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By: Ahmed Ishtiaq

ConocoPhillips (COP) is the world's largest independent exploration and production company. The company explores for oil and gas in more than 30 countries and has proved reserves of 8.4 billion barrels of oil equivalent. ConocoPhillips is one of the best dividend payers in the sector and the stock has an attractive yield of 4.50%, almost double the industry average. Furthermore, the stock has returned over 50% since the recession and it has proved to be an astute investment. The recent spin-off has separated the exploration and production (E&P) and marketing businesses of the company. As a result of the spin-off, the company now has more room to wriggle, and it can now focus on the exploration and production activities.

In this article, I have tried to look at the dividend and valuation of the company. Moreover, I have looked at the investor sentiment about the company and how it can affect the valuation. At the moment, dividends have a big impact on the valuation of the stock. However, the focus on dividends can affect the valuation in the future if the cash flows of the company fall below the expected levels. Let's take a look at the expected cash inflows and out flows and how these can affect the valuation.

Dividend Profile

The company has an impressive history of dividends. At the moment, the firm has a dividend yield of 4.50%, and an annual dividend of $2.64. In 2005, the company executed 2-for-1 split, which caused the per share dividend to come down. However, the change was merely numeric, and the rate of dividends remained unchanged. I always look at the free cash flow generating capability of a company in order to judge the strength of its dividends. I focus on the payout ratio based on free cash flows instead of payout ratio based on earnings.

Free cash flows have been strong for the company till the end of 2011. However, during the past twelve months the operating cash flows have come down substantially, but the capital expenditures have remained on the same levels. As a result, free cash flows have taken a hit for the company. Before the last year, payout ratio based on free cash flows was around 57%. Nonetheless, the dividends are safe for the company for the time being due to a focus on dividends by the company.

Future Capital Expenditures and Expected Funding Gap

Capital expenditures for the company were just below $16 billion over the past twelve months. ConocoPhillips have reiterated that the capital expenditures will remain flat for 2013. However, operating cash flows are expected to be around $12 billion for 2013. As a result, the company may face a funding gap of about $4 billion. ConocoPhillips will also need around $3.5 billion for dividend payments, which can increase if the company decides to increase the dividend. Just like other companies in the sector, ConocoPhillips have to spend substantially on replacing its depleting assets and maintain the growth in its production levels.

The company expects to grow production at 3%-6% through 2016. In order to achieve the target, ConocoPhillips will have to spend a considerable amount in capital expenditures. The companies in the sector are bridging the funding gap by sale of assets. Chesapeake Energy (CHK) is an example of a company suffering due to a funding gap. However, ConocoPhillips is not in such a miserable condition. The company has a lower debt-to-equity ratio and a much smaller funding gap than Chesapeake Energy. ConocoPhillips is selling its assets to bridge the funding gap, and there should not be any trouble in the short-term.

However, if the operating cash flows do not improve in the future, the company can come into serious trouble. ConocoPhillips will rely heavily on the oil prices, and commodity prices will have to go substantially high for the company to bridge the funding gap without asset sales and credit. The company may have to borrow in the future to manage its funding gap if the commodity prices do not move according to the expectations.

Comparison with Peers

ConocoPhillips peers include BP PLC ADR (BP), Exxon Mobil Corporation (XOM) and Chevron Corp (CVX). Below table lists some important metrics for comparison.

ConocoPhillips

BP

Exxon

Chevron

P/E

7.30

7.90

9.30

9

P/B

1.50

1.20

2.40

1.60

P/S

0.30

0.40

0.80

0.9

EPS Growth

N/A

6.40%

-0.90%

4.80%

Operating Margin

9.10%

7.20%

16.00%

18.40%

Net Margin

4.20%

4.60%

9.10%

10.00%

ROE TTM

18.40%

15.70%

27.50%

19.00%

Debt to Equity

0.40

0.40

0.10

0.10

Source: Morningstar

It is evident from the table that the firm is trading at a discount compared to its peers based on multiples. In addition, the firm has impressive margins and attractive ROE. ConocoPhillips has a manageable debt to equity ratio of 0.4.

Summary

ConocoPhillips is heavily dependent on commodity prices. As a result, the company will need crude oil prices to move substantially higher from current levels to bridge the funding gap in the future without borrowing. In the short-term, the dividends are safe for the company because of the focus it puts on maintaining its dividends. Investors are also attracted to the company due to its dividends. However, if the operating cash flows do not increase, investors may start moving away from the company. At that point in time, the valuation of the stock can come into question and investors can lose substantially. However, I believe that risk is far in the future, and the company has some room to wriggle at the moment. Recovering global economic conditions may push crude prices high and the company may be able to meet its targets. However, any negative price movement of crude oil can badly hurt the company.

Source: ConocoPhillips: Another Company To Suffer Due To The Funding Gap?