28 March 2010

COP: Look Ahead to March 2010 Quarterly Results

This post describes our model of ConocoPhillips's (NYSE: COP) Income Statement for the first quarter of 2010, which will end on 31 March.

The purpose of the model is to establish a baseline for identifying surprises, positive or negative, in the quarterly results that will soon be reported.  Estimates for each line of the Income Statement are derived from management's guidance, the company's historical financial results, and other publicly available data.

We begin by reviewing background information about ConocoPhillips and the business environment in which it is currently operating.

2010 Analyst Meeting March 24, 2010 Slide 57

ConocoPhillips is a large Integrated Oil and Gas company with global reach.  It has a market capitalization of about $75 billion, and its Revenue was almost $150 billion in 2009

The company was formed in 2002 when Conoco, Inc., merged with Phillips PetroleumBurlington Resources, with its extensive natural gas operations, was added in March 2006 (when gas prices were high).  In 2004, ConocoPhillips began investing in LUKOIL (OTC: LUKOY), which is now responsible for 18% of total Russian oil production.  At the end of 2009, Conoco owned 20 percent of Lukoil.

In 2009, the ConocoPhillips's worldwide production, excluding LUKOIL, averaged 1.85 million barrel-of-oil equivalents per day, compared with 1.79 million in 2008.

In October 2009, ConocoPhillips announced it would "improve returns and deliver long-term organic growth from a reduced, but more strategic, asset base."  The company signaled it would sell assets worth approximately $10 billion over the next two years, and it would trim capital expenditures in 2010 to $11 billion, from $12.5 billion in 2009. 

More details about the asset divestitures emerged in March 2010 when Conoco publicized its intent to sell half of its 20 percent stake in Lukoil.  If Conoco can sell its Lukoil shares at the current market price, it would take in almost $5 billion.  The Financial Times quoted Conoco CEO Jim Mulva as saying, "The new opportunities in Russia haven’t developed for us as quickly as we would have thought."

The Wall Street Journal reported that Conoco's "restructuring is mandatory" because of the company's concentration in oil refining and natural gas, which are two of the weakest sectors of the energy industry.  A check of Conoco's last 10-K indicates that its Refining and Marketing segment provided 72 percent of total Revenue in 2009, and the Exploration and Production segment was responsible for 25 percent.

The low price of crude oil at the end of 2008 led Conoco to conclude that the company's assets were worth less than before.  The company reduced the carrying value of its intangible assets and investments by $35 billion, which was about 19 percent of the company's Total Assets at the time.  Asset impairment charges led to a loss of $31.8 billion (minus $21.37 per share) in the fourth quarter of 2008.

Berkshire Hathaway (NYSE: BRK.A), run by investing guru Warren Buffett, owned about 79 million shares of ConocoPhillips on 31 December 2008.  By the end of 2009, Berkshire had reduced this stake to about 38 million shares.  Buffett characterized the purchase of Conoco shares, when energy prices were soaring, as his biggest mistake in 2008.
2010 Analyst Meeting March 24, 2010 Slide 13

Energy prices surged through the first half of 2008.  The price of crude oil exceeded $140 per barrel at its peak.  The global economy then stalled, and speculators exited the market later in 2008.  Crude oil plunged below $40 per barrel by the end of last year, but the price has rebounded above $70 in 2009.  The higher price has been attributed to optimism about the economy and fears of a weaker dollar, and greater compliance with output quotas.

Natural gas prices also soared and crashed last year, but spot prices haven't had much of a rebound.

We're now ready to look ahead to Conoco's results for the March 2010 quarter.

The company's presentation to analysts on 24 March 2010 provided a good starting point, but it did not include specific quarterly guidance.

Given historical and current energy prices and margins, our working estimate for first-quarter Revenue is $47 billion, which would be a 53 percent increase relative to the first quarter of 2009.

Of the various costs and expenses reported by Conoco, we group "Purchased crude oil, natural gas and products" and "Production and operating expenses" and call the combination Cost of Goods Sold.  In 2009, CGS was 75.5 percent of Revenue, which translates into a Gross Margin of 24.5 percent. Because prices have rebounded modestly, we are assuming the Gross Margin will expand to 25 percent.  In other words, we're estimating that the Cost of Goods Sold will be (1 - 0.25) * $47 billion or $35.25 billion.

Based on historic data, it seems reasonable to expect a Depreciation expense of $2.4 billion.  Similarly, we'll estimate SG&A expenses (including non-income taxes in our presentation) at 11 percent of Revenue, or $5.2 billion.  We will then add $350 million for Exploration expenses and $200 million for non-recurring operating charges.

These figures would result in an Operating Income of $3.63 billion.

We then need to consider non-operating income and expenses.  For equity in the earnings of affiliates, our conservative expectation is a $500 million.  For other income less interest expenses, a net loss of $220 million would be typical.  This pushes our estimate of pre-tax income to $3.9 billion.

ConocoPhillips' effective income tax rate is quite variable from quarter to quarter, but a rate around 45 percent wouldn't be unusual when special tax matters don't interfere.  This rate would lead to provision for income taxes of $1.8 billion. 

After subtracting $30 million for Minority Interests, our estimate for Net Income becomes $2.12 billion ($1.41 per share).  In the year-earlier quarter, the company made $840 million ($0.56 per share).

Please click here to see a full-sized, normalized depiction of the projected results next to ConocoPhillips's quarterly Income Statements for the last couple of years.  Please note that our organization of revenues, expenses, gains, and losses, which we use for all analyses, can and often does differ in material respects from company-used formats.  The standardization facilitates cross-company comparisons.

Notes:  Several figures above were extracted from the ConocoPhillips Annual Analyst Meeting Presentation [6 MB pdf] on 24 March 2010.

Full disclosure:  Long COP at time of writing

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