, Occidental uses a smaller amount of

financial leverage to improve their return on equity. The company reports a ratio of 1.73 of

financial leverage, more than .50 lower than that of the industry. Occidental also has maintained

a low amount of total assets to equity over the past five years, posting a ratio of 2.05. Occidental

does not rely as much on their equity capital to generate higher returns, a fundamental that

Buffett preaches. The amount of debt that Occidental has accrued has decreased dramatically

since 2003, with a decrease of about $2.3 billion. By relying less on debt to improve the
operations of the company, Occidental can focus on improving its facilities and expanding its

operations.

The company also does not try to improve its financial position by adding high amounts

of extraordinary items to its income statement, a testament that Buffett also follows. Though

Occidental has used extraordinary items in the past, the company has recently discontinued some

operations, leading to a decrease of $253 million in extraordinary items in 2006.

Since 2002, Occidental has seen an increase in its owner’s earnings. As of 2006,

Occidental reported $3.348 billion in owner’s earnings, an increase of 11.11% from 2005.

Incidentally, the five year average of owner’s earnings was 41.83% since 2002. Owner’s

earnings represent the amount of cash flows from operations a company has accumulated over

the year, less the amount of capital expenditures. By analyzing a company’s capital

expenditures, an investor can consider what purchases the company has made to improve its

current economic position. The five year average was calculated by finding the average of

annual changes in owner’s earnings.

Comparing the amount of owner’s earnings per share, Occidental has a current ratio of

3.927, while the five year average stands at 2.734. It can be implied that for every share

outstanding, Occidental has earned $3.93 of owner’s earnings in 2006. This difference in

owner’s earnings per share may be misleading, however. Since 2002, the change in owner’s

earnings has steadily declined. Though the company still has shown an increase in earnings, the

change each year has decreased; in 2004, earnings grew 46.60% from the previous year, in 2005

earnings grew 39.62%, and in 2006 they only grew 11.11%. The company has made $1.4 billion

in capital expenditures over the past two years, yet the change in cash flows has not seen the
same increase in growth. This may only due to the company investing more assets into more oil

fields, or could be due to slowing revenue from the company’s expenditures.

Philip Fisher makes a point in The Warren Buffett Way by saying that sales growth is

only useful to determine growth if the company is able to understand and reduce costs. The five

year average sales growth for Occidental was 25.10%, a smaller growth rate compared to the

industry average 30.03%. The sales growth was calculated using the five year average of annual

sales growth since 2002. The revenue the company incurred does not include interest income or

other revenues, since interest income is a source of income from companies financing their

purchases. Though the rate of growth in revenue has been slightly erratic, Occidental is finding

methods to receive the highest return from its expenditures. Occidental has also been able to

reduce its level of debt, reducing costs from $4.658 billion in 2002 to $2.79 billion in 2006.

Each year within this time frame has posted a decrease in debt from the subsequent year. This

shows a high amount of dedication that the company has shown to improve its financial position

while simultaneously cutting its level of annual debt.

During the past five years, Occidental has shown an increase in market value, posting a

dollar premise of $2.73. The dollar premise was calculated by dividing the change in market

value into the amount of accumulated retained earnings for the past five years. Retained

earnings were calculated by subtracting the amount of retained earnings from 2002 from the

amount in 2006. To determine the market value, the close price for December 30th was

multiplied by the current shares outstanding for both 2002 and 2006. By using these years

instead of a more current close price, the data was able to be compared at a more consistent level

to that of retained earnings. With a dollar premise of $2.73, Occidental has created $2.73 of

market value for each dollar of retained earnings. Instead of paying out the company’s earnings
as dividends or buying back shares, Occidental has reinvested its earnings to create a higher

market value for its shareholders. It should be mentioned, however, that Occidental does pay an

annual dividend of $1.44 per share, $0.20 higher than the previous year. This information can be

found in the shareholder letter, as well as reuters.com.

