Is BP a Bargain After the $20.8-Billion Settlement?

Early this week, the Obama Administration announced that it had finalized the terms of its settlement with BP (BP) stemming from the 2010 Deepwater Horizon oil spill. The final price tag will come in at $20.8 billion, which was higher than the $18.7 billion announced as recently as July. Nevertheless, this removes a major source of open-ended uncertainty for BP. Though it’s been a long road to get here, long-suffering BP investors should be relieved that the ordeal is finally over.

I should probably put “over” in quotation marks because there may still be some private claims from individuals and companies that could pop up. But the biggest potential liability – the federal, state and local-government lawsuit against BP for its violations of the Clean Water Act and other environmental regulations– is now over and done with. Any new claims to come along should be minor.

So, with the financial fallout now behind the company, what does this mean for BP and, the question that every investor wants to know, the BP dividend?

Let’s dig into the details.

BP currently yields a fat 7.0%, the highest among oil majors. And despite the barrage of legal setbacks – not to mention the plummeting price of crude oil over the past year – BP has continued to raise its dividend. Last year, BP raised its quarterly payout from $0.585 to $0.60. And BP has hiked its dividend by a cumulative 45% since reinstating it.

The BP dividend currently costs the company about $6.9 billion per year. That’s considerable higher than the $4.5 billion in free cash flow that BP has generated over the trailing 12 months. (Free cash flow is operating cash flows minus capital expenditures.) So as things stand now, BP has more cash going out the door in the form of dividends than it is taking in from current operations. That doesn’t give much confidence that the dividend is safe.

But it also ignores BP’s massive cash hoard. BP had $32 billion in cash and marketable securities as of the most recent quarter, and has a high credit rating that allows for additional borrowing. So, BP has plenty of cash on hand to pay the dividend at current levels for the foreseeable future.

Does the $20.8-billion settlement change this calculus?

Not really. To start, the damages are to be paid out over the next 15-18 years. So while the settlement represents a cash drain of a good billion or two per year for a long time to come, we’re not talking about a debilitating expense. It’s just a cost of continuing to do business in America.

Furthermore, BP knew this day was coming, and has already prepared for it. Through July of this year, BP had already taken $54.6 billion in pre-tax charges related to the spill. That’s an amount roughly equal to its gross profit for all of 2013 (before the slide in the price of crude oil started). If we want to make lemonade out of lemons, it also represents an asset in the form of tax write-offs. According to Forbes estimates, $15.3 billion of the $20.8 billion owed to the federal, state, and local governments is fully tax deductible. And BP has already taken $32 billion in tax deductions related to the cleanup of the oil spill itself.

The damages to be paid are a real cash expense, not a phantom expense like depreciation, so they won’t necessarily free up cash flow for the BP dividend. But think about how much worse this situation would have been for BP had the tax deductions been disallowed.

Finally, let’s look at valuation.

Looking at the price/sales ratio, BP trades at a massive discount to its Big Oil peers ExxonMobil (XOM) and Chevron (CVX). But prior to the 2010 disaster, this wasn’t the case. With Deepwater Horizon drifting further and further into the past, this gulf should gradually narrow. It may never fully close, but it doesn’t necessarily have to. BP doesn’t have to rival Exxon in order to be a fantastic investment at current prices.

There is a lot of pessimism built into BP stock’s price right now. That’s a good thing. With the overall market still looking very pricey, a 7% yielder would seem like an attractive bet.

Disclosures: Long BP

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.