ConocoPhillips (OP/A): Burlington integration progressing well; inexpensive valuation offers superior risk/reward for a high-quality company - Goldman Sachs - April 26, 2006
We maintain an Outperform rating on ConocoPhillips in the context of an Attractive coverage view as we see its inexpensive valuation, track-record of execution, and leverage to the commodity cycle as offering superior risk/reward in the shares. Conoco currently trades near our $67 "traditional" mid-cycle value, which is consistent with discounting only a $35/bbl long-term WTI oil price. Assuming a $45/bbl long-term oil price, we see 22% upside to an $84 "traditional" peak value. While we are comfortable buying Conoco shares outright today, we believe investors could also use structured trades to capture the significant valuation gap that exists between Conoco's E&P and R&M businesses versus the respective independent E&P and R&M equities. In particular, we see the spread between Conoco's implied R&M 2007E EV/DACF of 2.9X and the R&M average of 6.4X as unsustainably wide.
CONOCO SHARES OFFER REFINING EXPOSURE AT ONLY 2.9X CASH FLOW
Assuming only a domestic oil/E&P average valuation multiple for Conoco's upstream business, we estimate that the implied R&M 2007E EV/DACF (enterprise value to debt-adjusted cash flow) on its refining assets is a mere 2.9X. This compares to the R&M average of 6.4X and 6.5X for Valero Energy (IL/A). While we remain very bullish on the outlook for refining and find it logical that to a certain extent pure-play refiners could garner a valuation premium during an up-cycle, we believe the valuation gap is unsustainably wide. In our view, given Conoco's US-focused, geographically diverse, limited marketing asset base, and track-record of execution--essentially a "bellwether" US refiner similar to Valero--such a valuation discount, if any, is not warranted.
STRUCTURED TRADES CAN HELP "HEDGE" OUT UNWANTED RISKS
In our April 3, 2006 report, "US R&M: Conoco preferred over R&Ms for refining exposure" Message 22322575 , we highlighted several beta-neutral structured trades that can help capture the potential for a convergence between Conoco's valuation and that of the independent E&Ps/R&Ms. For investors that do not care for E&P exposure, for example, we estimate that for every $1 long Conoco that investor could short $0.65 of a basket of E&P companies. Further, for investors willing to take only minimal commodity price risk, we estimate that for every $1 long Conoco that investor could short $0.45 of a basket of E&Ps and $0.15 of Valero. To date, the suggested trades have gained only modestly, with the most recent pull-back largely attributable to headlines from Venezuela on the potential for re-nationalization of oil properties (see Exhibit 1).
On Venezuela specifically, we estimate that a worse-case scenario of Conoco losing all of its Venezuela production without any compensation would impact our 2007 EPS estimates by about 3%. In the more likely scenario that a combination of tax increases and majority ownership to the government is ceded, we estimate our EPS could be impacted by around 1%. Venezuela currently accounts for roughly 4% of Conoco's E&P production volumes and 9% of its oil and gas reserves. Note, we have already attempted to build in higher tax rates for Venezuela into our estimates, which we believe contributes to the fact that the EPS sensitivity does not appear to be as severe as one might have expected.
In our view, a broader take-away on recent news flow from Venezuela would be that, as with any oil company, political risks exist and heightened fiscal regime risk could among other factors cause stock-specific reactions. Having said that, we believe Conoco is no worse exposed to geopolitical risk than most large-cap international oil companies. In fact, whether or not it was Conoco management's intention, we believe the acquisition of Burlington Resources (hence greater exposure to North America) naturally reduced geopolitical risk in Conoco's overall portfolio.
BURLINGTON ACQUISITION INTEGRATION APPEARS TO BE PROGRESSING WELL
We believe management comments on its 1Q 2006 earnings conference call were positive as it relates to the integration of Burlington Resources. Full year 2006 production guidance of 2.38 million BOE/d appears consistent with management's previous guidance at the November 2005 analyst meeting. Assuming 500,000 BOE/d for Burlington's 2006 production (+5% versus 2005 actual production levels) over 3 quarters plus the 2.0 million BOE/d guidance for Conoco volumes given at the analyst meeting, overall production levels appear to be on-track. Higher expected synergies of $500 million pre-tax relative to its original expectations of $375 million are also encouraging. Finally, in our view, management's conservative approach to Burlington acquisition economics and break-even analyses (for example, assuming a much higher implied F&D assumption than Burlington historically achieved and operating costs similar to current levels as opposed to more "normalized" levels) raises confidence that it can make the acquisition work even under less robust commodity price scenarios.
1Q 2006 RESULTS IN-LINE WITH EXPECTATIONS
Conoco reported adjusted 1Q 2006 EPS of $2.34, in-line with the $2.34 First Call consensus and ahead of our $2.13 forecast. Earnings from E&P exceeded our expectations primarily due to higher-than-expected realized liquids and natural gas prices. E&P volumes were largely in-line at 1.918 million BOE/d versus our 1.880 million BOE/d forecast. Somewhat offsetting higher-than-expected E&P earnings were lower-than-expected R&M earnings, primarily driven by weaker-than-expected marketing margins.
UPDATED ESTIMATES
We have updated our 2Q-4Q 2006 EPS estimates for Conoco, which now stand at $2.36 ($2.51 before), $2.92 ($2.93 before), and $2.71 ($2.76 before), respectively. Our updated EPS estimates reflect lower assumed refinery throughput rates, updated E&P production profile, and minor other adjustments. We have made no change to our full-year 2006-2010 EPS estimates. See Exhibit 2 for a summary model.
Each of the analysts named below hereby certifies that, with respect to each subject company and its securities for which the analyst is responsible in this report, (1) all of the views expressed in this report accurately reflect his or her personal views about the subject companies and securities, and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report: Arjun Murti, Luis Ahn. |
