By The Valuentum Team
ConocoPhillips' capital spending may pressure dividend growth.
--> ConocoPhillips (NYSE:COP) 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 (NYSE:PSX), 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.
--> The firm boasts a disciplined investment strategy, with high-return hurdle rates. It plans to spend ~$10+ billion annually through 2017 (Permian, Bakken, Eagle Ford, etc) to drive yearly production growth of 2%-5%. These spending plans will put pressure on organic free cash flow, and falling energy resource pricing won't help.
--> 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.
--> 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. The company's biggest hurdle will remain the lower price of crude oil, however, and a return to yesteryear's prices may never happen.
--> 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, and recent energy resource pricing malaise has punished the company's results.
Note: ConocoPhillips' annual dividend yield is well above average, offering a ~6.35% yield at recent price levels. Though we generally prefer yields above 3% in our dividend growth portfolio, other factors keep ConocoPhillips from attracting our consideration for addition. A dividend cut may be on the horizon should energy resource prices remain at multi-year lows. We're concerned.
There's a lot of wonderful things we can say about ConocoPhillips. The company has a diversified asset base with material scope, and a number of large positions in key resource areas. At year end 2014, the company had 44 BBOE resources comprising mostly of liquids (~70%). The upstream giant offers investors multiple sources of production growth as it retains relatively low execution risk. Massive capital spending cuts have proven to be a prudent move to shore up cash retention during these difficult times, but it's hard to overlook the entity's massive net debt position. Continued portfolio optimization (deepwater exit) and operating cost reductions are the best hope to keep the dividend afloat if commodity prices do not recover.
We're going to call it how it is: ConocoPhillips' dividend is not safe. Though the company continues to slash capital spending, the collapse in energy resource pricing is hurting operating performance in a big way. Having spun off its downstream assets, ConocoPhillips now more than ever is exposed to volatile commodity prices. For a dollar change in Brent crude, net income is impacted by nearly $100 million. Though ConocoPhillips may increase the dividend in the near term, it will be some time before the company closes the gap to free cash flow neutrality. A prolonged period of low energy resource pricing could result in a dividend cut. A negative Dividend Cushion ratio is a clear warning sign.
From the Comments Section: How to Interpret the Dividend Cushion Ratio -- A Ranking of Risk
As for how to interpret the Dividend Cushion ratio, itself, it is a measure of financial risk to the dividend, much like a credit rating is a measure of the default risk of the entity. Said differently, a poor Dividend Cushion ratio of below 1 or negative doesn't imply the company will cut the dividend tomorrow, no more than a junk credit rating implies a company will default tomorrow. That said, the Dividend Cushion ratio does punish companies for outsize debt loads because in times of adverse conditions, entities often need to shore up cash, and that means the dividend becomes increasingly more risky.
We think investors should look at a variety of different metrics in assessing the sustainability of the dividend. Because the Dividend Cushion ratio is systematically applied across our coverage, it can be used to compare entities on an apples-to-apples basis. Dividend payers with significant free cash flow generation and substantial net cash on the balance sheet often register the highest Dividend Cushion ratios, as they should. These companies have substantial financial flexibility to keep raising the dividend.
We think the safety of ConocoPhillips' dividend is very poor. Please let us explain.
First, we measure the safety of the dividend in a unique but very straightforward fashion. As many know, earnings can fluctuate, so using the payout ratio in any given year has some limitations. Plus, companies can often encounter unforeseen charges, which makes earnings an even less-than-predictable measure of the safety of the dividend. We know that companies won't cut the dividend just because earnings have declined or they had a restructuring charge that put them in the red for the quarter (year). As such, we think that assessing the cash flows of a business allows us to determine whether it has the capacity to continue paying dividends well into the future.
That has led us to develop the forward-looking Dividend Cushion™ ratio, which we make available on our website. The measure is a ratio that sums the existing net cash a company has on hand (on its balance sheet) plus its expected future free cash flows (cash flow from operations less capital expenditures) over the next five years and divides that sum by future expected cash dividends over the same time period. Basically, if the score is above 1, the company has the capacity to pay out its expected future dividends and the expected growth in them.
As income investors, however, we'd like to see a ratio much larger than 1 for a couple of reasons: 1) the higher the ratio, the more "cushion" the company has against unexpected earnings shortfalls, and 2) the higher the ratio, the greater capacity a dividend-payer has in boosting the dividend in the future. For ConocoPhillips, this ratio is -1, revealing that on its current path the firm will have some difficulty covering its future dividends and growth in them with net cash on hand and future free cash flow.
