Given my expectations for a quicker-than-expected recovery, I am bullish about the energy sector at large. As an IR consultant, I see particularly strong upside for smaller under-followed companies Aroway Energy (ARWJF.PK) and Derek Oil & Gas (DRKOF.PK). These companies are significantly undervalued and are well positioned to gain from improving press coverage. Towards that end, I plan on writing focus pieces on these attractive gems soon.
In the meanwhile, larger producers like ConocoPhillips (COP) will receive a disproportionate amount of attention. In this article, I will run you through a DCF model on ConocoPhillips and then triangulate the result with an exit multiple calculation and a review of the fundamentals compared to Chevron (CVX) and Valero (VLO). I find that the company is attractively undervalued.
First, let's begin with an assumption about revenues. ConocoPhillips finished FY2011 with $251.2 billion in revenue, which represented a 26.5% gain off of the preceding year; a slight deceleration. Analysts model a 4.7% per annum growth rate over the next half decade, which seems much too conservative given that it is around 600 bps below what is expected for the S&P 500, despite stronger growth in the recent path. But for the sake of proving my point, I accept the projection.
Moving onto the cost-side of the equation, there are several items to consider: Operating expenses, capital expenditures, and taxes. I model cost of goods sold as 82.% of revenue versus 2.7% for SG&A, 0.6% for R&D, and 6.5% for capex.
We then need to subtract out net increases in working capital. I expect that this will basically net around 0% over the projected time period.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 8.7% yields a fair value figure of $101.10, implying 33% upside. The market seems to be factoring in a WACC of 10.5%, which is too high considering that the company has an unlevered beta of 0.95.
All of this falls within the context of strong momentum:
During the quarter, our earnings adjusted for special items were $2.7 billion or $2.02 a share. That's up from $1.9 billion or $1.32 a share in the fourth quarter of last year. Our annualized return on capital employed was 13%. We generated cash from operations of $5.8 billion, which is $4.39 per share.
In E&P, our production of 1.6 million BOE per day was higher than the prior quarter and slightly above our expectations. In R&M, our global refining capacity utilization rate was 94%. We made significant progress on our asset disposition program with the sale of the Colonial, Seaway Crude and Seaway Products pipelines for $2.4 billion in proceeds during the quarter. Our repurchase of 46 million shares is quite a represented [sic] 3% of our shares outstanding, and we ended the year with $6.4 billion in cash and short-term investments.
From a multiples perspective, ConocoPhillips is equally attractive. It trades at 8.5x past and forward earnings versus 8x for Chevron and a respective 7x and 5.8x past and forward earnings for Valero. Assuming a multiple of 11.5x and a conservative 2013 EPS of $8.90, the rough intrinsic value of ConocoPhillips' stock is $102.35 - virtually in-line with my DCF result.
Consensus estimates for Chevron's EPS forecast that it will be roughly flat around the $13 - $13.40 period. Assuming a multiple of 11.5x and a conservative 2013 EPS of $13.10, the rough intrinsic value of the stock is $150.65, implying 40.4% upside. With management committed to returning free cash flow to shareholders through a generous capital allocation policy (i.e. 3% dividend yield), I also believe the downside is fairly limited.
Valero is the riskiest investment of the three. Accordingly, it is 43% more volatile than the broader market. Consensus estimates for its EPS are that it will grow by 12.7% to $3.81 in 2012, grow by 16% in 2013, and then fall by 18.8% in 2014. Assuming a multiple of 8x and a conservative 2013 EPS of $4.35, the rough intrinsic value of the stock is $34.80, implying 35.8% upside. I like the firm's vertical integration and relative strength in absorbing input inflation, but risk does give me pause. Overall, however, the company leans more heavily towards reward than risk.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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