Current Price: $77.29
Fair Value Target: $107.00
Discount as a Percent: 28%
Thesis
ConocoPhillips offers investors a portfolio of oil and gas investments. These investments will grow COP’s bottom line as the stake in each investment is increased. The market currently is punishing the company for this portfolio, but we believe that upward momentum commodities prices will help unlock the fair value.
Background
ConocoPhillips offers investors significant exposure to oil and natural gas prices. Over the long term, ConocoPhillips will benefit from expensive oil and will benefit from any upward movement in natural gas prices. COP holds numerous equity investments in different oil and gas related venture. This offers investors significant value in the form of a future spin-off or divestiture; holders of COP in essence hold investments in multiple companies. Currently, the company is being punished for its purchase of Burlington Resources, which in our view was a great investment. COP should experience significant price appreciation as investors identify that COP is the equivalent of a three stock investment.
Catalysts
A thorough reading of the annual report helped me to identify the following catalysts:
1.) Purchase of Burlington Resources: the market is punishing COP for this purchase for two reasons: (1) assumption of debt; and, (2) a decline in natural gas prices. Investors feel that ConocoPhillips paid too much for this natural gas play. Secondly, the sharp decline in natural gas prices helped to solidify this view. We believe that COP paid less than fair value for Burlington Resources.
2.) Equity Investment in LUKOIL: COP holds a 20.6% equity stake in Russian oil producer Lukoil. This hidden asset offers investors in COP an added bonus. We think that COP will look to add to this already significant stake. First, the original stake in Lukoil was purchased and sanctioned by the Russian Government. This helps mitigate any geopolitical risk of investing in Russia; COP gets an indirect and somewhat safe investment in Russian assets. Secondly, the investment has proven quite profitable over the last year. Book value of the equity stake is $9,564M, but is worth $14,479M.
3.) Stock Repurchases: during the previous two years COP repurchased roughly $3B in common stock. The company added another $1B to the program for fiscal year 2007. COP’s commitment to share repurchases signals that the stock is undervalued.
4.) Significant Reserves: COP’s reserves increased from 7.92B BOE (Barrels of Oil Equivalent) to 9.36B. These numbers do not include the reserves from the LUKOIL investment or the Canadian Syncrude operation with EnCana.
Valuation
The following table illustrates the fair value of ConocoPhillips based on various valuation methods:
Table 1: Various Values for ConocoPhillips
Investors should pay close attention to earnings power value in comparison to the reproduction value. These values suggest that the company’s earnings are worth considerably more than what it would cost to build COP from scratch. The significant margin between these values suggests that COP is a very strong value investment.
Business Model
ConocoPhillips operates within the Major Integrated Oil and Gas industry. The majority of revenue is derived from the Exploration and Production (E&P) and Refining and Marketing (R&M) segments. Through the acquisition of Burlington Resources in the summer of 2006, COP significantly improved its Midstream segment; the acquisition added significant resources to the production of natural gas, as well as oil reserves. The company’s revenues are well diversified with 50% coming from the US and 50% coming from international markets.
COP derives significant revenue through its portfolio of oil and gas joint ventures and investments. Each of these entities is accounted for under the equity method of accounting. This allows COP to book a proportionate share of earnings, based on its percentage of ownership in each stake, to its own income statement. ConocoPhillips will achieve significant growth as it adds to its ownership in these investments. Furthermore, this structure allows COP to increase revenue without increasing working capital.
Key Highlights of FY 2006
- Lukoil equity investment increased from 7.6% to 20.6%
- Addition of Burlington Resources
- Higher crude oil prices
- 17% increase in domestic E&P net income
- 33% increase in international E&P net income
- Equity in earnings affiliates up 21%
- 18% increase in domestic R&M net income
Key Issues from FY 2006
- Increased debt levels due to Burlington Resources acquisition
- 33% decrease in International R&M net income
- 31% decrease in Midstream net income
Burlington Resources Acquisition
The details behind the acquisition will give most investor’s pause, since the purchase price was $33.9B. COP issued 270.4 million shares and paid approximately $17.5B in cash, with Burlington shareholders receiving $46.50 cash and 0.7214. These terms seem pricey at first glance, but an analysis of the balance sheet shows otherwise.
Table 2: Burlington Resources Balance Sheet
The balance sheet suggests that COP got a good deal for its $33.9B purchase price. The deal looks positive on two aspects: reproduction value and book value. First, Burlington had $50,327M in total assets which is considerably above the purchase price. Lastly, the COP paid about book value for Burlington Resources, which is a great price, considering most firms trade at a premium to book value.
Equity Investments
Here is a list of equity investments that contribute to COP’s net income
1.) OAO LUKOIL – 20.6% ownership in integrated oil and gas based in Russia
2.) DCP Midstream, LLC – 50% ownership in natural gas producer
3.) Chevron Phillips Chemical Co. LLC – 50% ownership in joint venture with Chevron
4.) Hamaca Holding LLC – 57.1% non-controlling interest produce of heavy and medium crude in Venezuela
5.) Petrozuata C.A. – 50.1% non-controlling ownership in producers of extra heavy crude and medium grade crude in Venezuela
6.) OOO Naryanmarneftegaz (NMNG) – 30% ownership and 50% governance interest in joint venture with LUKOIL to explore for and develop oil and gas resources in northern part of Timan-Pechora province in Russia.
Table 3: Presentation of Financial Data Pertaining to Equity Investments
Selected Financial Data
Table 4:E&P and Midstream 5-Year Operating Review
Table 5:R&M and LUKOIL 5-Year Operating Review
Table 6:5-Year Financial Review
*The author and Stock Research cannot be held liable for any gains or losses because of trades made based on the information presented herein.
**The author owns 19 shares of ConocoPhillips and is interested in adding to the position, as well as adding COP to his retirement portfolio
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