Conoco phillips analysis

Author: Vy Danay Course: Fundamentals of Investment Professor: Francis Thomas The Richard Stockton College of New Jersey

6 0 0 N o r t h D i a r y A s h f o r d , H o u s t o n , T X 7 7 0 7 9

CONOCOPHILLIPS

ConocoPhillips’s Analysis-‐Page.2

I. Company Structure:

ConocoPhillips is an international, integrated energy company. The merger between Conoco and Phillips was consummated on August 30, 2002. Headquartered in Houston, Texas, ConocoPhillips operates in more than 30 countries. As of March 31, 2011, the company had approximately 29,600 employees worldwide and assets of $160 billion. ConocoPhillips stock is listed on the New York Stock Exchange under the symbol COP. Market capitalization as of March 31, 2011, was approximately $113 billion.

• Exploration and Production (E&P)— This segment primarily explores for, produces, transports and markets crude oil, bitumen, natural gas, liquefied natural gas (LNG) and natural gas liquids on a worldwide basis.

• Midstream— This segment gathers, processes and markets natural gas produced by ConocoPhillips and others, and fractionates and markets natural gas liquids, predominantly in the United States and Trinidad.

• Refining and Marketing (R&M)— This segment purchases, refines, markets and transports crude oil and petroleum products, mainly in the United States, Europe and Asia.

• LUKOIL Investment— This segment consists of ConocoPhillips’s past investment in the ordinary shares of OAO LUKOIL, an international, integrated oil and gas company headquartered in Russia.

• Chemicals— This segment manufactures and markets petrochemicals and plastics on a worldwide basis. The Chemicals segment consists of 50 percent equity investment in Chevron Phillips Chemical Company LLC (CPChem).

• Emerging Businesses— This segment represents the investment in new technologies or businesses outside the normal scope of operations.

II. Economic Analysis: Economics risks are beyond ConocoPhillips’s management but have direct effects in its operations.

1) Domestic and worldwide political and economic developments could damage the Company’s operations and materially reduce its profitability and cash flows.

Actions of the U.S., state and local governments through tax and other legislation, executive order and commercial restrictions could reduce ConocoPhillips’s operating profitability both in the United States and abroad. The U.S. government can prevent or restrict the Company from doing business in foreign countries. These restrictions and those of foreign governments have in the past limited its ability to operate in, or gain access to, opportunities in various countries. Due to the fact that approximately 60 percent of ConocoPhillips’s hydrocarbon production was derived from production outside the United States in 2011, and 56 percent of its proved reserves, as of December 31, 2011, was located outside the United States, the Company is subject to risks associated with operations in international markets, including changes in foreign governmental policies relating to crude oil, bitumen, natural gas, natural gas liquids or refined product pricing and taxation, other political, economic or diplomatic developments, changing political conditions and international monetary fluctuations.

2) Changes in governmental regulations may impose price controls and limitations on production of crude oil, bitumen and natural gas.

The Company’s operations are subject to extensive governmental regulations. From time to time, regulatory agencies have imposed price controls and limitations on production by restricting the rate of flow of crude oil, bitumen and natural gas wells below actual production capacity in order to conserve supplies of crude oil, bitumen and natural gas.

3) ConocoPhillips expects to continue to incur substantial capital expenditures and operating costs as a result of its compliance with existing and future environmental laws


and regulations. The nature of its businesses is subject to numerous laws and regulations relating to the protection of the environment. These laws and regulations continue to increase in both number and complexity and affect its operations with respect to, among other things:

• The discharge of pollutants into the environment. • Emissions into the atmosphere (such as nitrogen oxides, sulfur dioxide and mercury

emissions, and greenhouse gas emissions as they are, or may become, regulated). • The handling, use, storage, transportation, disposal and cleanup of hazardous materials and

hazardous and nonhazardous wastes. • The dismantlement, abandonment and restoration of the properties and facilities at the end

of their useful lives. • Exploration and production activities in certain areas, such as offshore environments, arctic

fields, oil sands reservoirs and shale gas plays.

III. Industry Analysis: Industry risks are risks occurred in a specific industry and associated with the industry’s characters.

1) The effects of changing commodity prices and refining margins. The revenues, operating results and future rate of growth are highly dependent on the prices that the Company receives for the crude oil, bitumen, natural gas, natural gas liquids, LNG and refined products. The factors influencing these prices are beyond the Company’s control.

2) Any material change in the factors and assumptions underlying ConocoPhillips’s estimates of crude oil, bitumen and natural gas reserves could impair the quantity and value of those reserves.

