The new data did not significantly change the analysis results. The Cash Management Gauge was trimmed by one point, but the Overall Gauge score stayed the same.
With worldwide oil, gas, and chemical operations, ConocoPhillips is the third-largest integrated energy company based in the U.S. Among international energy giants, it ranks fifth by Revenue and eighth by Market_Capitalization. Holding the sixth spot on the Fortune 500, Conoco's heft was achieved with mergers and acquisitions. Most notably, Conoco, Inc., and Phillips Petroleum combined in August 2002. The resulting behemoth spent $33.9 billion in March 2006 to purchase Burlington Resources, which had extensive natural gas operations in North America.
The oil industry operates on a global scale, and Conoco's international holdings have become problematic. A disagreement with the Venezuelan government caused Conoco to record in its second-quarter financial results "a complete impairment of its entire interest in its oil projects in Venezuela of approximately $4.5 billion, before- and after-tax." A $4.5 billion write-off for a company with $170 billion in assets is not a cause for panic, but it is still significant.
Conoco shares surged in the first half of the year and have been bouncing between $80 and $90 recently. Super-investor Warren Buffett must be pleased since the company he runs, Berkshire Hathaway, owns about 18 million shares of Conoco. Of course, $80 for a barrel of oil didn't hurt.
When we analyzed Conoco after the June quarter, the Overall score was a weak 27 points. Of the four individual gauges that fed into this composite result, Cash Management was the strongest at 16 points. Value was weakest at 0 points, which really worried us (unnecessarily as it has turned out so far) at the time.
Now, with the available data from the September 2007 quarter, our gauges display the following scores:
- Cash Management: 13 of 25
- Growth: 3 of 25
- Profitability: 10 of 25
- Value: 0 of 25
- Overall: 24 of 100
Before we examine the factors that affected each gauge, let's compare the latest quarterly Income Statement to our previously communicated expectations. Prior to the release of the preliminary results, COP announced that production was down and refining margins were "significantly lower" in the third quarter. There have been reports that refining margins are down as much as 90 percent from their May 2007 highs.
| ($M) | | Sept 2007 (actual) | Sept 2007 (predicted) | (actual) |
| Revenue (1) | | 46062 | 50000 | 48076 |
| Op expenses | | | | |
| | CGS (2) | (33482) | (36000) | (33191) |
| | Depreciation | (2052) | (2225) | (2137) |
| | Exploration | (218) | (240) | (197) |
| | SG&A (3) | (5152) | (5500) | (5503) |
| | Other | (249) | (150) | (291) |
| Operating Income | | 4909 | 6010 | 6757 |
| Other income | | | | |
| | Equity income (4) | 1289 | 1150 | 1175 |
| | Interest, etc. (5) | 166 | 100 | 5 |
| Pretax income | | 6364 | 7110 | 7937 |
| Income tax | | (2691) | (2915) | (4061) |
| Net Income | | 3673 | 4195 | 3876 |
| | | $2.23/sh | 2.55/sh | 2.31/sh |
| | | | | |
2. CGS = Purchased crude oil, natural gas and products + Production and operating expenses
3. SG&A = SG&A expenses + Taxes other than income taxes
4. Equity income = Equity in earnings of affiliates - Minority interests
5. Interest, etc. = Other income - Interest and debt expense
Revenue fell below our admittedly uncertain expectations. We forecast Revenue to be 4 percent greater than in the year-earlier quarter, whereas Revenue actually decreased by 4.2 percent. Operating costs as a percentage of revenue were fractionally higher than we expected. We thought the Cost of Goods Sold (CGS) would be 72 percent of Revenue, and the actual value was 72.7 percent. Depreciation expenses were 4.5 percent of Revenue, matching our estimate. Sales, General, and Administrative (SG&A) expenses were 11.2 percent of Revenue, compared to our forecast of 11 percent.
The net effect of much less revenue, and slightly higher costs, was Operating Income 18.3 percent below the forecast value. [We should mention at this point that our definition of Operating Income, which we use for all the companies we analyze, is not identical to Conoco's definition. The differences can be determined from the footnotes above.]
