ConocoPhillips: Will Dividend Growth Accelerate?

Jun. 1.14 | About: ConocoPhillips (COP)


Cash flow will likely break even (i.e. capital plans are internally funded) by 2017.

On a sustainable basis, dividend could grow at 7%-8% per annum over the next few years.

Valuation is still reasonable from both absolute and relative perspectives, making the stock a buy.

ConocoPhillips (NYSE:COP) recently declared its 4th quarterly dividend of $0.69 per share for the current cycle. As the next dividend cycle is approaching (starting in July), the market is paying more attention on how much the next dividend hike would be. In this article, I will illustrate my cash flow analysis to provide readers some perspectives on COP's future cash flow and dividends.

To gauge COP's capacity for future dividend growth, I have performed free cash flow projections from 2014 to 2016 (see chart below).

My analysis started with consensus EBITDA estimates which predict EBITDA to increase by 3.9% CAGR from $23.6B in 2014 to $25.4B in 2016. COP's operating cash flow ("OCF") to EBITDA conversion rate ranged from 62% to 84% in the past 3 years at an average of 73%. It is noted that the company's cash flow came in strongly in Q1 2014, resulting in an OCF/EBITDA conversion ratio that was more than 100% in the quarter. To be conservative, I assumed the conversion ratio to be flat at 73% through 2016, which is consistent with its 3-year historical average. For capital expenditure, I used management's guidance of $16.7B for 2014 and assumed the figure to gradually reduce to $16.0B by 2016, which is consistent with consensus view.

Based on these assumptions, free cash flow was projected to grow considerably from $0.6B in 2014 to $2.6B in 2016. In terms of annual dividend spending, I assumed the amount to increase by 7% per annum through 2016 (reasons will be discussed later), resulting in $4.1B dividend spending in 2016. As my projected free cash flow is less than the dividend spending in the 3 forecast years, COP would need a total of $7B funding to cover the deficit in this period. Given COP's current cash balance of $7.7B, net debt to EBITDA ratio of only 0.6x, and management's intention to fund capital plans through continued asset sale, I believe the risk of not being able to close the funding gap to be minimal. For modeling purpose, I assumed the $7B funding gap to all come from future asset sale. Based on my projections, free cash flow dividend payout ratio will reduce substantially from ~600% in 2014 to ~150% in 2016. As COP's cash flow continues to grow (driven by increased production volume) while capex remains steady beyond 2016, cash flow should break even (i.e. capital plans are internally funded) by 2017, meaning that the free cash flow payout ratio could drop below 100% level in 2017 with dividend spending still growing by 7%.

As COP will require additional funding for dividend payment in the next few years, share repurchase will likely be minimal. As such, I assumed no share buyback from 2014 to 2016 and thus number of shares outstanding will stay roughly the same over the forecast period. Based on my estimated annual dividend spending and share count, dividend per share was projected to grow from $2.88 in 2014 to $3.29 in 2016 (see chart below).

Comparing with consensus EPS estimates, my dividend per share forecasts imply that earnings dividend payout ratio will stay within a range between 45% and 50% from 2014 to 2016, which is comparable to historical level. As free cash flow payout ratio will decline over time while earnings payout ratio will stay steadily, my dividend projections are believed to be within a sustainable range.

The table below shows a quarterly breakdown of my annual dividend per share forecasts, which suggests that quarterly dividend per share will grow by 7.5% CAGR over the next 3 dividend cycle, a higher growth than the most recent 4.5% hike in July 2013.

From a valuation perspective, I believe COP's current valuation reasonably reflects the potential higher dividend growth rate. Based on current annualized dividend of $2.76 per share and ~11% cost of equity, the Gordon Growth Dividend Discount Model suggests that the current share price of ~$80 implies a dividend growth rate in a range of 7.0%-7.5%, which is in line with my projection.

On a relative basis, COP's valuation also looks very reasonable. Although the stock's 12.8x forward 2015 P/E multiple is at 6% premium over the average of Exxon Mobil (NYSE:XOM) and Chevron (NYSE:CVX), the company's consensus long-term earnings growth estimate, profitability margins, capital return, and dividend yield are all above peer averages. As such, a modest valuation premium is warranted (see chart below).

Click to enlarge

In conclusion, COP's future dividend growth would accelerate to 7%-8% level due to strong free cash flow potential. As the stock valuation remains reasonable, a buy rating is recommended.

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.