ConocoPhillips (NR): Execution and commodity macro environment key to shares - Goldman Sachs - January 25, 2006
With many impactful E&P and R&M projects on the horizon, we believe the combination of execution and a favorable commodity macro environment are key to ConocoPhillips shares. On the one hand, investors will debate the appropriate use of above-normal free cash flow and worry that management is being overly-aggressive in its acquisition and investment program. On the other hand, COP's current strategy is strikingly familiar to that of several years ago in the merger between Conoco and Phillips and the acquisitions of ARCO Alaska and Tosco, which collectively have added significant shareholder via strong execution during a favorable macro environment. In our view, although investors are willing to give COP the benefit of doubt in terms of execution, COP's ability to generate resilient returns should the cycle turn unfavorable will continue to be questioned. We remain Not Rated on Conoco. (Goldman Sachs & Co. and/or one of its affiliates is acting as financial advisor to ConocoPhillips in the proposed acquisition of Burlington Resources Inc. Goldman Sachs & Co. and or one of its affiliates will receive a fee for its financial advisory role.)
GETTING BY IN A RESOURCE-CONSTRAINED ENVIRONMENT We believe ConocoPhillips at a minimum has built a strong pipeline of investment programs during a period when industry overall continues to struggle to find attractive opportunities. Given the pending acquisition of Burlington Resources (BR; Not Rated), expected increase in ownership of Lukoil, expanding US and international downstream investments, and re-entry into Libya, we believe Conoco's capital program appears robust. Whereas some companies have increasingly larger cash balances than debt levels, we estimate Conoco's net debt-to-tangible capital to hover around a healthy yet not over-capitalized level of 30% by year-end 2006.
This is not to say that companies should indiscriminately spend above-normal free cash flow. In fact, we view favorably ExxonMobil's (XOM; OP/A rated) patient, disciplined strategy of maintaining an ultra-strong balance sheet (substantially more cash than debt), buying back stock, and waiting for the opportune time to invest. Conoco, however, does not have the benefit of Exxon's high-quality, sizable asset base to indefinitely wait for the "perfect" investment opportunity. In our view, Conoco is essentially taking a calculated risk that the combination or future commodity pricing and strong execution will pay for an expanded resource base in the upstream and higher light-product yield throughput and greater crude diet flexibility in the downstream, all of which could help Conoco better compete with the super major peer group.
HIGH COMMODITY PRICES LIKELY REQUIRED FOR SUPER-MAJOR-LIKE RETURNS ON NEW INVESTMENTS When comparing ConocoPhillips to the super majors, the main concern we think investors have is Conoco's ability to generate competitive full-cycle returns on capital employed (ROCE), i.e., 12%-15% long-term ROCE versus industry overall earning 8%-10%. We estimate that for the announced Burlington acquisition, natural gas prices in the US need to average $8 per MMBtu long-term to generate a 12% IRR on the investment. For a 15% IRR, we estimate that a $9 per MMBtu gas price is required longer-term (for more details, please see our note published on December 14, 2005, "ConocoPhillips: The appropriate use of excess cash and the sustainability of $8+ US natural gas prices the key issues with Burlington Resources acquisition"). Message 21974683
For Conoco's US refining investments, we continue to believe a $5-$6 per barrel long-term Gulf Coast refining margin and $10 per barrel light-heavy crude oil spreads are required to generate a 12% IRR. For a 15% IRR, we believe an $8 per barrel margin and $14 per barrel light-heavy spread assumptions are needed (for more details, please see our note published on November 17, 2005, "ConocoPhillips: Analyst meeting takeaways"). Message 21893422
Although commodity prices certainly play a key role in determining returns on projects or acquisitions, upside to the resource base or synergistic/integration opportunities could ultimately help determine the level of success as well. Lukoil's recent large oil and gas discovery in the Northern Caspian underscores the resource base upside in Lukoil's acreage position, which in turn improves the outlook for Conoco's investment and ownership of Lukoil shares.
CONOCO VALUATION IN-LINE WITH CHEVRON AND AT A DISCOUNT TO SUPER-CAP INTEGRATEDS ON AVERAGE We see Conoco shares trading at 4.7X 2006E and 4.5X 2007E EV/DACF (enterprise value to debt-adjusted cash flow) relative to the super-cap integrated oils average of 5.9X and 5.4X, and Chevron at 4.8X and 4.4X, respectively (see Exhibit 1). In our view, investor confidence in Conoco's ability to generate robust returns irregardless of the commodity environment could help narrow the valuation discount.
We estimate 31% upside for Conoco shares to a "traditional" peak value of $84 and 87% upside to a super-spike-adjusted peak value of $120. This compares with the super-cap integrateds showing on average 36% upside to traditional peak and 77% upside to super-spike-adjusted peak values. Barring a major stock market correction, we see downside trading risk as likely limited to 5%-10% order of magnitude given that the super-cap integrateds, including Conoco, are trading at or below traditional mid-cycle values which assume a $35 per barrel long-term WTI oil price.
4Q 2005 RESULTS ABOVE EXPECTATIONS Conoco reported adjusted 4Q 2005 EPS of $2.69, ahead of the $2.62 First Call consensus and our $2.55 forecast. Earnings from E&P exceeded our expectations primarily due to higher-than-expected realized prices for both oil and natural gas. E&P volumes were slightly weaker than expected at 1.58 million BOE/d versus our 1.60 expectations. We estimate Conoco's 2006 E&P production to average 1.9 million BOE/d, which excludes its share of Lukoil production and includes roughly 250,000 BOE/d average production from Burlington operations.
4Q 2005 chemicals and midstream earnings were higher than expected primarily driven primarily by robust chemical margins and natural gas liquids prices. All chemicals facilities affected by the hurricanes have now resumed normal operations. Conoco's Alliance refinery in the Gulf Coast has restarted partial operations, with full operations expected by the end of 1Q 2006.
INTRODUCING QUARTERLY ESTIMATES FOR 2006 We are introducing quarterly 2006 EPS estimates for Conoco Phillips, which now stand at $2.30, $3.11, $3.02, and $2.87 for 1Q, 2Q, 3Q, and 4Q, respectively. We have made no change to our full-year 2006-2010 EPS estimates. Note, we have updated our 2006 Henry Hub spot natural gas price assumption to $9.50 per MMBtu ($10 before), our 2006 and 2007 California refining margin to $24 per barrel ($28 before), and our 2006 New York, Chicago, and Mid-continent refining margins to $10.75 ($11 before), $11.50 ($13 before), and $11 ($13 before) per barrel, respectively. See Exhibit 1 for a summary model of ConocoPhillips.
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. |
