ConocoPhillips: The Uptrend Will Not End Here

May.12.14 | About: ConocoPhillips (COP)


Improving cash margins and lower capital spending over time will drive notable free cash flow growth.

Although asset sale is still required to partially fund dividend commitment over the next few years, the funding need is limited.

There will be sufficient capacity to support a 6-7% annual dividend growth.

Current valuation reasonably reflects the dividend prospects.

The share price of ConocoPhillips (NYSE:COP) is on the rise and has appreciated by 22% since February, compared to a return of just 7% for S&P 500 Index. In my view, the stock remains a buy for income investors who are seeking exposure to global oil majors due to COP's healthy dividend prospects and inexpensive share valuation.

COP delivered strong Q1 2014 results with both top line and EPS beating market expectations driven by healthy production growth. A notable development in the quarter was 20% year-on-year increase in cash margin as COP continues to increase portfolio weighting toward liquids production. Given the company's liquids-rich project backlog, I believe the increasing cash margin should continue over the next few years. There are a few projects expected to come on line over the next 1-2 years (e.g. Gumusut, Surmont, and Kenai LNG expansion etc.), and the completion of these pending operations will reduce capital spending in the coming years.

I have performed an illustrative cash flow analysis to test COP's capacity to cover its capital programs such as capital expenditure and dividend payout (see chart below).

Click to enlarge

Over the past 5 years, COP has been able to maintain its EBITDA to operating cash flow ("OCF") conversion ratio at above 60% (or at an average of 75%). Based on consensus EBITDA estimates from 2014 to 2016 and my assumption that EBITDA to OCF ratio will increase from 75% in 2014 to 77% in 2016 thanks to the higher cash margin trend (COP's "clean" OCF (excluding working capital benefits and equity distribution) and EBITDA came in at $4.4B and $5.8B, respectively, in Q1 2014, suggesting an EBITDA to OCF ratio of 76%), OCF was projected to reach $19.5B by 2016. My capex assumption for 2014 was based on management guidance at $16.7B. I assumed lower capex in 2015 and 2016 due to new project completion. Based on the fair assumptions, free cash flow was projected to increase from $0.8B in 2014 to $3.7B in 2016. In order to support, say, 7.0% annual dividend growth, COP will need to secure funding deficit of $2.7B, $1.7B and $0.5B in 2014, 2015, and 2016, respectively, as internally-generated cash flows are not sufficient to cover capital distribution at 7% annual growth. Management has previously indicated their intention to fund the deficit through sale of non-core assets. Given that 1) future divestiture requirement ($4.9B in 3 years) is relatively low compared to COP's $14.5B asset sale in the past 3 years and 2) the company is on track to close its $1.5B Nigerian asset divestiture in 2014, I believe the required funding need can be comfortably met.

In the case that the divestiture process does not work out as planned, funding can come from COP's current cash balance of $7.7B and additional debt borrowing given that the company's current leverage is in line with its global oil major peers. As shown below, COP's net debt to EBITDA and total debt to capital ratios are fairly consistent with peer averages. As such, dividend growth should remain secure in the foreseeable future.

In terms of valuation, I believe the shares are inexpensively priced. Based on current annualized dividend of $2.76 per share and a 10.5% cost of equity (the CAPM model would result in a 10.3% cost of equity based on 3% risk-free rate, 6% equity risk premium, and COP's 5-year beta of 1.2), the Gordon growth dividend discount model suggests that the current share price of ~$77 implies a dividend growth rate at slightly above 6.5% (see sensitivity table below). As demonstrated by my cash flow analysis, COP would have the capacity to cover a 7% annual dividend growth over the next few years. As such, the assumption embedded in the current share price is believed to be reasonable in my opinion.

From a relative perspective, one can draw a similar conclusion. COP now trades at 4.6x forward 2015 consensus estimated EBITDA, which is at 8% discount to the average EBITDA multiple of its global oil major peers. The stock's 2015 forward P/E is at 12.7x, at 6% premium over peer average. Given that COP's consensus long-term earnings growth estimate of 7.9% is above peer average at 6.7% and both the company's return on equity and return on captain metrics are largely above par, the premium P/E valuation is completely warranted (see chart below). In addition, despite COP's price outperformance relative to S&P 500 Index since February, the stock's forward P/E multiple remains at 14% discount to S&P 500's 14.6x. As COP's long-term earnings growth potential is close to the average estimate of 8.5% for S&P 500 companies and its dividend yield (3.6%) is way above S&P 500's average at just 1.9%, the valuation gap looks attractive.

Click to enlarge

In conclusion, in near term, the funding deficit for dividend commitment is expected to be backed by continued sale of non-core assets. Given management's proven divestiture execution and the funding requirement is much less in the future than in the past, potential risks are limited. Over a longer term, as COP continues to see improved cash margins and less requirement for capital spending, free cash flow should experience notable growth, and COP would likely be able to fund its dividend program completely by free cash flow by 2017. As current stock valuation has reasonably reflected the dividend growth prospects, income investors are recommended to accumulate shares at the current level.

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.

Disclosure: I am long COP. 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.