Why ConocoPhillips Is Undervalued Right Now

| About: ConocoPhillips (COP)

This article is part of an ongoing series that highlights specific companies that are on sale. It helps me to document my thought processes when I add to my holdings or initiate new positions. Please provide your feedback in the comments section below.

ConocoPhillips (NYSE:COP) is currently offering investors an opportunity to buy portions of the company at $70/share. This is near the 52-week high, just hit about a week ago at over $71 per ownership interest. ConocoPhillips has been rising steadily for the past six months. This brief, albeit small, pullback provides long-term investors with a good opportunity to initiate a position.

COP has a business model that is sustainable. They have been focusing on improving margins for the past couple years, including the spinoff of Phillips66 (NYSE:PSX). According to the 2012 annual report, COP's crude oil average realized price has risen over 30% over the past two years, which would imply that they have been able to successfully pass along price increases to their customers.

ConocoPhillips had 8.6 billion barrels of proven reserves at the end of 2012, and it has been increasing this amount year over year. Additionally, their organic reserve replacement ratio has been over 120 for each of the past three years. Even if the price of oil declines to $50/barrel, the value of the oil is still hundreds of billions of dollars. Of course, there are costs associated with extracting this oil, and COP will not be able to realize the entire value as profit. What this illustrates, rather, is that the company is not dependent on the discovery of new oil for it to continue its current upward trend. It could still earn $7/share, buy back shares outstanding, and continue paying its dividend with the oil that it's sitting on. Additional discoveries will only increase future earnings.

COP currently sports a P/E of 11.4x. I would expect to see multiple expansion in the coming months due to the recent dividend increase. Prior to the increase, COP also traded at just under 11x earnings. There may be a small window here to acquire additional shares at the higher yield before the price increases further.

The payout ratio remains very strong at about 44%. By having a relatively high payout ratio, your investment is realizing higher current yields. The company still has room to increase the dividend, even if earnings should stagnate or decline. Additionally, ConocoPhillips has enough cash on the balance sheet to fully fund the dividend for more than the next year, even if the company stopped making any money.

The dividend is elevated as well. Because the stock is priced at a discount, I believe, your entry yield is a bit higher than it might be in the future. In fact, ConocoPhillips increased their annual dividend by 5% for this last payout. Currently, the yield is 3.92%. This yield acts as a floor for the stock price. If the price were to decline further the yield would increase, enticing investors to bid the price back up.

The catalyst to propel COP higher in the near future will be the Q3 earnings release. The Q2 earnings beat analyst estimates, but the average price of oil was much lower during the quarter at about $94. For most, if not all, of Q3 the price of oil has been well over $100, even over $105. This is a 6%-10% higher price that COP will be realizing. Even if production remains the same, they will be benefiting from the higher oil prices. The consensus analyst estimate for Q3 EPS is $1.44. This is only 2% higher than the Q2 EPS of $1.41. I believe that ConocoPhillips will beat the consensus, providing a catalyst to propel the stock price higher. Investors may want to buy COP now before the Q3 earnings release.

As always, this article represents my opinions at the time of writing. You should do your own due diligence before making any decisions. However, I believe that COP represents a quality company that is trading hands at a discount.

Disclosure: I am long COP, PSX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.