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03-Jul-08

ConocoPhillips: Good COP, Better COP

My latest column is up at RealMoney.

With oil dictating everything in this market, I can’t understand why ConocoPhillips (COP) is trading at 7 times next year’s earnings.

It’s not like the earnings estimates are falling. 90 days ago, analysts expected the company to earn $10.43 a share this year and $10.59 next year. Today, the estimates are $12.41 and $13.44, respectively. The consensus five-year growth rate is just 1%, which would mean a drop back to $7.65 a share within five years. I just don’t see that happening, so there should be potential upside surprise to the growth estimates as well.

It’s not the earnings quality, either — at least not as measured by the accrual ratio. That ratio shows that Conoco’s accounting-based earnings are within 3% of its cash-based earnings. At BP (BP) , the difference is 99%. Suncor Energy (SU) has a 50% accrual ratio. For Petrobras (PBR) , it’s a whopping 122%. I’ll take Conoco’s tight relationship between earnings and cash flow any day.

Speaking of cash flow, Conoco has just loads of it. Over the last 12 months, the company’s free cash flow (cash flow from operating activities less capital expenditures) was $12 billion. Cash from operations has been growing steadily, suggesting that the free cash flow may improve further. With Conoco’s $145 billion market capitalization, that amounts to a free cash flow yield of 8.3%. The 500-basis-point premium over Treasuries is a pretty attractive risk premium, even if the cash flow doesn’t grow. Among the integrated oil names, only Total Fina (TOT) has a higher free cash flow yield.

ExxonMobil (XOM - Annual Report) looks pretty good — its free-cash-flow yield is nearly as high as Conoco’s, and its earnings quality is equally robust. Its earnings estimates are rising as well, though not by as much as Conoco’s. Yet even though it’s got less earnings momentum, it is trading at a higher P/E of 9 times next year’s estimate.

I think Conoco’s growth rate will be more like 4% or 5% annually over the next five years, and that its price-to-book could expand to at least 2.0 times over the same time frame. By my calculations, that scenario would result in an average annual total return of 17% to 20% a year.

Disclosure: At time of publication, William Trent has no financial position in the companies mentioned in this article.

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