Last December we made the argument that a potential good idea was to go long on Conoco Phillips (NYSE:COP) at some point before the spin-off of its Phillips 66 (PSX-WI) downstream and mid-stream business.
On April 4th, the final spin-off plans were announced. Shareholders of COP as of April 16, would be given one share of the new company, PSX, for every two shares of COP stock owned. The new stock will begin trading on May 1.
To recap, here is the deal as it appeared last December:
|Calculation made last December||Price||Shares||Cost|
|COP Pre-Spinoff Price||68.55||1000||$ 68,550|
|COP Post-Spin||56||1000||$ 56,000|
|PSX Post-Spin||30||500||$ 15,000|
Based on a couple of different methods of calculating the value of PSX, we arrived at a spin-off price of roughly $30 per share. On that basis, we suggested that the pre-spin price of $68.55 for COP had about a 5% upside, and those who went long at about that time were treated to a nice improvement in stock price. COP traded at about $76 at the time of the cutoff date, so the shareholders who walked away from the commotion that day would have come out ahead.
For the interim period COP is being traded two ways: the "regular way" under the COP symbol, which entitles the buyer to the split, and "COP/WI" (When Issued) in which the buyer does not receive the split.
As of today, the price of PSX/WI is listed at $35.50 and COP/WI is $54.29. Based on this, someone who went long would be looking at the following calculation:
|Calculation as of Apr 24:||Price||Shares||Cost Basis|
|COP "Regular Way" Price||71||1000||71000|
So, either way, the value of the transaction is the same. The value of the transaction is similar to what we predicted last December, notwithstanding the fact that COP bought back some shares since then and the float is smaller. Since trading at about $76 a week ago, there has been a drop of $5 in the COP stock price. This no doubt reflected some issues in the overall marketplace.
The big question: Now what? Should a shareholder go long with the split, go long without the split, or trade PSX before the split?
Here is a price estimate for the upstream portion of COP:
|COP E&P Earnings 1Q ($B)*||2.26|
|Upstream annualized ($B)||9.04|
|Shares Outstanding (NYSE:B)||1.29|
|Current COP PE||8|
|Current MRO PE||12.2|
|Current XOM PE||10.23|
|Stock Price at current COP PE||56|
|Stock Price at current MRO PE||85|
|Stock Price at XOM PE||72|
It's not easy to get to these numbers. The first-quarter E&P segment earnings above were derived from the $2.548 from Page 1 of this quarterly report (pdf), and subtracting the Refining and Marketing, Midstream and Chemicals. Then, I estimated how much of the "corporate expense" is going to be retained by the upstream business. According to page 34 of this report (pdf), about 20% of the roughly $1B corporate expense was attributed to the new PSX portion of the business. Therefore 80% of the 1Q corporate expense is attributed to COP for this calculation, leaving a net of about $2.2B.
Annualizing this by multiplying by 4 gives an annual earnings estimate of about $9 per share. Last year's first-quarter earnings were 28% of the annual earnings, so this is in the ballpark.
The next question is: What will be the earnings multiple of the upstream-oriented COP after the spin-off? COP's current PE is about 8, which would suggest a price of about $56, which is roughly where the "When Issued" portion of the business is right now. I have used Marathon Oil (NYSE:MRO) as a guinea pig. MRO accomplished exactly this type of spin-off last year when it split off Marathon Petroleum Corporation (NYSE:MPC).
When we analyzed that deal, we knew that the strategy was to try to get a higher multiple for the upstream business in the marketplace, and that is exactly what happened. The MRO portion of that transaction is trading at 12 times earnings at the moment, compared with 8 at the time of that announcement a year ago. The MPC portion of the business is now trading at 6.5 times earnings.
Finally I have added in the current PE for ExxonMobil (NYSE:XOM), which everyone loves and is a par for the entire industry.
If COP's management can get what it wants, it can expect the price of the COP portion to be at the very minimum be about where it is, and if there is some justice in the marketplace, possibly considerably higher.
Now, for the downstream portion:
|R&M plus Chemicals plus Midstream Q1 2012 ($B)||0.691|
|Downstream annualized ($B)||2.764|
|Former COP PE||8|
|Current MPC PE||6.5|
|Current VLO PE||5.9|
|Price based on COP PE||34|
|Price based on MPC PE||28|
|Price based on VLO PE||25|
I used exactly the same methodology and table. The earnings estimate is the annualized first-quarter R&M plus midstream plus chemicals minus 20% of the reported corporate expense. The end result is about $4.29 per share.
A quick check, $2.7B above, plus $9B gives $11.7B. This is a little less than the $12.4B reported last year for the entire company. Last year's result did include a $1.7B 4Q profit in the R&M segment due to disposition of assets, so these 2012 estimates have a chance to be pretty close.
For the multiples, I have used the current COP companywide multiple of 8, the MPC multiple, per the conversation above, and the Valero (NYSE:VLO) multiple, Valero being an average independent refiner.
Here is the vulnerability in the plan: The current price of $35.5 is optimistic, and based on the historical multiple of the entire company and does not consider the typical multiple of the other refiners.
There are some compelling reasons to own the PSX part of the business once a reasonable price can be determined, according to the investors presentation. The strategy is to reallocate the capital expenditures to expand the midstream and chemical businesses, and to "rationalize capacity," which means further shutdowns and sales of the least profitable refineries. PSX also plans to pay good dividends and use excess cash from operations to buy back shares. Also, the management estimates $200M/year in possible cost savings and operational improvements are available.
The headwinds PSX faces are the same as the other refiners: An excess of capacity and weak economy in North America and Europe, and the continued situation of a high Brent/WTI spread, which puts refineries outside of the Midwest that use imported crude oil at a disadvantage.
The COP value proposition (pdf) is that once the company is freed of its downstream business, it can focus on expanding its reserves, growing production by 3-5% per year, focusing on efficiency, and spinning off cash for its shareholders.
The headwind, of course, is that the company is in the oil business, and is vulnerable to global financial contagion, revolutions in strange lands, and all of the other risks and problems associated with this industry.
Trading strategy: It is clear to me based on these calculations that the PSX is going to be a bit pricey at $35. When it starts trading after the spin-off it will be vulnerable to a correction. There may be a short sale opportunity in the short run, depending on what happens with the overall market.
The COP price of $54 is roughly correct, based on the 8:1 PE, and notwithstanding any market chaos that might drive it down temporarily. COP has some opportunity on the upside. We do have a precedent in the experience of MRO, but keep in mind that last fall, after the crude oil price corrected, MRO was trading in the 5-6 PE range. You might have to wait patiently for the seasonality to minimize your entry price.
Do you go long now, and avoid the rush? Keep in mind also that it is common for there to be some post-spin-off weakness, as there was with MRO, and the real buying opportunity might be a little later.
As we are so fond of saying, the world is full of chaos and there are no guarantees on anything, and anyplace in the above discussion where I used the word "if," there is an opportunity for uncertainty.
Do with this information what you will.
We will check back in a couple of weeks and see how everything shakes out.