Long Idea: Conoco Phillips Before The Phillips 66 Spin-Off

Dec.19.11 | About: ConocoPhillips (COP)

Six months have passed since I wrote this article in which we discussed the spinoff of the Conoco Phillips (NYSE:COP) downstream and marketing group into a separate company. At the time, there were a few unknowns about the details and timing of the reorganization which have since been explained in this presentation on Conoco Phillips' website.

At the time, I was cautious on the deal and on the refiners as a whole, as it turned out for good reason. Here is the price performance of some of the companies in this group as of the day after that announcement:

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Here is the six month price chart:

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The overall strategy of COP management was to spin off non-core assets, use the cash to retire debt, make strategically positive investments and "capture value", which is a euphemism for "increase the stock price somehow". The spinoff will occur in the second quarter of 2012 and result in two companies, an upstream E and P company, and the "mid- and downstream" company which will be called Phillips 66.

Conoco Phillips shareholders will receive stock in the new company at the rate of one share of Phillips 66 per two shares of COP. The resulting company will have about 650 million shares outstanding, and will carry about $8B in debt. The new company will be the second largest independent refiner, with a refining capacity of 2 mbpd, which will be accomplished by COP selling or closing some refining assets to reduce capacity from about 2.7 mbpd right now.

According to the company presentation, which is, after all, a "forward looking statement", the spun-off version of the 2011 Phillips 66 would have earned about $2.7B, compared to analysts estimates of $12B for the entire company. (When I did the analysis in July I thought the earnings of the spinoff company would be closer to $2.0B). The difference between the total company earnings and the downstream earnings would be attributed to the upstream portion, and might be about $9.1B if you use to company's numbers..

Based on a conservative PE ratio of 8, and 1.3B shares outstanding, we would be talking about a price of about 56 for the upstream portion of COP.

There are two ways to derive the value of the downstream portion:

If you estimate the price of the downstream business on the basis of 8 times the estimated downstream earnings of $2.75B, you get a selling price of about $34 per share.

If you estimate the price of the downstream business on the basis of the post-spin market capitalization of $18.2B, which is the difference between the current $91B and the market capitalization of the upstream business at a price of $56, we are looking at a price of $28. The market is discounting the analyst earnings estimates for the downstream business by about $6 per share.

Here is the hypothetical value of an investment of 1000 shares of COP before the split, based on these valuations, using a conservative post-spin value for Phillips 66 of 30:

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The market is currently valuing the whole at about 5% under the sum of the parts.

There is an alternate valuation method, which is to estimate the value of the refining capacity.

In a recent article we arrived at the following chart, which is the market value of the refining capacity of some of the major participants in this business:

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At the time of the article I did in July, I was roughly estimating the value of COP's refining capacity at about $6000 per barrel, which at the time was cheap.

Here is an estimate of the share price of COP's refining assets, at the rate of 2 million barrels per day post-spinoff, at various valuations of the company's refining capacity:

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The value of the refining assets, which includes Conoco Phillips' chemical business and some other downstream activities, is plausibly within the realm of the valuations of the other independent refiners. This is a second data point that says that this price of $30 is in the ballpark, which is logical if you assume that the divestiture and closings of refineries will be focused on the least productive assets in the system.

One last chart:

According to the Barclay's presentation, it is the intent of the management to operate the downstream business as a cash generating machine. They intend to distribute 21% of the free cash flow from operations as dividends, Also, the intent is to keep the currently pretty attractive COP dividend of around 4% the way it is, and based on the company's estimates, there could be a significant appreciation in the share price of the spinoff as well on the basis of higher earnings. Naturally, the higher earnings are an optimistic assumption based on the idea that refining margins remain where they are, or return to their historically high levels of earlier in the year.

The other hope is that the upstream business will be valued in the marketplace at something higher than a PE of 8, because it is no longer weighed down by the underperforming refining and marketing business, and there will be some appreciation of the upstream portion as well.

What are the risks in going long on COP at this point?

Well, the most obvious is the possibility that we are into another 2008-like debt implosion, and the entire market will correct like it did in the fall of that year. In 2008, COP went from 90 to 40 and with its current price of around 68, still has not completely recovered. Exxon Mobil (NYSE:XOM) went from 90 to 67 during that same time frame, and the Dow Jones Industrial Average went from 12600 to 7700 and it has not fully recovered either.

The Euro problem: This is a black swan, but the end game is not hard to predict for those with an understanding of math. One reason that the price of oil is high right now is that people are using it as a way to store wealth, because of currency risk in general. A high oil price favors COP and does not necessarily hurt Phillips 66 unless the price gets way out of hand and there is demand destruction like there was in 2008.

The Refining Margin Problem: We just went through a period of unprecedented refining margins, even with relatively low demand, because of the historically unusual spread between WTI and Brent, which gave the users of WTI in the middle of the country a big advantage. Phillips 66 will have 1.2 of its 2.0 million barrels of capacity either on the Gulf Coast or Midwest, so they too would benefit from a continuation of this. There are press releases weekly about some new idea to reverse pipelines, or develop other transportation methods to get landlocked WTI to market at a higher price, and in the next year or two someone will succeed, but not imminently.

Headline Risk: Problems with Iran? Another Arab Spring? Russia issues? These three possibilities all signal a big increase in Brent and a higher WTI/Brent spread which would work in the favor of COP and Phillips 66.

Bernanke Mischief? The College Professor is unlikely to deviate from his current policy with an election coming up.

The most obvious risk is that if the analysts missed their estimates because of operations and/or pricing issues that are related to the industry margins, the valuation of 30 is optimistic, and if that is the case the above valuation will have to be re-thought.

So, understanding the risks, the reward is that there is about 5% upside on the table in the market right now at the current valuation of COP. A prospective investor would end up with the #2 independent refiner, which would spin off cash, including presumably a generous dividend, and would potentially be getting on board when the refining group is beaten down a little. The prospective investor would also end up with a leading upstream company, the presentation above suggests that they would leave their dividend where it is right now, which is about 4% on the current price, and this would represent a pretty good income stream. There is also a chance for a higher multiple as the company moved forward without the refining group.

I was wary of this deal six months ago, but right now, with the refiners cheaper, I am more favorable to the idea.

The world is chaotic, and there are no guarantees of anything. The Ex-Dividend date should be at the end of January. There is still a little time to think about it and let some of the global events work through a little more.

Disclosure: I am long CLMT.

Additional disclosure: I am still delighted with my 8% dividend yield for CLMT.