The BMW Method
ConocoPhilips Analysis

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By kelbon
October 30, 2008

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I gave some thought to which stock I would give a quick presentation of, If I'd gone to the BMWM Conference. I don't know if it's my best idea; there are so many "bargains" now - accompanied by; I suspect, an unusual amount of risk. Given the risk, it's appropriate to look for a healthy margin of safety as far as valuation goes, along with a potentially healthy upside. I think I've found both.

The company pays a good dividend and It doesn't come up on any of those screens that are posted on this board on a regular basis. It slips through the cracks because there isn't a BMWM chart for it. All the same, every stock that has suffered a deep decline in share price, after a consistent upward climb over a number of years, is certainly going to be well into -RMS territory.

ConocoPhilips (COP)

ConocoPhilips is an integrated oil and petrochemicals company with assets around the globe. At its high this summer the stock price was $96.00 a share; now it's hovering around $50.00. This, of course, has mostly to do with the rapid decline in the price of oil from the highs of the summer. The fall in the stock has put COP into bargain basement territory, in a number of ways.

To try and level the playing field somewhat, I've taken the average Earnings Per Share over the last three years to calculate the P/E ratio. This allows for the fluctuation in the price of crude over the period. Average earnings over the last three years were $9.49 per share. For the sake of argument let's say the share price is $50.00 a share now (it's pretty close). COP's trailing P/E comes in at 5.27. Over the last 15 years the P/E range has swung between 30.9 and 5.

If you buy at $50.00 you get an initial return of return of 19% - your share of those earnings (The Earnings/Price ratio). COP is expected to grow earnings going forward at about 7% a year. If you add a 4% dividend to that, you have a stock that pays you an initial return of 19%, and should grow an additional 11% per annum going forward.

Doing the same exercise with Exxon Mobile (taking the average Earnings Per Share over the last three years, to calculate the P/E ratio) you get a P/E of 11.6. This is twice as high as COP's. XOM is expected to grow earnings at 9.5% and has a dividend yield of 2.1. Add them both together (11.6%) it's neck and neck with COP's 11%. So, pretty much the same expectations going forward; at half the price.

$50.00 a share is very slightly over 3 times COP's last year's Free Cash Flow. By this measure also; the stock is valued very cheaply. In comparison XOM, at $74.65, is selling for 7.7 times last years Free Cash Flow. Again, COP seems to be half price.

COP's debt level is conservative with about $21 billion in long-term debt - about 1.25 times last years Net Profit. Value Line gives them a Financial Strength rating of A++ (the highest) -and a Safety Rating of 2 (above average). Return on Equity last year was 17%, which is very respectable for a company with substantial equity and a modest amount of debt.

There has been a lot of emphasis lately around here on dividends; so how safe is COP's 4% yield? On average, over the last three years the pay-out ratio has been around 16%. In other words, the dividend payment represents 16% of earnings - this is very modest. For the dividend to be at risk earnings would have to decline mightily. Furthermore, COP has raised its dividend every year since 2000. You have to go back to 1992 find a better dividend yield.

The next way that COP seems so cheap: It's selling at less than Book Value. In comparison XOM goes for over 3 times Book Value.

For a company to be selling at a P/E of around 5 and less than Book Value is usually indicative of trouble. A company that is worth more dead than alive; a company that is never going to grow earnings; a company with Return on Equity in the low single digits; a cigar butt; a buggy whip company - certainly, a company whose prospects seem very poor; at least for the foreseeable future. But, ConocoPhilips' prospects are reasonably good. Oil is not a discretionary item; something you can do without. The price goes down with demand, as we've dramatically seen since the summer, but OPEC isn't going to let it slide indefinitely - they have, and will continue to reduce output to prop up the price and protect their own interests.

Even in this unusual environment there seems to be little permanent downside risk here, but considerable upside potential. I seriously doubt that oil will be as cheap as it is now in five years.

In summary:
P/E around 5
Share price only 3 times last years Free Cash Flow
Selling for less than Book Value
Good Return on Equity of 17%
Forward looking earnings expected to be 7%, plus a safe 4% dividend
Low long-term debt and excellent financial strength.
and, Conoco has allocated about $10 billion for share buy-backs for this year.

On a risk/reward basis COP is probably a winner.