Oh how we were ahead of this tragedy.
We first started taking note of ConocoPhillips (NYSE:COP) weakening cash flow trends in 2012, highlighting them on Seeking Alpha, "Dividend Investors Should Take Note Of ConocoPhillips' Cash Flow Trends." Those that know the ConocoPhillips story know that the firm slashed its payout by about two thirds in early February of this year; if you had been following our calculation of the firm's Dividend Cushion ratio, you would've been aware of the risk of such as move since late 2012, about the time of the publishing of the article. Imagine how much aggravation the Dividend Cushion ratio could have saved you? At the time of the dividend cut a few months ago, ConocoPhillips registered a -1 (negative 1) on the ratio. We continue to believe the Dividend Cushion ratio is the income investor's best friend.
Now that said, 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. 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.
With that in mind, we're going to call it how it is: ConocoPhillips' dividend is still not safe, even after the cut. 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, for example, net income is impacted by nearly $100 million. Though ConocoPhillips may try to keep its dividend alive in the near term, it will be some time before the company closes the gap to free cash flow neutrality. The company currently registers a 6 on the Valuentum Buying Index.
Conoco Phillips' Investment Considerations
• 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 (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 ~$6+ billion in 2016 (Permian, Bakken, Eagle Ford, etc) to drive yearly production growth. These spending plans will put pressure on organic free cash flow, which continues to bleed.
• ConocoPhillips had been fixated on providing investors with a compelling dividend until it cut it in February 2016. Recent cash flow performance continues to be weak, and the firm retains a hefty net debt position. Given the inherent volatility of energy prices, we continue to be concerned about the health of its payout during cyclical trough conditions.
• 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, having shed its downstream operations.
• 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.
Economic Profit Analysis
From our point of view, 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 8.7%, which is above the estimate of its cost of capital of 8.6%. As such, we assign the firm a ValueCreation™ rating of GOOD.
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. We assign the company an attractive Economic Castle rating, however.
Companies that have strong economic profit spreads are often also solid free cash flow generators, which also lends itself to dividend strength. ConocoPhillips' Dividend Cushion ratio, a forward-looking measure that takes into account our projections for future free cash flows along with net cash on the balance sheet and dividends expected to be paid, is -4 (anything above 1 is considered strong).
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 -0.4% 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. At ConocoPhillips, cash flow from operations increased about 9% from levels registered two years ago, while capital expenditures expanded about 21% over the same time period.
In 2015, ConocoPhillips reported cash from operations of ~$7.6 billion and capital expenditures of just over $10 billion, resulting in free cash flow generation of roughly -$2.5 billion (negative 2.5). This compares quite unfavorably to already negative free cash flow from 2014.
This is the most important portion of our analysis. Below we outline our valuation assumptions and derive a fair value estimate for shares.
We think ConocoPhillips is worth $40 per share with a fair value range of $32-$48. Shares are currently trading at ~$44, in the upper half of our fair value range. This indicates that we feel there is more downside risk than upside potential associated with shares at this time.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance.
Though we are expecting a decline in revenue in 2016 for ConocoPhillips due to continued pressure on crude oil prices, the drop off will not be nearly as significant as that of 2015. Moving forward, revenue will remain tied to prices of the black liquid. As it relates to the firm's bottom-line performance, we are building in significant operating leverage as revenue rebounds in coming years and costs grow at a much more moderate pace comparatively. Management has significantly reduced its capital spending, and we're expecting such a pullback to continue as long as crude prices are suppressed as the company preaches its new found "capital flexibility."
Our model reflects a compound annual revenue growth rate of -5.1% during the next five years, a pace that is higher than the firm's 3- year historical compound annual growth rate of -39.5%. Our model reflects a 5-year projected average operating margin of 2.5%, which is below ConocoPhillips' trailing 3- year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 8.3% for the next 15 years and 3% in perpetuity. For ConocoPhillips, we use a 8.6% weighted average cost of capital to discount future free cash flows.
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 $40 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 were 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 above, we show this probable range of fair values for ConocoPhillips. We think the firm is attractive below $32 per share (the green line), but quite expensive above $48 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 $40 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above 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 $51 per share in Year 3 represents our existing fair value per share of $40 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.
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.