24 February 2007

COP: Analysis through Dec 2006

With worldwide oil, gas, and chemical operations, ConocoPhillips (COP) is the third-largest integrated energy company based in the U.S. Among international energy giants, COP ranks fifth by Revenues and eighth by Market Capitalization. ConocoPhillips holds down the sixth spot on the Fortune 500.

The first challenge facing an analyst of ConocoPhillips is that the company's financial record effectively begins with the merger of Conoco, Inc., and Phillips Petroleum in August 2002. Financial statements for the two predecessor companies are readily available, but it is not practical for independent parties to integrate the data because they would lack the means to test the validity of the many assumptions that would be required. To complicate matters more, ConocoPhillips purchased Burlington Resources for $33.9 billion in March 2006 for its extensive natural gas operations in North America. Therefore, the analyst's second challenge is to determine whether recent alterations in the company's financial data represent "real" operational changes or simply the effect of the Burlington purchase. The third challenge for the analyst is that ConocoPhillips's performance is driven, first and foremost, by the price of oil. If the latter rises, ConocoPhillips will look good irrespective of the financial artifacts we work so hard to uncover and assess.

When we analyzed ConocoPhillips after the quarter that ended in September 2006, the Overall score was a modest 38 points. Of the four individual gauges that fed into this overall result, Growth was the strongest at 12 points. Cash Management was weakest at 5 points.

We have since updated the analysis to incorporate COP's complete financial results for 2006. With the data available through 31 December 2006, our gauges now display the following scores:

Cash Management. This gauge held steady at 5 points. The Current Ratio is now 0.95. It has been recovering since bottoming out at 0.80 in March 2006, when cash levels dropped to pay for the Burlington acquisition. We hope to see the increases continue. Long-Term Debt/Equity is 28 percent, up from 20 percent the year earlier, but down from 36 percent in the merger's aftermath. We're going to ignore Inventory levels, because our analytical techniques involving Inventory are geared towards manufacturers. (We're unsure that Inventory data on the Balance Sheet of an energy company provides useful information about current or prospective sales.) Accounts Receivable/Revenues are 28 days. This is several days higher than the historic value for the company, and it might indicate the company is having more trouble getting paid by its customers.

Growth. This gauge dropped 4 points from September. Revenue growth is now a tepid 2 percent year over year, down from a robust 33 percent a year ago. Net Income growth is a more encouraging 14 percent, although down from an unsustainable 68 percent a year ago. The increase was slowed by a change in the income tax rate from 42 to 45 percent. CFO growth is a solid 22 percent, down from a remarkable 47 percent a year ago. Revenue/Assets is 111 percent; it has been trending down. It indicates that the company is becoming less efficient at generating sales.

Profitability. This gauge dropped 2 points from September. ROIC slipped to a moderate 13 percent. It was 19 percent a year ago. FCF/Equity fell to 7 percent from 11 percent in a year. Operating Expenses/Revenue move down in the last year from 86 percent to 89 percent. The change was primarily due to an increase in Gross Margin. The Accrual Ratio, which we like to be both negative and declining, edged down from +7 to +6 percent. This tells us that slightly more of the company's Net Income is due to CFO, rather than changes in balance sheet accruals.

Value. This gauge, based on the stock price of $71.95 at year's end, dropped to a weak 4 points, compared to 11 and 14 points 3 and 12 months ago, respectively. The P/E at the end of the quarter was 7.8, up a little from recent quarters, but close to the longer-term average. The average P/E for the industry is 10.0. To remove the effect of overall market changes on the P/E, we note that the company's current P/E is only 48 percent of the average P/E, using core operating earnings) for stocks in the S&P 500. This discount to the market is consistent with the historical average for COP. The PEG ratio of 0.55 is indicative of a cheap stock. The ratio has increased from irrationally low levels. The Price/Revenue ratio has increased to 66 percent from about 50 percent. The increase suggests the shares are becoming more expensive. On the other hand, the average Price/Sales for the industry is almost 1.0.

Now at a disappointing 22 out of 100 possible points, the Overall gauge has fallen markedly. The Value score is telling us that a stock price increase to over $70 was too big a jump. The market said the same thing, as the price fell back into the mid $60's.

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