ConocoPhillips - Long-Term Appeal Remains, Short-Term Potential Is Limited After A Huge Run-Up

Jun.12.14 | About: ConocoPhillips (COP)

Summary

ConocoPhillips was upgraded by Howard Weil after shares have already risen 23% over the past quarter.

While I completely agree with the upgrade, I believe the timing is a bit ¨poor¨ after this run-up.

I remain a buyer on significant dips given the appealing valuation, growth and great cash flow profile.

Shares of ConocoPhillips (NYSE:COP) bucked the trend on Wednesday trading up slightly on a day when the wider market was trading down.

Analysts at Howard Weil saw further upside for Conoco after shares had already risen 23% over the past three months. Shares were trading in their low sixties as recent as during February's correction.

I continue to see Conoco's long-term appeal, yet the strong momentum limits the short-to-medium appeal in my opinion.

Howard Weil Sees More Upside

Analyst Blake Fernandez upgraded ConocoPhillips from sector perform to sector outperform. At the same time the price target was raised by 20% to $90 per share.

Fernandez has gained trust and comfort in the stock after "spending time" with executives. Increased production, improved efficiency and the positive developments outlined on Conoco's recent analyst day are the foundations for his optimism.

Further top-line production growth will boost earnings per share growth in the coming years as Fernandez sees further cash flow accretion in the coming years. After years of rationalization, the asset base is expected to deliver a 6-10% cash flow compounded annual growth rate through 2017. This should be driven by 3-5% production growth and a similar increase in margin expansion.

Investor Presentation

At the end of May, ConocoPhillips held its investor update presentation. The company stressed its commitment to deliver double-digit returns to its shareholders.

Its 1.53 million barrels of oil-equivalent production should increase by 3-5% per annum towards 2017. Fortunately nearly 9 billion in BOE reserves allows Conoco to continue current production levels for the coming 15-16 years. Production is set to grow towards 1.8 to 1.9 million barrels of oil-equivalent by 2017.

What is interesting in the light of anticipated production growth is the fact that Conoco aims to keep its investment budget flat at $16 billion from 2013 to 2017. The company will however shift its focus from major products more towards development programs which tend to be less risky and more predictable.

Growth will be tailored towards oil production, predominately in oil sands and unconventional North American assets. These assets tend to carry relatively high cash margins, as the company will reduce the focus on natural gas.

Cash Flow Bonanza

While capital expenditures are seen flat at $16 billion in the 2013-2017 period, ConocoPhillips anticipates its cash flows from operations to increase from $15.8 billion in 2013 to $20-$23 billion in 2017.

Note that the positive and increasing gap between those anticipated operational cash flows and capital investments will result in very strong free cash flows for the business. This is especially true given that Conoco earns about $8-$10 billion per annum already.

The past investments have however resulted in a modest built up in leverage. Conoco has access to $7.7 billion in cash and equivalents, which results in a net debt position of $13.5 billion given the firm's $21.2 billion in debt. This is very manageable given the strong cash flow and earnings profile of the business.

Valuing ConocoPhillips

At $82 per share, equity in ConocoPhillips is valued at roughly a $100 billion. Note that this values the company at roughly 11 times annual earnings assuming normal earnings of $9 billion.

This is appealing; however, note that the company could see its operational cash flows match capital investments already next year. If by 2017, this gap has risen to $4-7 billion, cash flows available to return to investors could amount to $14-$17 billion per annum based on a $10 billion future earnings assumption.

The company has not repurchased shares over the past quarters but instead focuses on dividends to return cash to investors. Its current dividend of $0.69 per quarter provides investors with a 3.4% dividend yield.

Takeaway For Investors

The timing of the upgrade is remarkable as indeed shares have already risen 23% over the past quarter which is a huge move for such a large company.

That being said, I completely agree with Howard Weil seeing further potential for Conoco given the growth profile, attractive valuation and appealing free cash flows in the coming years. I continue to like the shares and am willing to increase my position on dips around $75 per share.

Disclosure: The author is long COP. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.