|Shares Out. (in M):||1,328||P/E||8.1x||9.0x|
|Market Cap (in $M):||98,253||P/FCF||4.4x||4.5x|
|Net Debt (in $M):||17,124||EBIT||121,500||10,230|
The investment case on COP centers on short-term catalysts and longer term opportunities involving increased productivity, more disciplined capital investment and divestiture of non-strategic assets. Uncertainty because of the spin-off timing; the future corporate strategy; the transition in analyst coverage from Integrated Oil to E&P and the misperception on valuation factor performance in E&P are the reasons COP (pre-break up) is undervalued. Strategically, COP rationale makes lots of sense. The company will be the 2nd Integrated Oil Company to separate E&P and R&M during the past year. If you recall, MRO separated its E&P and R&M businesses last summer with both new equities outperforming their peer groups since that time. The same outcome will unfold for COP.
One reason for the strategic moves is that Integrated Oils face important strategic challenges in the form of opportunity constraints in both domestic and International markets. These constraints threaten the growth and returns profile longer-term, and left unaddressed, eventually threaten valuation in the equity market, in our view.
COP remains the least recommended Integrated Oil by sell-side analysts. Why? Current uncertainties include: the spin-off, future corporate strategy, the analyst coverage transition from Integrated Oil to E&P and misperception regarding factor performance in E&P and R&M. The new management teams will unveil E&P and R&M strategies in April. Strategies are likely to emphasize balance between growth and returns with monetization of “hidden assets” in E&P, R&M and Midstream probably significant. As many VIC members know, performance of corporate spin-offs is positive on an absolute and relative basis over most time periods. COP benefit from greater management focus and accountability, improved corporate governance, analyst coverage transition from Integrated Oil to E&P, and higher information symmetry. E&P production and production growth per share will approximate 3-5% and 6-7% annually in 2012-14. Surplus capital reduces equity and debt by 12% and 25% in 2012-13. Whether using conventional valuation measures or those with superior factor performance, undervaluation is significant. COP’s repositioning plan enhances the competitive outlook for the new E&P and R&M entities. While the new management teams are yet to unveil their strategies, important elements of the current plan will remain in our view. The list includes: 1) capital discipline, 2) divestitures of non-strategic interests, 3) monetization of “hidden assets”, 4) debt reduction, 5) share repurchases and 6) strong dividend growth. In E&P, a healthy portfolio of investment opportunities is present. Over 60 projects will drive performance during 2012-2014. However, full reserve replacement appears likely from 8 large projects, which utilize only 70% of projected capital investment. When considering the other 50+ projects, reserve replacement of 130-140% appears likely, before considering reserve gains from exploration. A major acquisition is not needed when considering the output from comprehensive assessment in this area. COP production and production/share should increase 3-5% and 6-7% annually. Returns on investment should remain strong. Gains will emanate from the Australia, Canada, Indonesia, Malaysia, Norway, the US and UK. In addition, Phillips 66 contains unique assets, strong competitive positions and “hidden value” too. The R&M position is the 2nd largest in the US. Chemicals ROCE exceeds 30% and is likely to be sustained in 2012-2014. Midstream assets may be restructured into an MLP format possibly unlocking $3-5 per pre-spin, COP share.
Management & the Balance Sheet
A strong management team and B/S are present. The new CEOs of E&P and R&M are Ryan Lance and Greg Garland. Both are experienced and capable and likely to be strong leaders of the new companies. COP’s pro-forma E&P and R&M balance sheets are strong and set to improve further. Debt to capitalization will approximate 25% and 27% in E&P and R&M. Surplus capital approximates $15B and $5B for E&P and R&M during 2012-2014. Meaningful reduction of debt and equity is ahead. Dividend yield will approximate 4% and 2% for E&P and R&M. With E&P (dividends + capital spending) / (operating cash flow) below peer group averages, the idea that the dividend is at risk is misplaced. Even though free cash flow is insignificant near-term (higher spending), cash plus proceeds from divestitures will approximate 40% of shareholder equity. Cash flow rises thereafter as operations commence on the new projects. We envision dividend growth of 3-5%/yr. in 2012-2014. The cash flow profile and balance sheet of the new E&P company stand to be strong too. The operations and investing portions of the cash flow statement indicate that COP E&P cash from operations and proceeds from divestitures will approximate $50-55B and $10-12B during 2012-2014. Capital investment and dividends will approximate $42-45B and $10B during the same period. If so, surplus capital from operating and investing will approximate $8-12B.
