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By Mark Bern, CPA CFA

ConocoPhillips (NYSE:COP) is one of my favorite stocks for dividends. The dividend has risen for 11 consecutive years and currently provides a yield of 3.7 percent. Even when earnings tanked during the Great Recession of 2008-2009, COP raised the dividend. How was it able to do this?

The company has historically kept its payout ratio relatively low, providing the flexibility to continue raising the dividend when times are bad. Even in 2008, when earnings dropped by 70 percent from record levels of 2007, the payout ratio climbed to only 57 percent. The ratio currently stands at about 32 percent so, once again, the company has flexibility.

Another way to look at it is to compare the cash on hand to the amount paid out to dividends. As of September, cash stands at about $3.4 billion and the company also has about $2.6 billion in short-term investments while the most recent quarterly dividend payment amounted to about $900 million. The company also generates over $20 billion a year in cash flow, of which about $13.3 billion is used for capital expenditures, leaving nearly $7 billion to service and pay off maturing debt. Long-term interest is about $1.5 billion per year and the company has about $7 billion in debt maturing over the next five years. I’d say that the dividend is very well covered.

Now, as to future prospects, I believe in the peak oil theory, but I just don’t see it peaking just yet. As demand continues to inch higher nearly every year oil companies somehow seem to find more reserves. I remember when someone said that all the really big oil reserves have been found several years ago and yet we see new major finds coming into play pretty regularly.

The new reserves are often harder to get and more expensive to extract, but as long as it remains profitable to do so I suspect we’ll keep finding ways to add to reserves and meet the world’s needs for another decade or two before the problem gets serious. And then the common people who have to pay the constantly rising prices will decide that the environment maybe isn’t quite so precious and demand that vast known reserves that have heretofore been off limits be tapped as well. I’m not trying to take sides here; I’m just saying that it is human nature for the majority to change its mind about things when the cost of not changing becomes too painful. And what is my point? I believe that COP is very well positioned to lead the charge when that change comes and it is taking advantage of new extraction technologies available today to increase its output.

On the downside, I believe that at the current price the appreciation potential for COP may be somewhat limited. From where we stand now, I expect earnings to increase in the mid- to high single-digits over the next few years while dividends may rise slightly faster, but still in the high single-digit area. The current dividend is $2.64 per share and I believe it should rise to at least $3.50 over the next five years.

While the P/E ratio seems low at 9.3 (trailing twelve months) the historical average is only about 10. So, it is not realistic to expect too much multiple expansion to help the price. But the good news is that the stock is not over priced and remains poised to appreciate along with earnings and dividends.

I know readers will ask questions about certain issues if I don’t discuss them here so I’ll do my best to cover those that I believe likely to be most material to future earnings prospects and shareholder values. First, there is the issue of the company splitting itself into two separate entities: the Refining and Marketing division is to be split from the Exploration and Production division and each will be a stand-alone, publicly traded company.

The split will be accomplished through a tax-free spinoff to shareholders pending regulatory approval. If you own the stock, as I do, you may want to consider how each new company is valued relative to its peers at the time of the spinoff. Personally, I prefer the exploration and production unit because I believe it has more long-term potential for growth and will likely be less volatile. That, of course, is my opinion. Readers are encouraged to voice their opinions in the comments section and convince me otherwise.

Next there is the oil spill at the Bohai Bay unit in China. This is really more of a production problem that will be addressed. The clean-up issues will be expensed as an unfortunate part of doing business in this sector. But this is all manageable and, in my opinion, will be addressed in due course without significant adverse effect on long-term prospects.

Finally I have to bring up the Libyan operations. Honestly, I don’t know what the outcome will be here. I expect that Libyan officials will figure out that they need help. I just don’t know what their political leanings are and whether or not COP leadership in the area has the relationship with them necessary to get things back on track.

What I do know is that I can put the importance of the region to COP into perspective (or at least I’m going to try). COP owns a 16.3 percent interest in the Waha Concession. The operator is Waha Oil Company, a wholly owned subsidiary of the Libyan National Oil Corporation. Total 2010 production was approximately 340 million barrels of crude oil equivalent (boe). That means COP’s share of production was about 54.4 million boe.

In 2010, COP had total production of 903 million boe from crude oil and natural gas liquids (ngls). So the Libyan piece equaled about six percent of total worldwide production of crude oil and ngls. But COP also had production of 4.4 billion cubic feet of natural gas as well as production of bitumen and synthetic oil.

Total worldwide production equaled approximately 1.762 billion (boe), making the potential loss of Libyan production equal about 3.1 percent of the total. So, while this could end up being a significant loss of investment and production, it is not earth-shattering for COP. The company will survive whatever the outcome. In the worst case scenario, COP will accrue some significant tax write-offs to help offset some of the financial pain.

In the end, I believe that COP has a good future in store for its investors that continue to hold the stock for the long-term. The dividends help ease the pain of slower potential growth and will continue to rise for the foreseeable future. I expect the annual increase in dividends to average near nine percent over the next few years. I kind of like looking forward to those increases to an already above average yield.

Source: ConocoPhillips: Great Dividend With Solid Prospects For Growth