Why A Precise Fair Value Estimate Of ConocoPhillips Will Always Be Conceptually Wrong

Feb.21.14 | About: ConocoPhillips (COP)

As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In ConocoPhillips' (NYSE:COP) case, we think the firm is fairly valued at $65--roughly in line with where the stock price is trading. However, as any investor knows, a precise fair value estimate is one that is precisely wrong. Let's work through our thesis on the company and explain why a probable range of fair value outcomes is more appropriate than any single fair value estimate or price target.

But first, a little background. We think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below). More interest --> more buying -- > greater likelihood of price-to-fair value convergence.

If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. ConocoPhillips posts a VBI score of 3 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its unattractive relative valuation versus peers, and bearish technicals. We compare ConocoPhillips to peers BP (NYSE:BP), Chevron (NYSE:CVX), and ExxonMobil (NYSE:XOM). Investors shouldn't panic by this score -- we only grow concerned about firms that register a 1 or a 2 on the scale.

Our Report on ConocoPhillips

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Investment Considerations

Investment Highlights

• ConocoPhillips is an independent exploration and production (E&P) company. The firm completed the separation of its downstream businesses into an independent, publicly traded company, Phillips 66, in April 2012.

• ConocoPhillips' operating results and future rate of growth are heavily dependent on the prices it receives for its crude oil, natural gas, and LNG. The factors influencing these prices are beyond the firm's control.

• ConocoPhillips is fixated on providing investors with a compelling dividend proposition. However, recent cash flow performance has not been stellar. The firm has a hefty net debt position, and given the inherent volatility of commodity prices, we're growing concerned about the growth potential of its payout when cyclical trough conditions inevitably occur.

• We like ConocoPhillips' diversification, scale and capability, all of which we view as competitive advantages against smaller peers. The firm is also well positioned to capitalize on global energy demand, which is expected to grow about 35% by 2040.

• The firm boasts a disciplined investment strategy, with high-return hurdle rates. It plans to spend roughly $16 billion annually through 2017 (Permian, Bakken, Eagle Ford, etc) to drive yearly production growth of 3%-5%.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital ((OTC:WACC)). The gap or difference between ROIC and WACC is called the firm's economic profit spread. ConocoPhillips's 3-year historical return on invested capital (without goodwill) is 6.7%, which is below the estimate of its cost of capital of 10%. As such, we assign the firm a ValueCreation™ rating of POOR. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. ConocoPhillips' free cash flow margin has averaged about 1.6% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At ConocoPhillips, cash flow from operations decreased about 22% from levels registered two years ago, while capital expenditures expanded about 45% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that ConocoPhillips' shares are worth between $52.00 - $78.00 each. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. Why do we use a probable range of fair value outcomes? Click here. The estimated fair value of $65 per share represents a price-to-earnings (P/E) ratio of about 11 times last year's earnings and an implied EV/EBITDA multiple of about 4.9 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 0.6% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -26%. Our model reflects a 5-year projected average operating margin of 28.2%, which is above ConocoPhillips' trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.6% for the next 15 years and 3% in perpetuity. For ConocoPhillips, we use a 10% weighted average cost of capital to discount future free cash flows.

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Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $65 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for ConocoPhillips. We think the firm is attractive below $52 per share (the green line), but quite expensive above $78 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate ConocoPhillips' fair value at this point in time to be about $65 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of ConocoPhillips' expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $81 per share in Year 3 represents our existing fair value per share of $65 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Additional disclosure: CVX is included in the Dividend Growth portfolio.