Markets have responded positively to news of ConocoPhillips’s decision to split its upstream and downstream businesses.
Research suggests specialist firms produce better outcomes in terms of production and profit, and speculation has follwed Conoco’s announcement that BP may do something similar on the back of tepid Q2 2011 results.
In this extract, Jens Zimmermann, CFA and Research & Strategy analyst at investment bank ABN AMRO, gives his analysis of Conoco’s decision.
As a going-away present before next year’s retirement, ConocoPhillips’s CEO Tony Mulva surprisingly announced the breakup of ConocoPhillips (COP) into two stand-alone exploration and refining companies.
Although the business separation makes sense strategically, our valuation analysis shows – based on conservative assumptions – that the strategic move will only create limited additional shareholder value to COP’s current share price level. While we maintain our ‘Buy’ rating at an unchanged price target of USD 90, we remove the stock from our recommended list because COP’s current restructuring programme has already eliminated the stock’s long-lasting valuation discount vis-à-vis its big Integrated Oil peers.
Disintegrating COP’s Integrated Business Model
In October 2009, COP reversed its previous (and highly criticized) “growth by acquisitions” strategy when management announced an extensive asset disposal programme aimed at future organic growth from a smaller and more profitable asset base.
The current restructuring and repositioning programme will generate cash of USD 20bln from asset disposals, by selling
underperforming assets (USD 10bln) and by divesting its 20% Lukoil stake (USD 10bln). About USD 15bln of these planned asset sales were already completed in 2010.
The key objective of this strategic shift is to unlock shareholder value by eliminating the company’s persistent valuation discount vis-à-vis its US Integrated Oils peers, Exxon Mobil (XOM) and Chevron (CVX).
The cash proceeds from these asset disposals will be used to return cash to shareholders through a massive USD 15bln share buy-back programme (of which about USD 4bln was completed in 2010) and through an increase in dividend payments. COP also intends to pay down debt to reduce its net gearing and to raise the company’s return on capital, which provides an additional valuation catalyst.
However, investors clearly favoured COP’s strategy to grow from a smaller and more focused asset base as seen in its strong share price outperformance vis-à-vis the MSCI World Energy index in general and XOM in particular.
Considering that COP’s noticeable share price outperformance has already confirmed the successful implementation of the company’s strategic repositioning, CEO Mulva’s final strategic move before his retirement next year to push for a full
separation between the upstream exploration & production (E&P) and downstream (refining & marketing (R&M) and
chemical) units took many investors by surprise.
COP intends to separate its upstream and downstream businesses into two stand-alone companies through a tax-free
spin-off of its downstream business. As COP will first need IRS approval for a tax-free spin-off, the separation is not expected to be completed before Q2 2012. After the split, COP shareholders will own shares in two separately-listed upstream and downstream companies.
Therefore, the key question for COP shareholders is: Now that COP’s strong outperformance has eliminated the stock’s
valuation discount vis-à-vis its US Integrated Oil peers, can totally splitting the company into two parts unlock additional
value by pushing the valuation multiples of its stand-alone upstream and downstream businesses higher than for the combined entity?
Risks to COP’s Spin-Off Plans
We believe the biggest obstacle for COP’s breakup plan will be for stand-alone COP Upstream to quickly achieve higher
production growth rates to reduce/eliminate a possible valuation discount vis-à-vis its faster-growing E&P peers. We see two risks that are directly related to achieving higher production growth rates, namely:
First, COP’s strong free cash flow-generating downstream business has financed the company’s upstream growth in the
past. As a stand-alone unit, COP Upstream will have to finance its exploration and development costs by itself, which will require higher debt and/or lower dividends as more cash will have to be channelled into expensive Capex requirements.
Second, as it is highly likely that COP Upstream will choose a sizeable acquisition to quickly boost its production growth, there is the risk that the company will be haunted by its own past by overpaying for a hurried or ill-timed acquisition (after all, it was this unsuccessful strategy of “growing by acquisitions” before 2009, which ultimately led to the strategic shift towards organic growth in October 2009).
