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Total Demonstrates Strength of Operations

Allen Good, CFA (allen.good@morningstar.com)

 Total TOT ended 2017 on a high note, reporting strong fourth-quarter results and reinstating the cash dividend via offsetting share repurchases. Management took the extra step of announcing its intentions to increase the dividend by 10% and repurchase $5 billion worth of shares through 2020. With its buyback announcement, Total joins peers that have already announced similar intentions or intimated that excess cash would go toward repurchase. However, its formalized plans to increase the dividend set Total apart from most peers, which have been less forthcoming on that front. The earnings and shareholder return announcements confirm our view of the strength of Total's operating businesses and cash flow generation capability, which create a low break-even level ($47 a barrel in 2018, by our estimate). Management also updated its long-term outlook, although most major guidance items such as production growth and capital spending were unchanged. Our fair value estimate and moat rating are unchanged as well.

Adjusted net earnings for the fourth quarter increased to $2.9 billion from $2.4 billion the year before, and operating cash flow climbed to $6.0 billion from $4.8 billion, thanks largely to a strong upstream performance, which offset downstream weakness. Upstream operating earnings increased to $1.8 billion from $1.0 billion the year before on higher price realizations and production. Production for the quarter grew 6% from the year before, thanks to new project startups and inclusion of the Al-Shaheen oil field concession, bringing full-year production growth to 5%. Total maintained its previous production outlook for a 5% compound annual growth rate through 2022 while expecting 6% growth in 2018, ranking it among the highest of the integrated group.

The refining and chemical segment proved a weak point during the quarter, with operating earnings falling to $886 million from $1.1 billion. Total has less North American refining exposure than peers, while operations at its Port Arthur, Texas, refinery were reduced for maintenance activities, limiting its exposure to a robust U.S. refining market that lifted peers' downstream earnings during the quarter. Gas and power operating earnings jumped to $232 million from $132 million on the addition of a solar farm in Chile. Marketing earnings increased slightly to $436 million from $406 million on stronger margins, particularly in Africa.

Peer-Leading Production Growth
Total stands to meaningfully improve its cash flow generating power in the next several years through peer-leading production growth and operating cost cuts, while already displaying one of the lowest gearing ratios among its peers. Production growth should prove to be a major driver of cash flow growth during the next five years, with Total anticipating averaging volume of growth of about 5% per year through 2022, the highest among its peers. That rate of growth from a major integrated should generally be viewed with skepticism, but given that Total has over 10 projects under construction and a large project queue awaiting final investment decisions, it's feasible, albeit with elevated execution risks, given the size and complexity of those projects.

Meanwhile, margins should improve as Total takes an ax to its operating costs. Already one of the lower-cost operators, Total aims to reduce operating costs to $5 per barrel of oil equivalent by 2018, a 50% cut from 2014 levels. The magnitude of the cost reduction should help Total, which lags peers in upstream margins due to a higher tax burden, make up some ground. Combined with reductions in operating costs in the downstream segment, annualized savings should reach $4 billion by 2018.

Capital spending should fall to $13 billion-$15 billion annually (excluding about $1 billion net in resource acquisitions) from $19 billion in 2016 and an average of $30 billion during the peak in 2013-14. Total's ability to reduce spending to this degree is due to the completion of major projects and the cost improvement it's been able to achieve in new projects. In some cases, it's reduced costs by 50% through design simplification, reduced equipment cost, and renegotiation of fiscal terms, which allow it to dramatically reduce spending yet maintain growth.

Portfolio Doesn't Allow Moat
Total does not earn an economic moat, in our opinion, as its asset base is not capable of delivering sustainable excess returns at our long-term oil price assumption of $60 a barrel. Based on an evaluation of its oil- and gas-producing assets using our exploration and production moat framework, Total's upstream portfolio fails to qualify for a moat. It managed to deliver upstream returns on capital employed of only 7% during the past five years, below average compared with other integrated companies, as greater exposure to natural gas weighed on margins and high levels of spending expanded its capital base. The increased spending should result in above-average production growth, but margins are set to contract on lower commodity prices, despite falling unit costs. As a result, we do not anticipate a material improvement in returns that would lead to a moat.

Total's downstream segment has proved to be a drag on company returns, averaging a return on capital employed of 7% from 2010 to 2014. While 2016 turned out to be a stellar year, those results are not sustainable, in our view. Total's refining assets are primarily located in Europe, where structural challenges including overcapacity, susceptibility to low-cost imports, and lack of a cost advantage will continue weigh on margins and returns. While Total has made strides in restructuring its portfolio and closing or converting uncompetitive facilities, we do not think these measures are sufficient to deliver sustainable excess returns.

We believe Total's moat trend is stable, as we expect the trend of ever-higher cost reserve replacement to abate during the next five years. While we anticipate that sustained lower oil prices and the addition of the higher-cost projects will result in returns on average remaining lower than in the past, we forecast the underlying cost structure and capital efficiency to improve from current levels. The improvements stem from the collapse in oil prices, which has brought about several changes to the company and industry.

Most notably, previously marginal projects are either experiencing substantial cost reductions (typically a result of services price deflation or redesign) or are being deferred indefinitely. Also, past investment in capital-intensive projects like liquefied natural gas has increased Total's exposure to long-life resources that do not decline and require little reinvestment. These projects may deliver lower full-cycle returns, given the high up-front capital cost, but as the capital base is depreciated and cash flow remains steady, returns should improve. These projects also sit on large pools of resources offering low-cost replacement opportunities. Collectively, these changes mean Total can meaningfully reduce future capital spending compared with the past several years while maintaining production and reserve levels.

Profits Pinned to Production and Prices
Total's profits and cash flow are largely tied to oil and gas production and suffer markedly during periods of weak commodity prices. Additionally, long-term price depreciation would expose the company to weakening returns on capital, as its large queue of new projects coming on line would be unlikely to generate their projected economic results. Total employs huge amounts of capital in building out its production portfolio, and cost overruns and/or completion delays are continued sources of uncertainty.

The company's oil and gas production involves operating in politically unstable regions: During the past few years alone, production was materially reduced because of geopolitical and/or security issues in Libya, Nigeria, Syria, and Yemen. Further, sanctions that target Russian gas producer Novatek could put at risk the value of Total's recent multi-billion-dollar investments in the country.

We advise U.S. investors that France has a 30% dividend withholding tax. The present tax treaty between the United States and France allows U.S. investors to use this tax as a credit only to offset U.S. earnings being reported to the IRS. Therefore, tax leakage from Total's dividends is possible, which would reduce dividends received. The lone country in Europe with no withholding tax is the United Kingdom, where BP BP and Shell RDS.A / RDS.B (the two other European supermajors) happen to have at least one share class.