The financing portion of the cash flow statement is important too. Pre-spin, COP R&M (Phillips 66) will raise $8B in new debt (3.0% AT) and will pay a $6B dividend to COP E&P. Surplus cash flow from financing therefore approximates $6B in 2012. Total surplus cash flow therefore approximates $14-20B during 2012-2014 and combines with the pre-spin cash position of $5B. Total surplus cash will therefore approximate $19-24B. This figure is impressive when considering that COP E&P debt ($22B) plus equity ($42B) only approximate $64B before the spin-off. COP plans to utilize $6B to reduce debt from $22B to $16B post spin-off. Share repurchases will likely utilize $10-12B, buy backs are concentrated into the first 2 years of the period. On dividends, the payout will approximate $2.64/sh. with the yield on COP leading the E&P industry at 3.7%. When considering the R&M dividend of $0.80/share during 2H 2012, current holders of COP Integrated Oil equity receive dividends of $3.00/sh. in 2012, representing yield of 4.2%.
Needless to say, cash will be significant when combining the pre-spin cash position of $5B and surplus cash flow of $15B prior to reduction of debt and equity. Accordingly, the idea that COP dividend is at risk does not make sense.
The new Phillips 66 will be a leading pure-play refiner with competitive and diverse assets in Midstream and Chemicals as well. Strategies emphasize higher returns through selective investment, portfolio rationalization and return of capital to shareholders. The balance sheet will hold a “BBB” credit rating and net debt/capitalization of 22% at year-end 2012. The position in Refining & Marketing represents 70% of capital employed and profits in Phillips 66 but growth will be higher in Midstream (10%) and Chemicals (20%) in 2012-2014. Each major business segment is unique, diverse, and highly competitive. Geographically, the majority of assets are in the US (84%) with positions in Europe (12%) and Asia (4%) too. The new Phillips 66 entity seeks to enhance portfolio quality by pursuing transactions and investments within a broader context than in the pre-spin format. Investment in refining will emphasize high-return refining projects especially those which raise clean product yield i.e. Wood River, IL. Growth opportunities appear more significant in Midstream and Chemicals. Monetization of “hidden value” in Midstream through an MLP appears likely to be capitalized upon, to the benefit of shareholders in 2012-2013. Phillips 66 financial outlook is strong as significant surplus cash flow appears likely. The priority for funds is: 1) maintenance investment in refining, 2) growth investments in Midstream and Chemicals 3) debt reduction and 4) shareholder distributions.
The new COP will be a uniquely positioned E&P company. The company holds strong competitive positions in 5 OECD and 4 non-OECD countries. Positions in 6 other countries are divestiture candidates with significant value creation likely to unfold during in the next few years. In E&P, major interests in OECD include: 1) the US, 2) UK, 3) Canada, 4) Norway and 5) Australia. Profits and production from these 5 countries approximate 80% of the total and will represent key areas of emphasis for ConocoPhillips E&P in 2012-2014. In the non-OECD, positions in China, Indonesia, Malaysia and Qatar hold high profitability and returns too. A strong platform for growth and returns is present for ConocoPhillips E&P, especially post completion of the divestiture plan in 2012-2013. Competitively, the new E&P entity is well-positioned. Size and scale are significant with strong technological capabilities, multi-national experience and project management skills enabling it to compete for any project on a global basis. Extensive experience in unconventional plays position the new company well in this area also.
ConocoPhillips’ valuation appears compelling. When using all conventional valuation measures or only those providing superior factor performance, ConocoPhillips is undervalued. The value of the E&P and R&M units approximates $72 and $20 per pre-spin ConocoPhillips share. A Midstream MLP would add another $3-5/sh. Total value approximates $94/share. Shareholders in COP receive $3.00/share in dividends in 2012 for yield of 4.2%.
1) April -- The new management teams will unveil E&P and R&M strategies in April. (COP board of directors approved division of the Refining, Marketing and Chemicals, and Exploration & Production (E&P) businesses in July 2011. This will be a tax-free spin-off of the R&M component to ConocoPhillips shareholders. )
2) May -- The price dislocations in the when-issued market and the actual Break-up of COP into two companies in May (Holders of 2 shares of ConocoPhillips equity to receive 1 share of the new Downstream entity, Phillips 66.)
3) In the Fall? -- Midstream assets may be restructured into an MLP