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Conoco Phillips Analysis

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By kelbon
September 15, 2009

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A little under a year ago, I posted on the subject of Conoco Phillips (COP). Here's what the year has brought, and how I see things now; with the stock and the company.

A year later things don't look so rosy. But how much of the bloom is off the rose? For starters, the stock price is down about 10% from the price I cited-$50 a share-for my argument (down only 6% if you account for the 4% dividend payment). Given the year we've had: not too bad.

The business has faired much worse than the stock price however. Earnings for this year are expected to be down 65-70% from last year's. Crude oil and natural gas prices were down about 20% for the period, along with lower refining margins, accounting for contracting top and bottom lines.

COP has tightened its belt and suspended its share buy-back program, but it continues to pay the dividend without a cut. The payout ratio has risen to 54% from 18% last year.

What's the good news, if any? This is a real earnings slump, but it's expected to be temporary. In fact, earnings are predicted to expand at around 28% a year over the next five years, giving COP estimated earnings of $12 per share in 2014.

This year every financial ratio worth mentioning has been deteriorating: ROE, ROTC, profit margins, price to book, etc-par for the course given the slump in earnings. However, incremental improvement is expected as earnings expand.

Why, given the year we've had in general, and more pertinently, COP's business performance specifically, has the stock held up so well? Simply because, in my opinion, it seemed like a screamingly greatly undervalued buy with a large margin of safety when I wrote last year. I reasoned if things went well, the stock price should do very well, if things went badly, and they have, the stock price wouldn't decline too much, for too long. Even with a bad outcome-so far, so good.

Even in it's weakened state, unless things go from bad to worse; which isn't in the cards (but the cards aren't always right), COP doesn't seem overpriced. In fact in some ways it seems as good an investment now as it did a year ago, given a little patience. And, there's a 4% dividend yield to help bide the time.

Earnings for this year are expected to be $3.50 a share: a forward p/e of 13, which is hardly heady and is below the historical average of the S&P 500. Earnings for 2010 are slated for around $5.85, which at $45 a share translates to a 2010 p/e of 7.7.

Although things have slipped this year on the earnings front, on 12-12-'08 Value Line raised COP's Safety Rating from 2 to 1 (highest), and COP retains A++ for Financial Strength (highest). Although the stock price might reasonably be expected to be a little sluggish for a while, with a little patience, there's a likely-hood it could well start outperforming later in '10. Value Line expects a stock price of between $100 and $125 for 2012-14.

Last year I wrote: If you buy at $50 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.

Fast forward to the present: If you buy at $50 a share you get an initial return of 7% - your share of those earnings (The Earnings/Price ratio). COP is expected to grow earnings going forward at about 28% a year, if you add a 4% dividend to that, you have a stock that pays you an initial return of 7%, and is expected to grow an additional 32% per annum going forward.

After some tricky math based on the last two paragraphs you could conclude that-based on the valuation and expectations I wrote of last year, and a $50 share price-there might have been a 32% compounding return over five years (19% initial return compounding at 11% for 5 years = 32). With today's situation and expectations there might be a 28% compounding return over five years (7% initial return compounding at 32% for 5 years = 28). This is a very abstract method of course, because you can't extract your initial percentage of the company's earnings and you can't control, or predict, how the market will value future earnings, but it does give an idea that your expectation from investing in COP isn't that different than it was a year ago-that the current potential of the stock, has degraded only slightly-though the uncertainty is generally greater.

As per the BMW method, referencing a 16 year history, this time last year COP was at a -1 RMS, now it's flirting with -2 RMS.

http://invest.kleinnet.com/bmw1/stats16/COP.html

If you adhere to the significance and extent of a low minus RMS, then COP looks like a potentially better buy now than it did a year ago.

So, to summarize: it's a highly-rated conservative stock which sits on it's -2 RMS line which is expected to turn its earnings slump around at a 28% CAGR for the next five years.

A year later, given a very bad year, it still looks attractive. But, like every other stock, the state of this uncertain economy, and in COP's case specifically the price and demand for oil and gas, weigh heavily.

To echo what I wrote last year: "I seriously doubt that oil will be as cheap as it is now in five years."

kelbon




Pasted below: my take on COP this time last year -
_______________________________________________________

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.

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.