07 October 2007

COP: Looking ahead to 3Q Results

Energy behemoth ConocoPhillips (COP) will announce its third-quarter earnings on 24 October.

Although crude oil prices have soared, the cost of natural gas has dropped and this will depress COP's earnings. COP's purchase of Burlington Resources made it more dependent on gas than the other major energy companies. According to one published report, "Oppenheimer & Co. estimate that low natural gas prices will reduce ConocoPhillips' third-quarter earnings by about $280 million compared with the second quarter."

If that's not enough, COP announced that production was down and refining margins were "significantly lower" in the third quarter. The company's disagreement with the Venezuelan government explains part of the production drop.

Nevertheless, the price of a COP share advanced from $78.50 to $87.77 in the third quarter, and the $90 threshold was crossed at one point. Was the gain justified given the operational factors discussed above? The share price is now several dollars less.

Given these circumstances, we feel like we are taking a stab in the dark at guessing Conoco's third quarter sales. The company doesn't provide revenue estimates. The Yahoo Finance page includes a $71.3 billion revenue estimate, but that figure was submitted by a single anonymous analyst. The estimate on this same page for the second quarter was nowhere close to reality, so we're going to dismiss the current Yahoo estimate aside and rely on our own intuition from looking at historical data.

We're going to set a more modest $50 billion target, without a whole lot of conviction, for third-quarter revenues. This figure is 5.5 percent greater that sales in the second quarter, but only 4.0 percent higher than sales in the year-earlier quarter.

Conoco's Gross Margin has edged up over the last couple of years from about 25 percent of revenue to over 30 percent. Given the guidance discussed above, Conoco will probably be doing well to hold onto the 30 percent figure. We'll set the gross-margin target in the third quarter at 28 percent. In other words, we're guessing the Cost of Goods Sold will be 72 percent of $50 billion or $36 billion.

We'll also assume, based on historic data, a Depreciation expense of 4.5 percent of revenue, or $2.25 billion. Similarly, we'll estimate SG&A expenses at 11 percent of revenue, or $5.5 billion given our revenue estimate. Per company guidance, we need to throw in another $240 million for exploration expense. We'll assume $150 million for non-recurring operating charges.

These figures would result in an operating income of $5.86 billion.

We then need to consider non-operating income and expenses, such as equity in the earnings of affiliates, minority interests, and interest. The net figure for these income and expense items has been trending up, and we will set our expectation at $1.25 billion. This pushes our estimate of pre-tax income to $7.1 billion

Conoco's effective income tax rate generally seems to be between 40 and 45 percent, but the company indicated there would be some reversals of deferred tax charges. This would suggest that the tax rate will end up in the lower part of the range. If the rate is 41 percent in the third quarter, the tax bill would be $2.9 billion.

Our estimate for net income is, therefore, $4.2 billion ($2.55 per share). This is somewhat higher than the average of the professional analysts, which leads us to suspect our revenue estimate is too generous. As an experiment, we ran the numbers again with $45 billion for revenue. With all the same assumptions described above, net income decreases to $3.84 billion ($2.33/share).

Sept 2007
Sept 2006
50000 48076
Op expenses

CGS (36000) (33191)

Depreciation (2225) (2137)

Exploration (240) (197)

SG&A (5500) (5503)

Other (150)
Operating Income
6010 6757
Other income

Equity income 1150 1175

Interest, etc. 100
Pretax income
7110 7937
Income tax
(2915) (4061)
Net Income
4195 3876

2.55/sh 2.31/sh

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