Greater than expected Non-Operating Income, by $205 million, helped close the gap. On the other hand, a slightly higher Income Tax Rate, 42.3 percent vs. 41 percent forecast) hurt Conoco's bottom line. As a result, Net Income fell below our prediction by 12.4 percent.
Cash Management. This gauge declined from 16 points in June to 13 points now.
The measures that helped the gauge were:
- LTD/Equity = 24.7 percent, down nicely from 29.5 percent in Sept 2006
- Cash Conversion Cycle Time (CCCT) = -0.1 days, down from 3.0 days in Sept 2006, for this measure of efficiency.
- Debt/CFO = 0.9 year compared to 1.4 years 12 months ago
- Working Capital/Market Capitalization = -0.3 percent, up from -2.2 percent.
- Days of Sales Outstanding (DSO) = 27.8 days, substantially above the 22.1-day level one year earlier
- Current Ratio =1.0; weaker than we like, but matching the historic average.
Growth. This gauge didn't change from June's 3 points.
None of our measures helped the gauge that much.
- Revenue growth = -8.9 percent year-over-year, down sharply from +15.4 percent
- Revenue/Assets = 101.6 percent, down significantly from 118.1 percent in a year; sales efficiency is worsening
- Net Income growth = -33.6 percent year-over-year, down from +31 percent (hurt substantially by the Venezuelan impairment charge).
- CFO growth = 13.2 percent year-over-year; not bad, but down from 27 percent.
Profitability. This gauge maintained the 10 points it achieved in June.
The measures that helped the gauge were:
- FCF/Equity = 13.0 percent, up from 7.4 percent in a year
- Accrual Ratio = -0.3 percent, down (a good thing) from +6.2 percent in a year.
The decreasing Accrual Ratio tells us that more of the company's Net Income is due to CFO, and, therefore, less is due to changes in non-operational Balance Sheet accruals.
The measures that hurt the gauge were:
- ROIC = 10.1 percent, down from 13.3 percent in a year
- Operating Expenses/Revenue = 87.4 percent, up from 86.7 percent in a year.
Higher Depreciation expenses were the main reason Operating expenses rose over the course of the last year.
Value. Conoco's stock price rose over the course of the quarter from $78.50 to $87.77. The combination of lackluster operating performance and a soaring stock price is the reason why the Value gauge is stuck at 0 points.
- Enterprise Value/Cash Flow = 7.1, not expensive, but up from 6.2 in Sept 2006
- P/E = 13.5, up from 6.2
- P/E to S&P 500 average P/E = 17 percent discount, compared to a 60 percent discount one year ago
- Price/Revenue ratio = 0.8, compared to 0.5 one year ago.
The average P/E for the Integrated Oil and Gas industry is also 12.3. The average Price/Revenue for the industry is currently 1.2.
One reason Conoco shares appear overvalued relative to historic norms is the termination of operations in Venezuela. Net Income would have been 43 percent higher if we had ignored the $4.5 billion impairment charge, and even more if Venezuelan operations were continuing to contribute to revenue and earnings. In the September 2006 quarter, about 9 percent of Conoco's crude-oil production came from Venezuela.
We don't have a sufficient understanding of company operations to perform a rigorous what-if analysis, but we backed out the impairment charge to see how this factor alone would change the analysis. The gauge scores barely budged. We were initially mystified, but a closer look provides the explanation. Instead of Net Income dropping by 33.6 percent, year-over-year, it would have dropped by only 5 percent. This difference is huge, but a drop, irrespective of magnitude, isn't going to stir the Growth gauge. Similarly, instead of the P/E soaring to 13.5, this ratio would be a seemingly inexpensive 9.4 if the Venezuelan charge is ignored. However, the P/E would still be up substantially from where it had been over the last few years.
More important to Conoco than Venezuela is the refining margin (gasoline prices have not kept up with crude oil costs), a recovery in the price of natural gas, and improved operational efficiency.
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