ConocoPhillips’s proved reserve information included in its annual report has been derived from engineering estimates prepared or reviewed by the Company’s personnel. Any significant future price changes could have a material effect on the quantity and present value of its proved reserves. Future reserve revisions could also result from changes in, among other things, governmental regulation. Reserve estimation is a process that involves estimating volumes to be recovered from underground accumulations of crude oil, bitumen and natural gas that cannot be directly measured. As a result, different petroleum engineers, each using industry-accepted geologic and engineering practices and scientific methods, may produce different estimates of reserves and future net cash flows based on the same available data. Any material changes in the factors and assumptions underlying ConocoPhillips’s estimates of these items could result in a material negative impact to the volume of reserves reported.

3) Barring a successful addition to ConocoPhillips’s existing proved reserves, its future crude oil, bitumen and natural gas production will decline, resulting in an adverse impact to the business. This is typical of energy companies.

The rate of production from upstream fields generally declines as reserves are depleted. This depends on the extent that ConocoPhillips conducts successful exploration and development activities, or, through engineering studies, identifies additional or secondary recovery reserves. It’s proved reserves will decline materially as it produces crude oil and natural gas.

IV. Fundamental Analysis: Intrinsic value provides a measure of the underlying worth of a share of stock. Fundamental analysis is closely linked to the notion of intrinsic value because it provides the basis for projecting a stock’s future cash flows. A key part of this analytical process is company analysis, which takes a close look at the actual financial performance of the company.


1) Key Ratio Analysis:

ConocoPhillips as well as all public companies have to release a 10-K report annually. The 10-K report delivers the financial information during the fiscal year to the Company’s shareholders. However, to understand what accounting statements really have to say about the financial condition and operating results of a firm, one must turn to financial ratios- the study of the relationships between various financial statement accounts.

a) Profitability ratios: is a class of financial metrics that is used to assess a business's ability to generate earnings as compared to its expenses and other relevant costs incurred during a specific period of time.

Ø Rate of Returns: The table shows key profit measures of ConocoPhillips during the last 10 fiscal years (from December 2002 to December 2011).

The profitable key ratios graph (as a percentage of revenue) suggests the probable

points in the ConocoPhillips’s financial statement that an investor should dig deeper into. During the last 10 fiscal years from 2002 to 2011 ended in December, Cost of Goods Sold and Gross Profit as the percentage to Total Sales/Revenue remained constant, if not improved, even in 2008. All other indicators in profitability fell hard during 2008 fiscal year. So an investor can predict that something negative happened between the Expenses sections and Net Income in 2008. A 2008 Income Statement of the Company shows a huge impairment on Goodwill of $25.44 billion, and on LUKOIL investments and other impairments of $9.1 billion. These impairments were posted in the last quarter of 2008. To explain for the huge loss ConocoPhillips incurred in 2008, the Chairman and Chief Executive Officer James J. Mulva wrote in its letter to shareholders of the company: “With the recent substantial decline in commodity prices and worldwide equity markets, I expect to recognize several significant noncash impairments in the fourth quarter. The largest of these is a $25.4 billion after-‐tax impairment to goodwill related to our Explorations & Productions segment. I also plan to

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reduce the carrying value of our equity investment in LUKOIL by $7.3 billion after-‐tax, and record other asset impairments totaling $1.3 billion after-‐tax. These impairments are primarily a function of falling commodity prices and the decline in the market capitalization of ConocoPhillips and of LUKOIL. These noncash charges do not impact the strategic value of ConocoPhillips’ assets, including our LUKOIL Investment; our estimated resource base of more than 50 billion barrels of oil equivalent; or our ability to generate cash flow”.

As to General Accepted Accounting Principles (GAAP), Goodwill resulting from a business combination is not amortized but is tested at least annually for impairment. If the fair value of a reporting unit is less than the recorded book value of the reporting unit’s assets (including goodwill), less liability, then a hypothetical purchase price allocation is performed on the reporting unit’s assets and liabilities using the fair value of the reporting unit as the purchase price in the calculation. If the amount of goodwill resulting from this hypothetical purchase price allocation is less than the recorded amount of goodwill, the recorded goodwill is written down to the new amount. Therefore, the total of $34.5 billion in impairment on the Income Statement is added back to the Company’s Statement of Cash Flows.

Ø Findings: • From an accounting standpoint, what appeared to be a profit loss in 2008 at

ConocoPhillips is actually an impairment write-‐off. This noncash loss didn’t derive from the strong fundamentals in ConocoPhillips’s business. In fact, it reduced the company’s Income taxes in the 4th Quarter when posted.

