ConocoPhillips Plans Two Year Makeover

ConocoPhillips (COP) released its 3^rd 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 1^st 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 3^rd and 4^th 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

Comments

[redbaron]

A fair, logical evaluation. Thank you for sharing. I own the stock, also, and agree with your conclusions.

2009 Oct 13 08:09 AM

[31October]

Excellent piece by Mr. Armistead. I stand by what I said on the referenced article. COP has a bad RoE, especially considering debt. The natural gas play is providing COP with un-storable inventory. I would look elsewhere until demand for crude & especially n.gas is on a climb, and inventory is in a long-term decline.

2009 Oct 13 08:42 AM

[jimmy46]

Good analysis Tom, I owned COP a few years ago and it was good to me, I still keep it on my yahoo portfolio so I can see news and stock action.

One thing that bothers me about the company is its "investment" in Lukoil.
They put a lot of money there, have NO management input, and Russia has historically been a place where outsiders get ripped off.
Even some insiders, like the Russian guy in prison because Putin didn't like him.

What value do you place on the Lukoil stake?
If COP needs cash, that's a non core asset I'd think would be at the top of the list to turn to cash.

Does COP get anything besides passive ownership out of it?

Another thing that bothers me is the CEO.
Mulva is one of those hideous CEO's that pay themselves a mind boggleing compensation, and does a horrible job.

Buy high (Burlington), and sell low (now that gas is depressed).

The rest of us try to do it the other way around.

Buffet says COP was a big mistake for him.
He's a very polite person.
He says he likes to take stakes in companies with great management.

Do you think when he says COP was a mistake,
he was referring to the ability of the CEO?

2009 Oct 13 02:45 PM

[Tom Armistead]

jimmy, as you know Warrne Buffett has a very good track record as an investor. So his mistake in buying COP high was on a level with Mulva's mistake buying Burlington Resources high, it's really the same mistake. Warren had the humility to confess his error, of course, he could have been wrong when he thought he was mistaken.

If Mulva has confessed the error of his ways, I haven't seen the article.

I didn't specifically look at the Lukoil thing, my thinking was, after the writeoffs at the end of 2008, when we get the plan to sell ten billion of assets that would be the amount they expect to get for selling the remaining bad assets. What remains will presumably enable them to get the ROE up around 20, maybe a little less. As you say, Lukoil could be part of what needs to go. Maybe Mulva could sell it to Hugo Chavez.

Anyway the carrying value of the Lukoil shares is less than their market value, or was at the end of the 2nd quarter. The 2008 writedowns indluced 7 billion for Lukoil so some progress has been made getting things down to fair value. Maybe all of that provides a way to get around giving some of it back to the Russions, they already wrote it down so the giveaway won't show. I agree doing business with the Russians is an uncertain process, you never know when they are going to change the rules or rewrite the contract, similar to USG under Paulson.

My thought process when I look at a mess like this is I don't try to figure out how management gets from here to there, I just envision and evaluate the final result. Doing the work is management's job, I assume they are capable and basically all I want to know is do they have the resources. COP has huge resources, whether Mulva is the man to downsize the company without wasting them is debatable, I thought 70% recovery on the non-core assets after writedowns have already been taken would allow for any wastage.

Tom

2009 Oct 13 04:31 PM

[jimmy46]

Hello Tom
Zacks has a blog about COP today:

"ConocoPhillips’ earnings from its LUKOIL Investment segment came in at $545 million as against $438 million in the prior-year quarter.
The year-over-year increase came primarily from refinery throughput.
LUKOIL’s estimated contribution to the company’s quarterly E&P volumes was 424,000 barrels of oil equivalent per day.
The Chemicals unit reported earnings of $104 million as against earnings of $46 million a year ago.

I assume the "Chemicals" isn't related to Lukoil,
but zack's editing made it hard to be sure.

I also assume that the $545,000,000 earnings they got from Lukoil is a bookkeeping entry and that they got no cash from them.

finance.yahoo.com/news...

2009 Oct 28 05:02 PM