ConocoPhillips (NYSE:COP) released its 3rd quarter interim results on 10/2, followed on 10/7 by an announcement of a dividend hike, together with plans to rationalize their portfolio and grow production. Shares closed Friday at 50.84, up 13% so far in October. Shiv Kapoor drew a lot of comments with his October 1st article, suggesting COP may be a multi-bagger. Warren Buffett uncharacteristically admitted a mistake and took large losses on the company, a fact which seemed to distract some of the commentators from the fundamentals.
I have owned COP off and on for years, reliably extracting profits via covered calls at the lower end of its value range, and mentioned a recently added long position in a September article focused on changes in portfolio emphasis. However, I did not look that carefully at the selection when I made it, and I must confess to being a little surprised at the rapid price movement. Studying the 10/7 press release what I see is management's tacit admission of strategic errors, followed by corrective action, which is winning market support.
Symptoms – COP is difficult to evaluate by my usual methods, which rely on historical average multiples and an expectation of mean reversion. In part, this is caused by dramatic fluctuations in earnings and asset values: the company reported its best and worst quarters back to back in the 3rd and 4th quarters of 2008. This reflected their heavy participation in the huge spike and crash of energy prices that year and the first quarter of this year. Looking at Price/5 year average EPS, Price/Sales and Price/Tangible Book, I get mid point targets of 48, 52 and 81, respectively. Anytime these values vary by that large a margin, analysis is required.
These variations in value according to different metrics are consistent with the criticisms of the Burlington Resources acquisition, which made COP the largest North American producer of natural gas. As this has progressed, the company's debt to equity has increased, cash flow was negative in 2008 and nowhere near covered capital expansion, and substantial write-downs were incurred.
Diagnosis - basically the company has too much debt supporting assets which are not generating cash or EPS consistent with their historical performance.
Corrective action – from the 10/7 press release:
Capital expenditures in 2010 are expected to be approximately $11 billion, down from $12.5 billion in 2009. At this level of funding, the company will support exploration, production and reserve replacement, while preserving its project portfolio for future development. Further details of the company's 2010 capital program will be announced near the end of 2009. The company intends to achieve its objective of replacing reserves through organic growth. Upstream production growth will occur from a reduced base, as a result of the asset rationalizations.
To improve its financial position and strengthen its balance sheet, ConocoPhillips intends to sell approximately $10 billion of assets over the next two years. The dispositions will occur across the company's Exploration & Production and Refining & Marketing portfolio. Proceeds from dispositions will be targeted to debt reduction, accelerating the company's return to its stated target debt-to-capital ratio of 20 percent to 25 percent.
Mr. Market hates negative cash flow, and despises capex that can't be paid from operating cash flow. Obviously, by selling assets to generate cash and reducing capex year over year, ConocoPhillips is toeing the line. Upstream production growth would mean finding and pumping more oil, increasing revenues and EPS.
Presentation – Here is a link to a presentation (.pdf) given on 9/9 at the Barclays Capital 2009 Energy & Power Conference. What I saw was increased emphasis on “Big E,” higher impact wildcat opportunities to test new plays. That and the assertion that “Deepwater GOM (Gulf of Mexico) has legs, steep creaming curve suggests material running room in Paleogene.” This sounds almost as good as tech companies talking about “ramping.” Seriously, a more aggressive approach to exploration should contribute to upstream production growth.
Target Price and Time Frame – COP says the makeover will take two years. Doing the math on the 10 billion of asset sales, that would bring debt/capitalization in line with COP's target and historical norms. Subject to market conditions, production growth will increase revenue and EPS.
What Graham called the vexed question, whether to look past the horrible Q4 08, will be answered in the affirmative, so 5 year average EPS can be ignored or adjusted. The market will look forward. Price/Sales ratios are difficult to interpret in an environment where oil goes from a peak of 147 to less than 30 in a matter of months.
That would leave book value: with the assets written down, and with energy prices recovering from their low point, but with 10 billion identified as “non-core.” or whatever they choose to call it. The point is, some of the assets are good, and some are not so good. Working off tangible book value, and assuming they get 70 cents on the dollar for the 10 billion of non-core assets, I apply a historic average Price/tangible book ratio of 2.2 and get a target price of 72, within two years when the makeover will be complete. From Friday's 50.84 close, that implies a 20% return annualized, not too shabby for a large cap dividend stock.
Disclosure – Long OJPAF, COP Jan2011 30 Calls; short COPAI, COP Jan2010 45 calls