• From a financial standpoint, the loss in 2008 is believed to be a financial strategic movement for a better financial structure. As this table breaks down the Total liabilities as % to Total Assets and Total Stockholders’ Equity as % to Total Assets. ROE was down to -‐23.6% and ROA declined to -‐10.6%. The Income Statement already showed the total loss of almost $17billion in 2008. To understand the total effect of the decline in ROE and ROA in 2008, a step into Equity and Assets analysis is much needed. The capital structure is formed by liabilities and equity. From 2002 to 2007, ConocoPhillips decreased its liabilities over time. As a result, equity increased during that period until they met in 2006 and 2007. The main responsibility of a financial manager is to maximize the wealth of his shareholders. Debt can be acquired at a cheaper expense. In addition, what makes debt more attractive is tax deductible. Combined both factors of debt, funding the Company’s assets with debt is a lot cheaper as compared with equity which is not tax deductible and higher required rate of return. I believe the ConocoPhillips’s Executives decided to take a bigger hit with ROE together with the loss. It is also a chance for the company to restructure its financial plan for the upcoming years.

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b) Activity Ratios: Ø Cash Conversion Cycle: The cash conversion cycle is the number of days it takes a

company to run cash through the sales process, from sitting in the bank, through buying the inventory, selling the inventory, and receiving the cash from the sale. Shorter is better.

ConocoPhillips has improved its Cash Conversion Cycle (CCC) since the huge impairment write-‐off, which caused profit loss that the company reported in 2008. This means the Company has been able to convert its inventories through sale to cash before it has to pay for the goods to its suppliers. The positive trend in ConocoPhillips’s CCC has been significantly improved since 2007 and remained through the recession in 2008. The Company has shown a strong standing in its business cycle and has been getting even stronger since 2008.

Ø Findings: • To enhance my point from a financial restructuring (in part a) in ConocoPhillips in

2008, I analyzed the Cash Flows Statement over the past 10 years.

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• The graph gathers key data in the Statement of Cash Flows from 2002 to 2011, which are Cash Dividends paid, Repurchase of Common Stock (Treasury Stock), changes in Assets/ Liabilities and Cash flows from investing activities. The biggest change in 2008 is probably an aggressive increase in investing activities, specifically in acquiring new properties, planning and equipment (PPE) of $19 billion. Even though the company incurred a big loss in profit in 2008, it continued to maintain higher payout rate (Cash dividend payout + repurchase of Common Stock). The retained earnings was used to purchase more inventory in 2008, when the gas and oil price was at record low (it is also the reason that ConocoPhillips wrote off its impairment loss). A significant capital expenditure to acquire PPE of $19 billion, a payout of $11 billion in Dividends and Repurchase of Common Stocks, and $1.3 billion increase in Inventory can offset the entire loss of $17 billion. ConocoPhillips has a fabulously strong business model.

• Notes: ConocoPhillips repurchased $8.25 billion of its Common Stocks during the market crash. Assuming the company’s net profit remains the same, its EPS will increase due to stock repurchase program. Therefore, PE will be lower and become more attractive to common investors. ConocoPhillips’s Board of Directors probably predicted that the company stock would have a negative effect after the financial statements were released in 2008. Thus they decided to repurchase $8.25 billion worth of common stock to keep their stock trading at an accepted price. This can be a reasonable assumption.

c) Liquidity and Leverage Ratios:

Liquidity measures are concerned with the firm’s ability to meet its day-‐to-‐day operating expenses and satisfy its short-‐term obligations as they come due. To understand better about ConocoPhillips’s liquidity and financial trend, a comparison between the Company and Exxon Mobil-‐ the largest leader in the energy sector with over $400 billion in market cap-‐ is analyzed.

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The trending graph is calculated by subtracting each liquidity ratio of COP to each of XOM. The difference in that last 10 years is showed in the graph. Before 2009, Current Ratio and Quick Ratio was weak compared to Exxon Mobil. The positive trend in both of the ratios started to appear after 2009. Because ConocoPhillips has improved its Cash Conversion Cycle (part B findings) since 2008, the positive liquidity trend is confirmed. Leverage ratios didn’t improve significantly but the Executives are focusing on a more attractive leverage ratios.

2) Stock Price Projection: The single most important part in evaluating a company is to project how it will perform in the future. Historically, ConocoPhillips (COP) has yielded higher return than its competitors as well as the market as a whole.

As of March 9, 2012, COP was trading at $77.16/share on NYSE. Is COP an undervalued stock?

Ø Discounted Free Cash Flows: ConocoPhillips’s Free Cash Flows (FCF) trend from 2009 to 2017 will probably repeat what happened from 2002 to 2008. If I consider 2002 is a bottom year for the positive FCF trend, the new trend started in 2009 has formed very similar to the trend started in 2002. That is the reason I will project the future Free Cash Flow in ConocoPhillips for the next 5 years based on the similar trend that happened from 2002 to 2009. I also assume that roughly every 6 or 7 years, ConocoPhillips will incur a significant downturn like they had in 2008. Therefore, I can create a projection table for FCF for the next 5 years, and it will increase constantly at 2% a year after that.

