19 December 2010

COP: Look Ahead to December 2010 Quarterly Results

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

The purpose of the model is to establish a baseline for identifying surprises, positive or negative, in the quarterly results the company will report.  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.

ConocoPhillips is one of the ten biggest Integrated Oil and Gas companies, which produce, refine, transport, and market energy products.  The company was formed in 2002 when Conoco, Inc., merged with Phillips Petroleum.  It added Burlington Resources, with its extensive natural gas operations, in March 2006 (when gas prices were high).

The market value of the company is now around $100 billion, up from about $60 billion in early 2009 but still well below the all-time high of $150 billion.

ConocoPhillips has business interests in 26 countries around the world, from Algeria to Vietnam.

For financial data reporting, ConocoPhillips has six operating segments:  Exploration & Production, Midstream, Refining & Marketing, Lukoil Investment, Chemicals, and Emerging Businesses.  The Chemical segment consists of a joint venture with Chevron.

The Refining and Marketing segment provided more than 70 percent of ConocoPhillips's Revenue in 2009, and Exploration & Production contributed most of the rest.  However, Exploration & Production and the Lukoil Investment generated much of the year's Net Income.

The company's worldwide production, excluding Lukoil, averaged 1.85 million barrel-of-oil equivalents per day in 2009, compared with 1.79 million BOE/day in 2008.

ConocoPhillips earned $4.86 billion ($3.24 per share) on revenue of $152.8 billion in 2009.  In 2008, the roller-coaster rise and fall of crude oil prices resulted in record-high annual revenue of $246.2 billion.  However, charges slashing the carrying value of intangible assets and investments by $33 billion led to a $17 billion loss 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. 

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.

Conoco first stated it would sell half of its 20 percent stake in Russian oil producer Lukoil (OTC: LUKOY), which it began acquiring in 2004.  The company later decided to pursue the sale of its entire Lukoil investment by the end of 2011.  Many of Conoco's shares were sold directly to a Lukoil subsidiary; Conoco indicated it would sell additional shares in the open market.  As of 30 September 2010, Conoco's ownership in Lukoil has been cut to 5.9 percent of the Russian company.

ConocoPhillips has also sold equity investments in Syncrude and CFJ Properties.

Some part of the proceeds from these asset sales are being used by ConocoPhillips to repurchase its own shares.

Prices of energy products move up or down based on numerous factors, including (1) the demand for energy, which is related to worldwide economic conditions; (2) geopolitical, environmental, and regulatory constraints on the supply; (3) compliance with output quotas; (4) the availability of new energy sources; and the value of the dollar.  In 2010, the price of crude oil has generally been between $70 and $90 per barrel, and it is now near the top of this range.  Although the price has more than doubled from early 2009, when the global economy seemed most fragile, crude oil remains well below its $140 peak in 2008. 

Natural gas prices also soared and crashed in 2008, but spot prices haven't had much of a rebound.  Increased production from shale formations has greatly increased the supply of gas.

Investing guru Warren Buffett, of Berkshire Hathaway (NYSE: BRK.A), characterized the purchase of ConocoPhillips shares, when energy prices were soaring, as his biggest mistake in 2008.  Berkshire still owned 29 million COP shares on 30 September 2010.

ConocoPhillips earned $2.05 per diluted share on a GAAP basis in the September-ending third quarter of 2010, more than double earnings of $0.98 in the same three months of last year. 

Adjusted earnings, which exclude special items, rose from $0.95 to $1.50 per share.  Gains on asset sales were the principal difference between adjusted and reported earnings in the most recent quarter.

Readers wanting to take another look at ConocoPhillips's September 2010 quarter might wish to review our Income Statement and Financial Gauge analyses.

We're now ready to look ahead to ConocoPhillips's results for December 2010 quarter.

The press release on 27 October 2010 announcing third-quarter results did not include any specific guidance for ConocoPhillips's fourth quarter or the remainder of 2010.  However, during the ensuing conference call, the company's management commented on expectations for production, refinery utilization, and costs.  See the transcript from SeekingAlpha and the presentation slides [pdf] and for the details.

Production is expected to average 1.8 million barrel-of-oil equivalents per day in 2009, or about the same as in 2008.  Production in the fourth quarter should be similar to the third quarter's 1.72 million  BOE per day.  A variety of circumstances, such as asset sales, will trim production by about 100 thousand BOE per day.

Refinery utilization will be negatively affected by maintenance activities. 

Conoco's Revenue in the December 2010 quarter should benefit from the rise in crude oil prices and modestly improved refining margins, but production constraints and asset dispositions will limit gains.  Given these circumstances, our Revenue estimate is $49.0 billion. 

This amount is 3.8 percent greater than the company's Revenue in the September 2010 quarter, and it is 14 percent higher than in the fourth quarter of 2009.

Of the various costs and expenses reported by ConocoPhillips, we group "Purchased crude oil, natural gas and products" and "Production and operating expenses" and call the combination Cost of Goods Sold.  ConocoPhillips has kept the CGS close to 76 percent of Revenue, translating into a Gross Margin of 24 percent, in recent quarters.  However, CGS increased to 77.6 percent (Gross Margin = 22.4 percent) in the September 2010 quarter.

Energy prices, refining margins, and maintenance activities can affect the Gross Margin.

We estimate the Gross Margin will recover to about 23 percent in the December 2010 quarter.  In other words, we're estimating that the Cost of Goods Sold will be (1 - 0.23) * $49.0 billion = $37.7 billion.

Based on historic data, it seems reasonable to expect a Depreciation expense of $2.3 billion.  Similarly, we'll estimate SG&A expenses (including non-income taxes in our presentation) at 10 percent of Revenue, or $4.9 billion.  We will then add $300 million for Exploration expenses and $200 million for non-recurring operating charges.

These figures would result in an Operating Income of $3.6 billion, up from $2.4 billion in December 2009.

We then need to consider non-operating income and expenses.  The first such item is equity in the earnings of affiliates, and it has not been unusual for ConocoPhillips to record $1 billion of this income in a quarter.  Most equity income has been due to Conoco's Lukoil investment (now being sold) and the joint venture with Chevron. 

Since the divestiture of the Lukoil shares will trim equity income by a significant amount, our estimate for equity in the earnings of affiliates is $700 million for the December 2010 quarter.

The second non-operating item is gains or losses on asset sales, which can have a substantial and difficult-to-predict impact on reported earnings.  ConocoPhillips has recorded asset-sale gains of $4.0 billion in the last six months.  We will be more conservative and set a $250 million target for this item in the current quarter.

For other income less interest expenses, a net expense of $150 million would be typical.  This brings our estimate of pre-tax income to $4.4 billion.

ConocoPhillips' effective income tax rate is quite variable from quarter to quarter, but a rate around 44 percent wouldn't be unusual when special tax matters don't interfere.  This rate would lead to provision for income taxes of $1.9 billion. 

After subtracting $20 million for Non-controlling Interests, our estimate for Net Income becomes $2.43 billion ($1.64 per share).  In the year-earlier quarter, the company made $1.29 billion ($0.86 per share).

Please click here to see a 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.

Full disclosure:  Long COP at time of writing

No comments:

Post a Comment