ConocoPhillips (NR): The appropriate use of excess cash and the sustainability of $8+ US natural gas prices the key issues with Burlington Resources (NR) acquisition - Goldman Sachs - December 14, 2005
The two major issues we see with ConocoPhillips' (NR) announced acquisition of Burlington Resources (NR) is the appropriate use of excess cash generated during a period of high commodity prices and the sustainability of $8+ per MMBtu US natural gas prices. With Conoco shares having fallen a cumulative 8% since investors first became aware of its interest in BR, the consensus view appears to reflect concerns on both counts. However, Conoco has not moved into the vicinity of the super majors without taking calculated risks and it has a strong track record of execution following major acquisitions. If US natural gas prices stay above $8 per MMBtu over the next several years, we believe the Street?s view of the transaction will improve.
(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.)
Without taking risks, ConocoPhillips would not be within the realm of the supermajors ConocoPhillips' announced acquisition of Burlington Resources adds primarily North America natural gas assets and increases the company's US natural gas price exposure. The transaction comes at a time of excess free cash flow driven by high commodity prices and increasing difficulty by western oil companies to replace and grow production volumes. The deal, in our view, is capturing a combination of
(1) an arbitrage that appears to exist between natural gas-leveraged E&Ps and commodity strip prices,
(2) the opportunity to reinvest excess free cash in an otherwise prospect-poor environment, and
(3) the ability to expand the company's natural gas portfolio and potentially increase opportunities for E&P production growth.
Investors appear to be most concerned about the sustainability of $8+ per MMBtu Henry Hub natural gas prices long-term that we think are required for the transaction to generate acceptable rates of return. Investors wonder whether excess cash should not have instead been returned to Conoco shareholders. In our view, a major stock buyback program instead of an acquisition would certainly have been the safer approach. However, a safe approach would not have transformed Conoco from a third-tier domestic oil to the realms of super major status. Appropriate use of above-normal free cash flow will be debated by the Street
When looking at the Burlington Resources acquisition as a stand-alone "project," we estimate it will take roughly four years of commodity strip prices ($8-$12 per MMBtu Henry Hub spot natural gas) to sufficiently pay down acquisition capital such that there is no long-term dilution to ROCE in the event natural prices revert to a lower $5 per MMBtu level long term. Including the application of free cash flow from legacy ConocoPhillips would decrease the needed period of commodity strip pricing (i.e., strong commodity prices) to a little over 2 years.
The question therefore boils down to whether Conoco should effectively be transferring its near-term legacy free cash flow to current Burlington shareholders, but with the back-end payoff of gaining a sizable, high-quality US natural gas asset base that it will own into perpetuity. The natural Street reaction is that returning the excess cash from legacy Conoco properties to Conoco shareholders is preferable. Conoco is taking a calculated risk that the combination of future commodity pricing and resource upside on Burlington properties justifies the temporary redirection of near-term legacy free cash flow to Burlington shareholders. This is not the first calculated risk the company has taken. ARCO Alaska, Tosco, the Conoco-Phillips merger, and the ongoing acquisition of Lukoil shares have moved ConocoPhillips into the realms of super major status in terms of both size and current profitability. The nagging question for Conoco investors is whether its will generate super major profitability in a less robust commodity environment (i.e., 12%-15% return on capital employed (ROCE) at a time the rest of industry is earning 8%-10% ROCE).
We attribute Conoco's ongoing valuation discount on an EV/DACF basis (enterprise value divided by debt-adjusted cash flow from operations) relative to the super majors Exxon Mobil, BP, Total, and Royal Dutch Shell to investor concerns that comparative ROCE will not look as favorable in a less robust commodity environment. Conoco does trade similarly to Chevron, as Chevron faces some of the same questions as Conoco in terms of "normalized" ROCE. In years past, Conoco traded at a discount to Chevron, suggesting investors have assumed it has closed the gap with Chevron in terms of asset quality, breadth, depth, profitability, and balance sheet strength, which we agree has occurred. In our view, the likelihood of generating a sustained improvement in ROCE in a less robust commodity environment would have been enhanced if all of Conoco's excess cash had been used for stock buyback or dividend payments rather than a major acquisition.
