How Does The Settlement Agreement Impact BP’s Valuation?

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BP Plc. (NYSE:BP) recently agreed to pay more than $18.7 billion, spread over a period of 18 years, to settle all federal and state claims arising from the 2010 Deepwater Horizon oil spill incident. [1] According to our estimates, BP’s net present liability arising from the settlement is around $6.9 billion, strikingly close to our previous estimate of just over $7.2 billion. Therefore, we maintain our current price estimate for BP at $45 per share, which values the company at around 17.7x our 2015 full-year adjusted diluted earnings per share (EPS) estimate of $2.54.  Below, we outline the key factors driving our net present liability estimate of the recently-announced settlement agreement.
  • According to the settlement agreement, BP will pay the U.S. federal government a civil penalty of $5.5 billion under the Clean Water Act (CWA) and $7.1 billion to the federal and state governments for natural resource damages (NRD), over a period of 15 years. In addition, the company will also shell out $4.9 billion over a period of 18 years to settle economic and other claims by the five Gulf Coast states, namely Alabama, Mississippi, Florida, Louisiana, and Texas. A schedule detailing the timing of these principal payments, totaling $17.5 billion, was made public by the company along with the press release. [1]
  • In addition, BP has also agreed to pay $1 billion to settle the claims made by more than 400 local government entities, and another $600 million to cover outstanding NRD assessment costs, and to cover the full settlement of outstanding response costs. The company did not clearly spell out the timing of the $1 billion intended to settle claims made by the local government entities. We have therefore assumed it to be spread evenly over a period of 9 years, as with the $600 million payment. [1]
  • BP also mentioned that interest will accrue to the outstanding principal amounts of the civil penalty and natural resource damages payments at a fixed rate, based on the average market yield on U.S. Treasury securities at 2-year and 3-year constant maturities for the 12-month period ending May 27, 2015, which comes out to be around 0.75%. The company stated that interest will be compounded annually and be payable in years 15 and 16 for CWA and NRD payments, respectively. [1]
  • We use the above information to calculate the total annual pre-tax payments to be made by BP under the agreement. We then apply the marginal tax rate of 35% to calculate the post-tax cash outflow for the company each year.  Discounting these annual cash flows at 9.5%, our current estimate for WACC (weighted average cost of capital) for the company,  gives us the net present liability figure of almost $6.9 billion. [2]
  • In our valuation model, we have treated post-tax cash flows (lying within our forecast period) as a cash expense, and added the discounted present value of the payments lying outside our forecast period to the company’s current outstanding long-term debt. We have also added another $500 million to the company’s current outstanding long-term debt as a proxy for the present value of future payments related to the 2012 settlement agreement, which was aimed at resolving a substantial majority of individual and business claims arising from the oil spill incident. It was an uncapped agreement and total nominal costs associated with it have soared significantly over the past few quarters. (See: BP’s Supreme Court Appeal Rejection A big Setback In Its Attempts To Limit Settlement Costs)
  • Overall, based on our valuation model, we believe that BP’s shares are currently trading at a discount of about 10% to their estimated fair value, despite roughly $7.4 billion in oil spill-related liabilities.

See Our Complete Analysis For BP

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Notes:
  1. BP To Settle Federal, State, and Local Deepwater Horizon Claims For Up To $18.7 Billion With Payments To Be Spread Over 18 Years, bp.com [] [] [] []
  2. BP 2014 20-F SEC Filing, bp.com []