Since reaching its 52-week high of $74.59 in October 2013, share price of ConocoPhillips (COP) has lost 12%, compared to a 4% return for the S&P 500 Index. I believe the recent price weakness has presented a buying opportunity for the stock as valuation has come down but fundamentals and positive catalysts remain intact.
Owing to the price decline, COP now trades at 10.8x 2015 forward P/E multiple, which is at 31% discount to S&P 500's 15.6x (see chart below). I believe the current valuation discount to be somewhat stretched and thus should present a buy signal because 1) COP traded at an average discount of 24% in the past 12 months and there has not been any notable deterioration in the company fundamentals over the past 12 months that warrants a deeper discount; 2) the company's consensus long-term earnings growth potential of 7.4% is not significantly off from the average estimate for S&P 500 companies; and 3) the stock offers a 4.2% dividend yield, which considerably exceeds S&P 500's average at just 1.9%.
COP also looks attractively priced when comparing to its U.S. comps. The stock's P/E multiple trades at 11% discount to comps average despite the facts that COP has a superior long-term earnings growth potential and provides a better return on common equity, as well as a much higher dividend yield. By considering the earnings growth estimate, COP trades at 1.5x PEG, which is 27% below the comps average at 2.0x (see chart below).
Looking forward, I expect the following developments to drive a meaningful price upside:
- Near-term liquidity position looks healthy as pending divestiture of Nigerian assets is expected to be closed in 2014 with a sale proceeds of approximately $1.8B. Further, funding needs would likely start to decline beyond 2014 owing to operation commencement from high-margin projects which would lead to higher cash flow generation.
- Management's ongoing effort to shift production mix towards higher-margin natural gas liquids (NGL) is expected to continue supporting margins. Production volumes for NGL from Lower 48 and Canada continue to rise while dry gas production has fallen. Going forward, it is expected that production ramp-up from COP's high-margin growth projects, such as the U.S. unconventional assets (i.e. Eagle Ford, Bakken, and Permian), Canadian oil sands, and the U.K. North Sea projects would not only support management's goal of 3% to 5% long-term production growth, but also support a healthy profit margin.
- Among the mega-cap universe (i.e. COP, Exxon Mobil (XOM), and Chevron (CVX)), I believe COP should draw the most interests from investors owing to the facts that 1) COP has experienced notable improvement in production margin and cash flows over the past few years, exceeding the performance for both XOM and CVX; 2) the profitability prospect for COP is brighter as its production has been shifting towards NGL; 3) COP trades at much lower PEG at 1.5x, compared to XOM's 2.6x and CVX' 2.0x; and 4) COP offers the highest dividend yield.
- There is a fair chance for a positive surprise from management's future updates on resources in Eagle Ford and Bakken, as the company has only booked less than 30% of identifiable resources in these regions, which is based on management's well spacing assumptions at 80 acres in Eagle Ford and 320 acres in Bakken.
- COP faces limited geographical risk given that 75% of the company's profits are generated from 5 developed countries (i.e. the U.S., Canada, the U.K., Australia, and Norway).
In summary, COP's risk-reward profile has become much more attractive after the pullback as upside would likely be driven by continued monetization of the high-margin projects, while downside is limited by the current low valuation. A buy rating is thus warranted.
All charts are created by the author and data used in the article and the charts is sourced from S&P Capital IQ, unless otherwise specified.