With the recent meteoric rise of ConocoPhillips' (NYSE:COP) spin-off Phillips 66 (NYSE:PSX), we thought we'd take a closer look at its former parent and evaluate whether ConocoPhillips is a Valuentum stock.
Our Report on ConocoPhillips
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Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. ConocoPhillips's three-year historical return on invested capital (without goodwill) is 7.2%, which is below the estimate of its cost of capital of 10.5%. As such, we assign the firm a ValueCreation™ rating of Poor. 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.
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's free cash flow margin has averaged about 2.4% during the past three years. As such, we think the firm's cash flow generation is relatively Medium. 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 57% from levels registered two years ago, while capital expenditures expanded about 22% over the same time period.
Our discounted cash flow model indicates that ConocoPhillips's shares are worth between $47.00 and $77.00 each. The margin of safety around our fair value estimate is driven by the firm's Medium ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $62 per share represents a price-to-earnings (P/E) ratio of about 6.9 times last year's earnings and an implied EV/EBITDA multiple of about 3.6 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of -23.5% during the next five years, a pace that is lower than the firm's three-year historical compound annual growth rate of 0.7%. Our model also reflects a five-year projected average operating margin of 19.4%, which is above ConocoPhillips's trailing three-year average. Beyond year five, we assume free cash flow will grow at an annual rate of 2.1% for the next 15 years and 3% in perpetuity. For ConocoPhillips, we use a 10.5% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
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 $62 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 was 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 below, we show this probable range of fair values for ConocoPhillips. We think the firm is attractive below $47 per share (the green line), but quite expensive above $77 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's fair value at this point in time to be about $62 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of ConocoPhillips's 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 three 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 $78 per share in year three represents our existing fair value per share of $62 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.
Pro Forma Financial Statements
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. COP and PSX are included in our Dividend Growth portfolio. 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.