Dividend Cushion Ratio Cash Flow Bridge
The Dividend Cushion Cash Flow Bridge, shown in the graph below, illustrates the components of the Dividend Cushion ratio and highlights in detail the many drivers behind it. ConocoPhillips' Dividend Cushion Cash Flow Bridge reveals that the sum of the company's 5-year cumulative free cash flow generation, as measured by cash flow from operations less all capital spending, plus its net cash/debt position on the balance sheet, as of the last fiscal year, is less than the sum of the next 5 years of expected cash dividends paid.
Because the Dividend Cushion ratio is forward-looking and captures the trajectory of the company's free cash flow generation and dividend growth, it reveals whether there will be a cash surplus or a cash shortfall at the end of the 5-year period, taking into consideration the leverage on the balance sheet, a key source of risk. On a fundamental basis, we believe companies that have a strong net cash position on the balance sheet and are generating a significant amount of free cash flow are better able to pay and grow their dividend over time.
Firms that are buried under a mountain of debt and do not sufficiently cover their dividend with free cash flow are more at risk
of a dividend cut or a suspension of growth, all else equal, in our opinion. Generally speaking, the greater the 'blue bar' to the right is in the positive, the more durable a company's dividend, and the greater the 'blue bar' to the right is in the negative, the less durable a company's dividend.
Dividend Cushion Ratio Deconstruction
The Dividend Cushion Ratio Deconstruction, shown in the graph below, reveals the numerator and denominator of the Dividend Cushion ratio. At the core, the larger the numerator, or the healthier a company's balance sheet and future free cash flow generation, relative to the denominator, or a company's cash dividend obligations, the more durable the dividend. In the context of the Dividend Cushion ratio, ConocoPhillips' numerator is smaller than its denominator suggesting weak dividend coverage in the future. The Dividend Cushion Ratio Deconstruction image puts sources of free cash in the context of financial obligations next to expected cash dividend payments over the next 5 years on a side-by-side comparison. Because the Dividend Cushion ratio and many of its components are forward-looking, our dividend evaluation may change upon subsequent updates as future forecasts are altered to reflect new information.
Please note that to arrive at the Dividend Cushion ratio, divide the numerator by the denominator in the graph below. The difference between the numerator and denominator is the firm's "total cumulative 5-year forecasted distributable excess cash after dividends paid, ex buybacks."
Now on to the potential growth of ConocoPhillips' dividend. As we mentioned above, we think the larger the "cushion" the larger capacity the company has to raise the dividend. However, such dividend growth analysis is not complete until after considering management's willingness to increase the dividend. To do so, we evaluate the company's historical dividend track record. If there have been no dividend cuts in the past 10 years, the company has a nice dividend growth rate, and a solid Dividend Cushion ratio, we characterize its future potential dividend growth as excellent. ConocoPhillips however has a dividend growth rating of very poor.
Because capital preservation is also an important consideration to any income strategy, we use our estimate of the company's fair value range to assess the risk associated with the potential for capital loss. In ConocoPhillips' case, we currently think shares are fairly valued, meaning the share price falls within our estimate of the fair value range, so the risk of capital loss is medium (our valuation analysis can be found by downloading the 16-page report on our website). If we thought the shares were undervalued, the risk of capital loss would be low. Please visit our website for our valuation assumptions.
Wrapping Things Up
Though ConocoPhillips' diversification, scale, and capability are competitive advantages against smaller peers, the firm is now more sensitive than ever to volatile commodity prices. Capital spending cuts have proven to be appropriate given the recent collapse in crude oil prices, but it is impossible to overlook the firm's high net debt load when there is significant pressure on its operations. Despite the reductions in capital spending, it may be some time before ConocoPhillips gets back to positive free cash flow generation. This causes us significant pause when considering the company and its dividend, which we feel is not safe by any means.
Breakpoints: Dividend Safety. We measure the safety of a firm's dividend by adding its net cash to our forecast of its future cash flows and divide that sum by our forecast of its future dividend payments. This process results in a ratio called the Dividend Cushion. Scale: Above 2.75 = EXCELLENT; Between 1.25 and 2.75 = GOOD; Between 0.5 and 1.25 = POOR; Below 0.5 = VERY POOR.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.