29 January 2011

COP: Income Statement Analysis for the December 2010 Quarter

ConocoPhillips (NYSE: COP) earned $1.39 per diluted share on a GAAP basis in the December-ending fourth quarter of 2010, up 63 percent from $0.86 in the same three months of 2009. 

Adjusted earnings rose from $1.20 to $1.32 per share, a 10 percent increase.   Adjusted earnings exclude gains on asset sales, impairment charges, and other special items.

This post examines ConocoPhillips' Income Statement for the latest quarter and compares the entries on each line to our "look-ahead" estimates.  Reported earnings were 15 percent below our $1.64 EPS estimate.

The principal sources for this income statement analysis were the earnings announcement, the ensuing conference call presentation [pdf], and transcript (the latter provided by Seeking Alpha).

In a second article, we will report ConocoPhillips' scores as measured by the GCFR financial gauges.  The follow-up post will also provide the latest figures for the various financial metrics we use to analyze Cash Management, Growth, Profitability and Value.

Before getting into t
he details, we will take a step back to introduce the subject of today's analysis.

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 much higher than they are now).

The market value of the company is now around $100 billion, double its low in March 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 (NYSE: CVX).

ConocoPhillips earned $11.4 billion on revenue of $189 billion in 2010, with the Exploration & Production business generating $9.2 billion of the reported profits.  Earnings were $4.86 billion on revenue of $152.8 billion in 2009

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 a two-year period, and it would trim capital expenditures in 2010 to $11 billion, from $12.5 billion in 2009. 

A key component of ConocoPhillips's strategic plan has been the sale of its equity investment in Lukoil (OTC: LUKOY).  The investment represented a 20 percent stake, with a book value of $6.4 billion, in the Russian oil producer at the end of 2009.  Share sales in 2010 reduced the investment to a 2 percent equity interest by the end of the year.

The cash received from this and other asset dispositions has been used by ConocoPhillips to repurchase its own shares, pay dividends to shareholders, and fund capital investments.

ConocoPhillips produced 1.75 million barrel-of-oil equivalents per day in 2010, excluding Lukoil, down from 1.85 million BOE/day in 2009.   ConocoPhillips blamed the decrease, which was expected, on field decline and asset disposals.  ConocoPhillips estimated it had 8.3 billion BOE of proven reserves at the end of 2010, down 2.2 billion BOE.

Additional background information about ConocoPhillips and the business environment in which it is currently operating can be found in the look-ahead.

Please click here to see a normalized depiction of the actual and projected results for the just-concluded quarter, as well as the 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. 

Sales and other Operating Revenues of $51.7 billion in the fourth quarter were 20 percent more than last year.  Our $49 billion estimate was 5.3 percent too low.

Higher energy prices and refinery margins during the quarter more than compensated for a decline in energy production.  Production, not including a share of Lukoil's output, averaged 1.73 million barrel-of-oil equivalents per day in the quarter, down 5.5 percent from the same period of 2009. 

Of the various costs and expenses reported by ConocoPhillips, we group (for simplicity) two items --  "Purchased crude oil, natural gas and products" and "Production and operating expenses" -- and call the combination Cost of Goods Sold.  For the December 2010 quarter, we excluded $638 million in non-cash impairments, primarily related to the company’s investment in the Naryanmarneftegaz joint venture, from the CGS amount.  On this basis, CGS totaled $40.4 billion or 78.0 percent of Revenue. 

This equates to a Gross Margin of 22.0 percent, which is 180 basis points less profitable than the 23.8 percent margin in the same three months of 2009.  The Gross Margin was also 100 basis points below our estimate of 23.0 percent.

The Gross Margin might have fallen due to production or refining inefficiencies, maintenance costs, investments, or one-time charges. 

The Depreciation (including Depletion and Amortization) expense of $2.2 billion was 7.3 percent lower than last year's $2.39 billion.  The reported Depreciation expense was only 3.7 percent less than our $2.3 billion estimate.

Exploration costs in the fourth quarter of $307 million were down marginally from the same period last year.  We had estimated $300 million for these costs.

Taxes other than income and Sales, General, and Administrative expenses -- we combine these items -- totaled $4.9 billion, up 7 percent from last year.  The reported amount essentially matched our estimate.

Special operating expenses totaled $858 million, which includes the aforementioned $638 million impairment charge.  Please be aware this amount was cited in the earnings report but it was not separately identified on the Income Statement.  We assume it was included as a production expense, but this needs to be confirmed. 

Other special charges are related to impairments, accretion on discounted liabilities, and foreign currency transactions. 

We had only expected special charges of $200 million. 

Operating Income, which we define to be the difference between revenue and the expenses discussed above, was $3.1 billion.  This amount is 28 percent more than the comparable Operating Income of $2.4 billion in 2009's fourth quarter.
Operating Income was about $500 million, close to 14 percent, less than our $3.57 billion estimate.  The $638 million asset impairment charge was the most significant difference between the actual results and our estimates, but Revenue was better than we expected and the Gross Margin was less.  Other items were consistent with our expectation.

Equity in the earnings of affiliates fell from $545 million last year to $173 million.  The decline is a consequence of the company's termination of equity accounting in conjunction with the now-diminished Lukoil investment. 

Our $700 million for equity income was much too high.  We did not expect the Lukoil shares to be sold as fast as they were.

The earnings announcement for the most recent quarter states that ConocoPhillips had "$718 million in gains from North America E&P asset sales and LUKOIL share dispositions."  We assume this gain is included in the $1.318 billion entry labeled "Other Income" on the Income Statement, and we broke up the latter item accordingly.

Our earning model had only assumed an $250 million gain on asset sales.

For Net Interest and Other Income we subtracted $273 million in interest and debt expenses from Other Income (excluding the asset sale gain.)  This calculation resulted in income of $327 million, whereas we expected a net expense of $150 million. 

We need better insight into the components of Other Income to understand the difference.

Despite the various differences discussed above between the actual and predicted results, pretax income of $4.29 billion was only 1.8 percent below our estimate.

Income tax was what really threw our numbers out of whack.  The 52.2-percent effective Income Tax Rate for the quarter was far more burdensome than our 44-percent estimate.  We suspect the higher rate is somehow tied to Lukoil divestment.

Bottom-line Net Income rose to $2.04 billion ($1.39 per diluted share), compared to restated earnings of $1.29 billion ($0.86 per share) in the year-earlier quarter. 

Our $1.64 estimate for EPS was much too high, primarily because of the higher-than-expected income tax rate.  Other differences were related to asset impairment charges,  gains on asset sales, and equity in the earnings of affiliates.

As noted above, we had to make several assumptions about special items and other elements of the Income Statement.  The assumptions are subject to review and revision when more information (e.g., the 10-K) becomes available. 

Full disclosure: Long COP at time of writing

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