• Determine Weighted Average Cost of Capital: To determine WACC, 10 year Treasury bills and Market return must be estimated.

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From the U.S Department of Treasury (http://www.treasury.gov/resource-‐center/data-‐chart-‐center/interest-‐rates/Pages/TextView.aspx?data=yield), 10-‐year T Bill yield as of March 9, 2012 is 2.051%. A conservative market return in 2012 is estimated at 9%. Therefore, I have a required rate of return for Equity roughly 10%. The average Cost of Debt is the average of the next 5 year Interest Rate, which is 5.01%. Because the Corporate Tax for ConocoPhillips in 2011 is 45.65%, the effected after-‐tax interest rate is (1-‐45.65%)*5.01%= 2.724%. Because ConocoPhillips doesn’t have any Preferred Stock, its capital structure contains only Debt and Equity WACC: 5.65% WACC is continuously used to discount future free cash flows and dividends payouts.

• Discounting Free Cash Flows:

Based on the projection of FCF for ConocoPhillips, the Present Value of Discounted FCF ($156,059 million) is the sum of all the Present Value of FCF each year (the last line). To be more conservative and confident, assuming ConocoPhillips’ actual PV of Discounted FCF would be 80% of the projection, which is $124,847 million. This is the Enterprise Value of ConocoPhillips. In order to determine the share price, I need to adjust by adding Cash ($5,780 million) to the Total value of Discounted FCF and subtracting it from Long-‐term Debt ($21,610 million). This is current data from the Financial Statement. After all the calculation, that number is divided by total common stock outstanding estimated at 1.28 billion shares (from Google Finance). The fair market value for the firm is determined at $85.17 a share. If an overall market supports ConocoPhillips, the best possibility is its share can be traded at 20% higher than the projected FCF, which is $134. An average stock price traded at projected FCF is $109.50 a share. Right now, ConocoPhillips is trading at around $77 a share, a 9.4% below the fair value in an average condition, a 29.5% below fair value in good market, and a 42.42% below the best scenario. ConocoPhillips is slightly undervalued as of March 9, 2012, investors should consider to purchase at $60 a share (approximately 20% under the fair market value).

• Dividend Discount Model:

ConocoPhillips has a substantial dividend payout ratio of approximately 16% of EPS. As assumed in FCF trend, the dividends trend is expected to be similar to the FCF trend. Projected Change % is what actually happened from 2002 to 2009. The Cost of Equity is 10.03% and is used to discount the future dividends stream. The estimated fair market value of ConocoPhillips share is almost $78. It is 8.2% lower than using discounted free cash flows. The average of both is $81.50 a share. Using Dividend Discount Model, estimated fair market is $78 a share, very close to its current trading price as of March 9, 2012-‐ $76.16 a share.

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V. Conclusion: The Efficient market advocates believe that the market is so efficient in processing new information that securities trade very close to or at their correct value at all times. Throughout this analysis, you will find out how I approach to determine Weighted Average Cost of Capital and all the key analysis to calculate ConocoPhillips’s intrinsic value. After carefully analyzing the company’s financial statements, I believe ConocoPhillips is currently trading close to its fair market value. Investors should consider very carefully about the company itself and the overall stock market. After the financial crash in 2008, which was also the company’s reason to take advantage of writing off billions of dollars of Goodwill impairment, COP bottomed out at around $35 a share. It reached the peak in early March 2011 at almost $80 a share. That is a 128% increase in 26 months-‐ A fabulous return that any investor dreams of. Even though ConocoPhillips is fundamentally strong, it hasn’t showed a significant positive trend in its leverage ratio (the measure between debt and assets/equity/Net income). ConocoPhillips share is believed to be in a correction period after forming 2 tops at $80 a share in 2008. For investors who are interested in owning equity at ConocoPhillips, I strongly suggest to wait. For investors who currently own some shares at ConocoPhillips, I would recommend them to consider selling it now and wait to buy it back sometime in the near future. I target the considering buy price at below $60 a share if ConocoPhillips share price can drop down in the near future. Similarly, the targeted selling price is at $109. Notes: ConocoPhillips repurchased $11 billion worth of its Common Stock at the end of 2011. The company is expected a much higher Earnings Per Share (EPS) due to a higher projected Net Income and lower Common stock Outstanding in 2012. The company’s accumulated Treasury Stock as of December 31, 2011 is almost $31.8 billion. Why did ConocoPhillips have such a grand preserved Treasury Stock? Is a more attractive EPS a prediction for a declining trend in stock price in 2012? Or is ConocoPhillips planning to make a substantial acquisition in 2012 for its business expansion?

Date post:	27-May-2015
Category:	Business
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