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ConocoPhillips Stock Upgraded: What You Need to Know

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

West Texas Intermediate (WTI) crude oil is selling for just shy of $58 a barrel today, down 15% from a year ago, but up 11% over the past month.

Outside U.S. borders, Brent is the favored flavor of crude oil, and it's showing less volatility, but similar dynamics -- down 11% over the past year, but up 6.5% over the past month (and still more expensive than WTI at a per-barrel price of about $65).

Happily, ConocoPhillips (NYSE: COP) is "exposed to all the good bits" of the oil market, says investment banker Merrill Lynch -- and that's why it's upgrading ConocoPhillips stock.

Here's what you need to know.

Image source: Getty Images.

Upgrading ConocoPhillips

Early this morning, Merrill Lynch announced it is upgrading shares of ConocoPhillips to buy and assigning a $75 price target -- up $10 from its last target. You can find one of the analyst's reasons right up there in continuing premium prices earned from selling Brent oil rather than WTI. As Merrill explains in a note covered on TheFly.com, 75% of the oil ConocoPhillips sells is Brent, and the company has managed to avoid the "worst of onshore price dislocations" with WTI.

Granted, this hasn't translated into great performance for ConocoPhillips stock, which is down 15% over the past year, and performing worse than peers Exxon (NYSE: XOM) and Chevron (NYSE: CVX). But as Merrill further explains, this may be more the fault of investors ignorant of ConocoPhillips' strengths, than of ConocoPhillips itself.

Cash is king

What are these advantages? Let's start with the cash. With $8.3 billion in cash on its balance sheet and a debt load of $15.9 billion, ConocoPhillips may not be in a "net cash" position, exactly, but its balance sheet looks a lot healthier than, say, Exxon's -- at $39.9 billion more debt than cash -- or Chevron's ($28.5 billion in net debt).

Merrill goes so far as to call ConocoPhillips' balance sheet "pristine."

And it's getting even pristine-r.

By the end of this year, in fact, Merrill estimates that ConocoPhillips could have as much as $10 billion in cash on hand -- enough loot that the company could "potentially" decide to pay out a special dividend to its shareholders and/or buy back stock.

Free cash flow is pretty nice, too

But where is all of this cash going to come from? From free cash flow, of course -- the actual cash profits that the company earns, as opposed to the net income that it reports under generally accepted accounting principles (GAAP). According to S&P Global Market Intelligence's last tally, more than 90% of the net income ConocoPhillips reports under GAAP is backed up by cold, hard free cash flow.

Last year alone, the company generated $6.1 billion worth of the stuff, and after a strong Q1 2019, its FCF number now reads closer to $6.6 billion generated over the last 12 months.

The real reason to own ConocoPhillips stock

And this, when you get down to it, is the real reason that Merrill Lynch likes ConocoPhillips stock so much. Although shares may be down significantly over the past year, free cash flow is up. And in Merrill's estimation (as explained in a note on StreetInsider.com), the reason for the former is that investors have failed to recognize the latter.

They're not giving the oil giant enough credit for the cash it's churning out.

The upshot for investors

So as one of those investors that Merrill Lynch is talking about, how should you react to this upgrade?

Valued at $67.5 billion in market cap with net debt of about $7.5 billion, ConocoPhillips' $75 billion enterprise value is only 11.4 times trailing free cash flow (and only 10.4 times reported earnings). The stock sports a 2% dividend yield, and most analysts agree that the company will grow its profits at about a 7% annualized rate over the next five years.

To my mind, this means investors can expect a total return of about 9% annually on a ConocoPhillips investment today -- not quite enough to make the stock a bargain at 11.4 times FCF, but close. And if ConocoPhillips can find a way to keep on increasing free cash flow at the rate it's been growing these last few years, the stock could soon evolve into what Merrill Lynch says it already is:

A buy.

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Rich Smith has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.


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