ConocoPhillips: The Concho Deal

by The Compound Investor

I last covered ConocoPhillips (COP) in the early days of the second quarter. Suffice to say, the stock has not shifted much on the price front since then. Its shares traded for around $32.90 back then, while they currently change hands for around $32.35. That rather disappointing performance comes despite oil prices rallying from $25 per barrel to around $40 per barrel over the same period. That isn’t a Conoco-specific issue of course; the entire energy sector is in the toilet right now.

Although the stock price might not be up to much, the company certainly is. A deal to acquire Texan producer Concho Resources for just under $10B was announced yesterday morning. It is a good one in my view. Concho produces around 320,000 barrels of oil equivalent per day (BOE/D) in the Permian Basin, and that led to EBITDA in the $3B region last year. Quick math puts the deal valuation at 4.25x FY19 EBITDA including debt, with EBITDA based on then-oil prices of around $57 per barrel. It looks like a pretty cheap price for Conoco. As for Concho shareholders, they also get cheap Conoco stock in return (the proposed deal is all-stock, with Concho stockholders receiving 1.46 Conoco shares for each Concho share owned).

Overall, it strikes me as a pretty good deal for both parties. One other plus point: leverage looks quite modest. Concho’s net debt load stood at around $3.6B at the end of 2Q20. Add in Conoco’s $8.1B, and that implies the enlarged firm sporting around $11.7B worth of debt net of cash. That figure is easily swallowed by combined FY19 EBITDA of circa $16.5B.

Outlook

I was bullish on ConocoPhillips stock back in April, and so it stands to reason that not much has changed on that front: it is very cheap, even based on fairly modest oil price conditions. Assuming the deal completes on the above terms, the enlarged firm sports an enterprise value of just under $60B. I make that equivalent to somewhere in the region of 3.4x EBITDA at oil prices in the $55 per barrel area. Granted, oil prices are not currently anywhere near that figure, but this is really the whole point of commodity stocks: the best time to buy is typically at low commodity prices; the best time to sell is in periods of high prices.

Although that last sentence may seem obvious, it is tougher to swallow in practice. Profit disappears at low prices and becomes plentiful again at higher prices. Most folks like owning money makers rather than strugglers. Fortunately, Conoco throws off a bunch of cash in modest pricing environments. For instance, operating cash flow over the two year period covering FY18 and FY19 – in which its average oil sales price came in at $64 per barrel – clocked in at $24B. The combined capital spending and dividend bill came in at $16.25B.

(Source: ConocoPhillips Investor Presentation)

Some other things to consider. Firstly, the capital allocation plan. The company plans to return 30% of operating cash flow to shareholders “via compelling dividends and additional distributions”. Quick math puts the implied shareholder yield in the double-digits in the above price environment. Secondly, the buyback program: Conoco resumed $1B worth of share repurchases this quarter. It is good to see an oil company conducting buybacks at depressed prices and not just in the more profitable points of the cycle. Indeed, it eats up over 10% of the implied Concho dilution on its own.

Finally, a note on the dividend: Conoco’s $1.72 per share annualized distribution equates to a yield of 5.3% right now. It costs the company around $1.8B per year in cash terms. If Conoco issues another 290M shares to fund the Concho deal, that is an extra $500M or so in annual cash outflow. Concho’s own free cash flow covers that with change. For shareholders, cashing over 1.3% every quarter certainly sweetens the deal until oil prices recover. As per April’s article, it now seems even more likely to me that Conoco stock returns over 100% within the next few years.

Note

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