Whoa! ConocoPhillips Has Moved Too Far Too Fast

Jun.25.14 | About: ConocoPhillips (COP)


ConocoPhillips has made its shareholders very happy.

The company's share price is starting to get ahead of fundamentals, however.

We think investors should expect some profit-taking way up here.

ConocoPhillips (NYSE:COP) has been wonderful for shareholders as of late. From the spin-off of Phillips 66 (NYSE:PSX) and then its spin-off of Phillips 66 Partners (PSPX), original holders of ConocoPhillips from just a few years ago are rolling in the doe! But what can investors expect from here on out? Let's calculate ConocoPhillips' intrinsic value and run shares through the Valuentum process.

Understanding What Moves Stock Prices

For those that may not be familiar with our boutique research firm, 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. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. 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.

Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.

We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.

At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. ConocoPhillips posts a Valuentum Buying Index score of 5, reflecting our "fairly valued" DCF assessment of the firm, its unattractive relative valuation versus peers, and neutral technicals. Given ConocoPhillips' rapid stock price rise recently, readers probably shouldn't be too surprised by this rating. A score of a 5 is middle-of-the-road in our coverage universe, but it's worth noting that this assessment is based only on the company's valuation and technical/momentum indicators. ConocoPhillips has strong fundamentals, and let's keep reading as to why.

ConocoPhillips' 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. It has also been engaged in selling non-core assets, but these one-time cash proceeds will eventually come to an end.

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

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

• The firm boasts a disciplined investment strategy, with high-return hurdle rates. It plans to spend ~$16 billion annually through 2017 (Permian, Bakken, Eagle Ford, etc) to drive yearly production growth of 3%-5%. These spending plans will put enormous pressure on organic free cash flow.

• 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 largely beyond the firm's control.

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 with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. ConocoPhillips' 3-year historical return on invested capital (without goodwill) is 8.3%, which is below the estimate of its cost of capital of 9.4%. 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 -0.2% during the past 3 years. As such, we think the firm's cash flow generation is relatively WEAK. 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 increased about 9% from levels registered two years ago, while capital expenditures expanded about 17% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that ConocoPhillips' shares are worth between $54-$82 each. The company's stock price rise has been so parabolic that by the time we finished transcribing our report onto Seeking Alpha, shares rocketed above the high end of the fair value range. Investors should expect the firm to come out as OVERVALUED upon the next update, all things equal. It may be fair to expect some profit taking at present levels of $85 per share.

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. The estimated fair value of $68 per share represents a price-to-earnings (P/E) ratio of about 10.6 times last year's earnings and an implied EV/EBITDA multiple of about 4.7 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 3.1% during the next five years. Our model reflects a 5-year projected average operating margin of 25.8%, which is above ConocoPhillips' trailing 3-year average. We think there could be upside side to these fundamental forecasts, but even the high end of the fair value range (which considers more optimistic forecasts) has been breached by ConocoPhillips share price. The company is in heavy favor.

Beyond year 5, we assume free cash flow will grow at an annual rate of 10.6% for the next 15 years and 3% in perpetuity. For ConocoPhillips, we use a 9.4% weighted average cost of capital to discount future free cash flows. The discount rate and perpetuity growth rate are appropriate for a company of ConocoPhillips' size and risk profile.

We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare ConocoPhillips to peers BP (NYSE:BP) and ExxonMobil (NYSE:XOM), among others.

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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 $68 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 $54 per share (the green line), but quite expensive above $82 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 $68 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 $84 per share in Year 3 represents our existing fair value per share of $68 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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In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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. PSX is included in the Dividend Growth portfolio.