In several prior articles, I have articulated my vision that natural gas should be, and likely will be, the major energy source within the coming decade. In particular, I have highlighted my bullish positions on Chesapeake Energy (CHK) and El Paso (EP). While Chesapeake has immeasurable upside given its leading play exposure, El Paso is an attractive investment given its spin-off. However, all of this is not to say that I am bearish on integrated oils. ConocoPhillips (COP) is one such oil titan that will outperform the market and its peers, while remaining well-exposed to natural gas.
As one of the world's largest energy companie, ConocoPhillips is heavily vertically integrated. It operates in six segments: Exploration & Production (E&P); Midstream, involving natural gas fracking; Refining and Marketing (R&M); LUKOIL Investments; Chemicals; and Emerging Businesses. While analysts currently rate the stock around a hold, I find that management's proposed split will unlock tremendous shareholder value and present investors with resulting companies that offer improved risk/reward and efficiency. The individual parts are just not being properly valued by the market, due to confusions over core competencies and crossover relationships.
Management has proposed creating an Upstream business and a Downstream business. R&M, Chemicals & Marketing will make up the latter unit, and will have $8B worth of debt and $2B worth of cash. It will also offer an additional $0.80/share dividend, effectively raising the yield to 4.5% from around 3.9% currently. The Upstream business will be the flagship enterprise and will carry $18B debt and $6B cash. This unit stands to benefit in the coming years from improved production growth, margin expansion, and development. Shareholders are to receive 1 share of the new company for every 2 shares of COP currently held. The risk/reward is thus highly favorable: while the upside is holding a company to benefit from enhanced capital allocation and managerial support, the safety is nice dividend yield of 4.5%. Not a bad shake.
In addition, corporate fundamentals are strong. Says the CFO:
During the second quarter, we had adjusted earnings of $3.4 billion. That's $2.41 a share. That compares to adjusted earnings of $1.63 a share in the second quarter of 2010. During the quarter, we generated cash from operations of $4.44 per share. This was a good quarter for the company. We ran well both in E&P and R&M. Second quarter production was 1.64 million BOE per day. Our global refining utilization was 91% during the quarter. We generated $6.3 billion in cash from operations. Our annualized return on capital employed was 15% for the quarter, and our cash return on capital employed was 24%. Also, during the quarter, we distributed $4 billion in cash to our shareholders in the form of shareholder distributions -- share repurchases and dividends. Our repurchase of 42 million shares this quarter represented about 3% of our shares outstanding.
Management will continue returning cash to shareholder, likely buying back upwards of a staggering 17% of current market cap in 2012. And on the production side - although Q2 2011 production for the Upstream business was down 5% from Q2 2010, or 93K BOE per day, this decline was due to asset dispositions, the loss of production in Libya, and a drop off in North American natural gas production. My concern is that the company will limit much of its natural gas developments as a result, which I believe will not be beneficial for long-term value creation. Although this energy provides relatively lower margins currently, pressing security demands, environmental standards, changing automobile manufacturing, and the bountiful supply nevertheless make it the way of the future.
Should ConocoPhillips split, it is my hope that the Upstream business moves more into natural gas through the E&P segment, while the Downstream business concentrates on the fractionation of this clean energy source. With $5B to $10B worth of asset sales in 2011 and 2012, the company stands to benefit from improved focused and production efficiency. Shifting production to lower operating mediums could help improve margins per barrel while not requiring a shift away from natural gas.
As more details about the spinoff get released, the stock will appreciate when it gets a clear idea of how less can sometimes be more. Recall that when Standard Oil was controversially broken up in 1911, the stock eventually more than tripled in value. El Paso and ConocoPhillips will benefit, in my opinion, from a similar process.
I anticipate revenue rising by 39.4% to $201B in 2011 and then having a CAGR of roughly 6.5% in the next two years. Consensus estimates for EPS are that it will increase by 39.4% to $8.25 in 2011 and then by 2.1% and 1.8% in the next two years. With the stock trading at 8.6x and 8x past and forward earnings, respectively, ConocoPhillips is undervalued an attractive defensive play.