At half price, value investors should not ignore the steep discount on ConocoPhillips (NYSE:COP). ConocoPhillips stock is on sale because crude oil prices face plenty of downward pressure.
Not only is the coronavirus lockdown sending energy demand lower but increased production is flooding supply. How might ConocoPhillips stand out against the other major oil suppliers? And how will the company manage costs to adjust for falling revenue?
On March 18, ConocoPhillips listed several steps to cut costs. It lowered its capital expenditures by 10%, or $700 million, over its previously announced guidance. This will slow development activity in the Lower 48. As a result, COP’s 2020 production guidance will fall by ~20,000 barrels of oil equivalent per day.
Despite ConocoPhillips’ stock trading at lows, management will cut its stock buyback plan to $250 million a quarter. This is down from the $750 million per quarter plan.
The capex cut and slower stock repurchase plan will save the company $2.2 billion in the use of cash. The unfavorable market conditions justify the cash savings but investors are getting a lower return in the stock they own. Instead of reducing the share count at a favorable discount, management may end up buying more shares as the price recovers.
Healthy Balance Sheet and ConocoPhillips Stock
ConocoPhillips ended the fiscal year 2019 with $8.4 billion in cash. It generated over $5 billion in free cash flow, thanks to the $11.4 billion in cash flow provided by operations.
At the time, the company’s operations thrived as underlying production grew by 5% and the Lower 48 Big 3 production rose by 22%. But the $3.5 billion in stock buyback at over $60 a share will prove costly. The company will need to slow its project developments instead of growing the business.
Investors also have to wait for oil prices to improve before the company increases its operational spending. Before the drop in oil prices, COP posted a strong gross margin of 28.6% and a return on assets of 10.2%. This is above the average S&P 500 and earns the company a quality score of 94 on Stock Rover. The stock also earns a high-value score because of its low price-to-earnings and price-to-free cash flow ratios:
|Price / Earnings||5.5||74.8||20.9|
|Price / Sales||1.2||0.9||2|
|Price / Free Cash Flow||8.9||12.8||19.7|
Data courtesy of Stock Rover
On Tipranks, the average price target on ConocoPhillips stock is $48.13. Conservative investors may use a 5-year discounted cash flow model: EBITDA Exit model instead. Assuming the following metrics, the fair value is $40.20:
|Discount Rate||12.0% – 10.0%||11.00%|
|Terminal EBITDA Multiple||4.1x – 6.1x||5.1x|
|Fair Value||$32.76 – $48.24||$40.20|
For 2020, ConocoPhillips planned for exploration in Alaska, testing in Argentina and Norway, and continued Montney appraisal drilling, but since its operating plan will fall, underlying production growth will slow.
Still, the company must align operating costs with the realities of lower oil prices. Management prepared for a $45 – $65 per barrel West Texas intermediate price point this year. Instead, at $18/bbl, the company will lose more money as it sells more product.
In the fourth-quarter conference call, management said it cut its demand forecast down by 100,000 to 200,000 barrels a day due to the coronavirus in China. And after much of the major countries implemented a lockdown, COP’s demand forecast is likely lower.
Investors should brace for a sharp drop in sales in 2020. Oil prices may have further to fall but at current levels, it does not have much downside ahead.
Instead, a gradual reopening of businesses and an OPEC production cut should ease supplies. ConocoPhillips stock will recover as the energy market reaches a more stable equilibrium. Timing the general rebound in the sector is impossible. Instead, investors should pick the strongest companies in the space in which ConocoPhillips is one of them.
Disclosure: As of this writing, the author did not hold a position in any of the aforementioned securities.