To determine the intrinsic value of Occidental Petroleum, the expected earnings are

discounted to the present day. Using a normal growth rate of 6% (the expected growth rate of

the economy), a supernormal growth rate of 18.23% (from owners earnings), and a discounted

cash flow rate of 10% (since the required rate was originally 9.14%, but a 10% minimum is

required, the intrinsic value of Occidental is $40.21. To find the discounted rate, the capital asset

pricing model was used, using the current t-bill 3-month rate as the risk free rate, and the market

risk premium quoted in the handout 3.11 given in class (the average of the geometric and

arithmetic rates). By assuming a slower amount of growth in future years, it is possible to

determine the implied worth of the company. Much of the company’s earnings are dependent on

the price of oil, so it would be difficult to predict the amount of future earnings since an investor

would have to rely on the supply and demand of oil.

Occidental should be viewed as a glamour stock, since it has high past growth rates, and

growths in revenue (25.1% compared to S&P 12.5%). Cash flow has been growing for the past

five years, yet at decreasing rates. The company has a low standard deviation of returns, which

may also suggest it to be a glamour stock. Though this may not be a good measurement for

comparison, value stocks do, on average, tend to have higher standard deviations closer to an

average of 24%. Another key point to make is that glamour stocks, on average, have done well

in the past, and do not expect to have financial issues in the future. Occidental portrays these

fundamentals, with high sales growths of 25%, and decreasing levels of debt. A final measure is
the amount of institutions that hold stock in Occidental. 77.71% of shares are held by

institutions, which is much higher than the industry and the S&P 500 (49.53% and 70.73%,

respectively). This measure would indicate that Occidental is more of a glamour stock than a

value stock.

The margin of safety provided by Occidental is very low, with the intrinsic value 13.55%

lower than the current share price. Buffett would not see this as very beneficial to him, because

there is no margin of safety, and he would have no reason to invest in a stock with no margin of

safety, since it is overvalued. The margin of safety is low compared to Buffett’s standard, who

requires a 25% discount of the intrinsic value. Occidental’s low margin of safety should be a

warning for future investors, who may be investing a lot of money in a company that may not

produce significant returns. Should the market decline, Occidental’s share price would drop due

to the low intrinsic value. Occidental does not have enough intrinsic value to justify a large

investment in the company.

The stock price for March 1, 2007 was $46.51, which was an increase from the previous

day. Using weekly prices since March 8, 1998 to February 28, 2007, a standard deviation of

3.949% was determined, along with an average weekly return of 7.377% in adjusted closing

prices. Though the weekly returns are high, they mainly represent earlier returns from the late

1990s and early 2000s. Due to this misrepresentation, an investor may expect higher returns

because of higher returns almost ten years ago. Since May 2006, the share price for Occidental

has shown a decreasing trend. In May 2006, the stock price was about $53.00, $7.00 higher than

the current price. Shown below is a graph of the five year change in stock price:
Because of a recent decline in share price, an investor should be monitoring the continued

performance of Occidental.

Based on all of the above information, I would recommend a decision to hold shares of

Occidental. The company has been progressing by purchasing new oil fields and expanding its

operations, with an operating profit margin of 43.12% (about 11% higher than the industry).

Occidental has also been decreasing its amount of debt, as well as using a smaller amount of

financial leverage compared to its industry. Unfortunately, Occidental has also shown a decrease

in growth of owner’s earnings, mainly due to a rise in capital expenditures. This rise is higher

compared to the amount of cash flow received from these expenditures. With the company

relying so much on the price of oil, investors should be cautious about the future of Occidental.

Since the company also has a small margin of safety, an investor should be wary about the future

of the share prices compared to the Occidental’s intrinsic value.

A reversal to this decision would be if the company’s ROE narrows closer to its industry

(sell), or if the ROE expands even more (buy). If the growth rate of owner’s earnings drops

below 11% between 2006 and 2007, I would recommend a sell decision. A rise would indicate a

hold decision, until there is a consistent rise in growth. One further factor to consider is if the

intrinsic value grows over $58, the margin of safety would be over 25%, thus implying a

decision to buy shares.

Sources

www.reuters.com

www.finance.yahoo.com

www.moneycentral.msn.com

www.oxy.com

www.morningstar.com

The Wall Street Journal

www.wsj.com

Hagstrom, Robert G. The Warren Buffett Way. Wiley and Sons, Inc. New Jersey: 2005 pg. 17,

13-14, 109-111, 130-131