You Can Profit From This Company's Split

Recently, ConocoPhillips (NYSE: COP  ) completed its spinoff of what is now Phillips 66 (NYSE: PSX  ) , splitting the previously integrated oil player into an upstream company and a downstream one. Whether you are a new investor looking at the two companies, or a current investor holding shares of ConocoPhillips and the new Phillips 66, you might be wondering what all this means and whether either company is a good investment. Read on to see why I think both companies are, and am making outperform CAPScalls to back it up.

How spinoffs play out
There are some important things to recognize about spinoffs. When a parent company spins off a stock, the stock tends to get sold off for structural reasons -- perhaps the parent was in an index but the spinoff won't be, so index funds have to sell their new shares; the new company is often much smaller than the parent, so funds based on market cap can't invest in them; or the new shareholders simply aren't interested in trying to analyze and value the new company.

Some of those reasons don't apply here. Phillips 66 has already been added to the S&P 500, displacing SUPERVALU, and has a market cap of about $20 billion, large enough for any large-cap fund. Investor disinterest may apply, however.

In this case, both companies will be specialists, and investors interested in an integrated oil play might dump both companies and switch to a competitor such as Chevron (NYSE: CVX  ) or ExxonMobil (NYSE: XOM  ) . In the year since ConocoPhillips announced the breakup, shares of the combined company have fallen 6.7%, compared to basically no change in Chevron or ExxonMobil.

In his book You Can Be a Stock Market Genius, stock market genius Joel Greenblatt covers spinoff investing in depth, noting that the best returns for a spinoff happen in the second year after its completion, suggesting that it can take up to a full year for the selling pressure to finish. That was based on a nearly 25-year-old study, however, and today's fast-paced trading environment may speed that process up.

But what about the opportunity?
The opportunity in spinoffs can be huge. The above-mentioned study found that, over a 25-year period, spinoff companies beat the S&P 500 by 10% per year for the first three years of independence, and even the parent companies beat their peers by 6%.

Even without the statistics, the new ConocoPhillips and Phillips 66 look set to be winners. ConocoPhillips is now the world's largest exploration and production company based on proven reserves and production of liquids and natural gas, and Phillips 66 will vie with Valero (NYSE: VLO  ) as one of the biggest gas refining and marketing companies in the United States.

ConocoPhillips will also see its margins expand considerably after shedding the less profitable downstream operations. In 2011, the E&P operations carried a profit margin of 16%, while the operations now contained in Phillips 66 only returned 13%. That's still lower than the upstream margins at ExxonMobil and Chevron, but Conoco's margins have improved significantly over the last couple years, from just 8% in 2009, and are likely to continue improving as the company sells off non-core assets. The company plans to use the proceeds to fund dividend increases and share buybacks, as well as targeted investments in its remaining higher-margin assets.

Phillips 66's operations, meanwhile, have also seen margins improve from just 1% in 2009 to 8% in 2011. The majority of Phillips 66's refineries are based in the mid-continental region, close to the important Cushing, Okla., storage facility where the price of West Texas intermediate oil is set. Because of its higher quality, WTI oil has tended to carry a premium when compared to Brent oil. But because of a massive oversupply, it currently trades $13 per barrel cheaper, giving refineries that have access to it a strong cost advantage. Phillips also plans to extend rail lines to different shale oil plays, giving it further access to cheap feedstocks.

The Foolish bottom line
Spinoffs tend to outperform because they free managers up to focus on what they're best at and unlock some of the potential in the newly independent business. It may take a couple years, but I wouldn't be surprised if ConocoPhillips and Phillips 66 shareholders are well rewarded for their patience as these two companies continue to improve their businesses.

In the meantime, three of The Motley Fool's top Rising Stars have put together a free new report with their top three stocks for $100 oil. Enjoy, and Fool on!

Fool contributor Jacob Roche holds no position in any of the stocks mentioned. Check out his Motley Fool CAPS profile or follow his articles using Twitter or RSS. Motley Fool newsletter services have recommended buying shares of Chevron and ExxonMobil. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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