However, that does not mean that Burlington is not a risk worth taking. The reality is that under short-term Wall Street consensus thinking, Phillips Petroleum would not have purchased ARCO Alaska, Tosco, or merged with Conoco. ConocoPhillips management to its credit looked past short-term Street thinking and pursued what it believed was the right strategy to create long-term shareholder value. The irony is that Conoco also created significant short-term shareholder value as reflected by its strong price performance over most of the last several years. In essence, growth ahead of a commodity upcycle has been a superior strategy to a defensive ROCE maximization approach that would have assumed a lower commodity price environment was imminent. This will likely prove true until commodity prices fall. The key therefore for companies pursuing growth strategies during an upturn is to at some point stop spending capital. Conoco is taking the view that the time to stop spending has not yet arrived. This is not inconsistent with our own view that above-normal commodity prices are likely to persist through the remainder of this decade. If US natural gas prices stay above $8 per MMBtu long term and Conoco uses excess cash to pay down acquisition capital as it has done in all of its previous transactions, we think the opportunity for sustained ROCE improvement in a less robust commodity environment exists. In that scenario, Conoco will likely have earned its super major valuation on a much expanded asset base and the risk in acquiring Burlington will have been worth the price paid.
To generate a 12% IRR, we estimate US natural gas prices need to stay above $8 PER MMBTU We estimate the Burlington acquisition will generate an 8% after-tax IRR assuming
(1) three years of commodity strip prices ($8-$12 per MMBtu for Henry Hub spot natural gas and $60-$64 per barrel for WTI spot oil) followed by "normalized" $5 per MMBtu gas and $35 per barrel oil thereafter,
(2) $375 million of annual pre-tax synergies, and
(3) an $88 per BR share acquisition price (based on December 13, 2005 closing stock prices).
In order to generate a 10% IRR, we estimate the long-term Henry Hub gas price would need to be around $7 per MMBtu (with all other assumptions remaining the same). A 12% IRR would require a long-term gas price of $8 per MMBtu and a 15% IRR an approximate $9 per MMBtu long-term gas price. Under our base-case commodity price assumptions, we estimate the Burlington acquisition will be dilutive to near- and long-term EPS as well as ROCE.
Note, we have removed our previous assumption for share repurchases in 2006, but resuming in 2007. We see 2%, 7%, and 12% dilution to our 2006E, 2007E, and 2008 normalized EPS estimates, respectively. We estimate the acquisition will be dilutive to ROCE using tangible capital (i.e., excluding goodwill) by 0.8%, 0.5%, and 0.3% for 2006E, 2007E, and 2008 normalized, respectively. Our base-case commodity price deck remains $68 per barrel for WTI spot oil for 2006 and 2007, $10 per MMBtu for Henry Hub spot natural gas for 2006 and $9 per MMBtu for 2007, and a normalized $35 per barrel oil and $5 per MMBtu gas price for 2008 and beyond. Asset quality, balance sheet health, integration do not appear to be major risks We believe Burlington has a high-quality North America asset base, but with less unbooked future resource upside than peer companies like EnCana (OP/A), XTO Energy (OP/A), and EOG Resources (IL/A). However, the assets seem consistent with Conoco's legacy asset base in the sense of offering longer-lived, lower-risk steady production without much by way of needed exploration success in order to at least replace production every year. The transaction looks quite manageable from a balance sheet perspective. Immediately following the deal, we estimate Conoco's net debt-to-tangible capital ratio will rise to 32% from 11%. By year-end 2007, we assume the application of free cash flow to debt reduction will decrease Conoco's net debt-to-tangible capital ratio to 13%. Given Conoco's strong track-record of merger integration and operational execution, we have confidence that Burlington will be integrated seamlessly into the Conoco organization.
Culturally, we see a strong fit, as both companies employ a lower-risk operational and financial approach to the business. Two current Burlington directors, Bobby Shackouls (CEO) and William Wade, are expected to join Conoco's Board. Randy Limbacher, Burlington's executive vice president and COO, will take responsibility for Conoco's North and South America E&P.
Updated estimates
We have updated our 2006-2010 EPS estimates for ConocoPhillips to reflect the estimated impact from the announced acquisition of Burlington Resources and minor other adjustments. Our respective 2006-2010 EPS estimates now stand at $11.35 ($11.55 before), $11.45 ($12.25 before), $4.80 ($5.45 before), $5.07 ($5.84 before), and $5.30 ($6.17 before).
I, Arjun Murti, hereby certify that all of the views expressed in this report accurately reflect my personal views about the subject company or companies and its or their securities. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report. |
