ConocoPhillips: How Risky Is The Dividend?
Jan. 12, 2015 9:57 AM • cop
- The current 4.5% dividend yield is appealing, but is it sustainable amid the weak oil outlook?.
- Free cash flow will likely be negative in 2014 and 2015 (maybe 2016), hence COP will need liquidity from balance sheet cash and debt financing to maintain its dividend.
- Two scenario analyses were performed to test COP's liquidity position, and the results suggest the dividend will be safe in the next few years.
Thanks to the oil turmoil and collapse of the share price, the dividend yield for ConocoPhillips (NYSE:COP ) has gone up to 4.5% as this article was written. A message had been delivered from management that protecting the dividend payout is the company's priority amid the weak oil environment. While the 4.5% dividend yield appears to be very attractive, an understanding of the company's current liquidity position would definitely help in gauging the risk in sustainability of the 4.5% yield. I will provide some insights in this article.
To start the liquidity analysis, I first constructed a cash flow model to forecast COP's free cash flow and its various components in the period from 2014 to 2016 (see chart below).
My analysis relies on current consensus EBITDA estimates, which predict the metric to drop from $21.8B in 2014 to $18.2B in 2015 and then recover modestly to $22.5B by 2016. As a note, the market's current consensus forecasts are based on average Brent price expectations of $65-$70 per barrel in 2015 and $70-$80 per barrel in 2016 (see the first chart).
In the past 3 and 5 years, COP's average EBITDA to operating cash flow conversion rate came in at 74.0% and 71.7%, respectively. To be conservative, I assumed the conversion to be flat at the 71.7% level through 2016. In this case, operating cash flow was projected to drop from $15.6B in 2014 to $13.0B in 2015 and then rise to $16.1B in 2016 (see the first chart).
With the weakened oil outlook, management announced a lower capital spending budget of $13.5B for 2015 (PR linked above), which is 20% below the $16.8B figure in 2014. By plugging these figures in my model and assuming the capex to rise by inflation rate in 2016, my analysis suggests COP's free cash flow will be in negative territory by 2015 and turn positive in 2016 (see the first chart).
COP made a total dividend payment of $3.3B in 2013. With an assumption that the company will stop hiking its quarterly dividend (currently at $0.73 per share) and will not repurchase any shares in the next few years given the constrained liquidity condition, I forecasted the total dividend payment to be about $3.5B-$3.6B from 2014 to 2016 based on the most recent amount of shares outstanding (see the first chart).
In order to meet the dividend protection goal, COP will need funding from 4 sources: 1) internally-generated cash; 2) current cash on the balance sheet; 3) additional debt financing; and 4) asset sales.
As just illustrated, the internally-generated cash option is not viable (at least up to 2015) given the negative free cash flow forecasts. Asset sales are also not possible as it would not make economical sense to sell assets at a discounted price in the low oil price environment. Apparently, cash from the balance sheet and debt financing arethe only two options.
For 2014, COP received proceeds of $1.4B from asset sales and paid down $0.5M debt without any borrowing. Given my free cash flow forecast of -$1.2B for the year, the company would need to draw $3.8B cash from the balance sheet to make the $3.5B dividend payment (see the first chart).
Fortunately, COP's balance sheet is solid enough for such a cash drawdown.
Given the cash balance of $6.5B as of December 31, 2013, the drawdown of $3.8B in 2014 would reduce the balance to $2.7B (see chart below) at the end of 2014.
Assuming that total assets remain unchanged, the total cash to total asset ratio will drop from 5.5% as at December 31, 2013 to 2.3% as at December 31, 2014. Compared to COP's historical cash/total asset ratios, the 2.3% level is the lowest in the past 5 years but remains way above the average level of 0.5% in the period from 2006 to 2009, which covers the credit crisis (see chart below). This comparison indicates that cash drawdown remains viable in 2015. Assuming a floor level of 1.0%, COP would have $1.6B cash available from its balance sheet in 2015 and no more in 2016.
By taking the balance sheet cash into consideration, my model suggests that COP will need to borrow $2.5B and $1.3B in 2015 and 2016, respectively, such that its liquidity will break even after making the forecasted dividend payments (see the first chart).
Based on my total debt forecast of $20.2B as at December 31, 2014 (calculated by subtracting the year-to-date September 30, 2014 paydown of $0.5B from total debt balance of $20.7B as at December 31, 2013 and assuming no additional borrowing or paydown in Q4 2014), the debt balance will climb to $24.0B by the end of 2016 (see chart below).
With the consensus EBITDA forecast of $22.5B for 2016, COP's total debt to EBITDA multiple would be 1.1x by 2016, which is in line with its 10-year historical average at 1.0x and much lower than its 10-year peak at 1.7x experienced during the credit crisis in 2009 (see chart below). Even at the 1.7x leverage back in 2009 with oil prices similar to today's levels, COP was able to maintain the dividend throughout the crisis period (see chart below).
By far, my liquidity analysis suggests that COP has sufficient liquidity to protect the current dividend level given the current consensus financial forecasts that are based on oil price expectations of $65-$70 per barrel in 2015 and $70-$80 per barrel in 2016.
Now, what if things become worse than expected? I then ran a second scenario, which assumed a 20% haircut on the current consensus EBITDA forecasts for 2015 and 2016. Based on my estimation, this would translate into approximately 10%-15% drop in the oil price expectation (now at $55-$60 per barrel in 2015 and $60-$70 in 2016) (see chart below).
Under the second scenario, the cash amount drawn from the balance sheet stays the same as it is limited by my 1.0% floor assumption. The need for additional debt financing increases substantially as the company is forecasted to remain free cash flow negative by 2016. However, even in this pessimistic scenario, the forecasted total debt to EBITDA multiple of 1.7x in 2015 and 2016 will still be in line with its peak level of 1.7x during the credit crisis in 2009 (see charts below).
In summary, COP's strong balance sheet provides solid liquidity in sustaining the current dividend level. In light of the appealing 4.5% dividend yield, if you do not expect oil prices to continue plunging materially from the current level and believe in a price recovery within 1 and 2 years, the stock is a bargain from an income investing perspective.
All charts are created by the author, and historical data used in the article and the charts is sourced from S&P Capital IQ. unless otherwise specified.
Disclosure: The author is long COP.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.