ConocoPhillips is making its second massive acquisition in four years as consolidation sweeps the oil patch.
ConocoPhillips (COP 2.55%) made a splash on May 29 when it announced an all-stock acquisition of Marathon Oil (MRO 2.66%). The purchase price represents a 14.7% premium to the closing price of Marathon on May 28, giving the company an enterprise value (market cap plus debt) of $22.5 billion.
Here are the deal’s pros and cons and whether ConocoPhillips is a dividend stock worth buying now.
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A wrinkle in an otherwise steadfast strategy
ConocoPhillips has fostered a reputation for measured spending and financial stability. In January 2021, it completed its acquisition of fellow exploration and production (E&P) company Concho Resources at a price that was, in hindsight, a steal. Because of its strong balance sheet and manageable expenses, it was able to stick its neck out and make a sizable acquisition during a downturn.
The oil patch is much different today than in 2020. Outsize profits have unleashed a frenzy of merger and acquisition (M&A) activity. But true to form, ConocoPhillips has been noticeably absent from the buying spree.
Acquiring Marathon Oil is a major change in ConocoPhillips’ prudence. It’s an all-stock transaction, and Marathon is up over 430% in the last four years compared to 170% for ConocoPhillips. However, Marathon has a lot of similarities to ConocoPhillips.
For starters, Marathon is a cash cow, with one of the highest free-cash-flow (FCF) yields of the leading E&P companies.
MRO free cash flow yield data by YCharts.
FCF yield is a company’s FCF divided by its market cap or FCF per share divided by the stock price. A high FCF yield indicates the company can accelerate growth by reinvesting in the business, paying higher dividends, or repurchasing stock. In a theoretical sense, FCF yield is what the dividend yield could be if a company distributed all of its FCF to shareholders through a dividend.
ConocoPhillips focuses on a low cost of production and a diverse asset base to generate FCF even when oil and gas prices are low. The year 2020 proved to be a litmus test for the company, as it eked out $87 million in FCF during a severe downturn.
Part of its recipe for success is its effective use of capital throughout the market cycle.
EOG return on capital employed; data by YCharts.
In the chart, notice the consistency of the blue line (Conoco) relative to the other companies. For example, Devon Energy has a high return on capital employed right now, but the metric has swung wildly for Devon depending on the market cycle. ConocoPhillips is a great capital allocator, and Marathon’s cash-cow business model gives it more capital to use wisely.
Returning value to shareholders
In its investor presentation for the acquisition, ConocoPhillips laid out three clear benefits of the transaction. The first is that it will boost the company’s earnings and FCF. Second, it expects $500 million in annual cost savings between the two companies thanks to adjacent drilling acreage across key plays. And third, the transaction lowers the combined company’s FCF break-even price on oil, which should lead to higher margins.
With the higher FCF, ConocoPhillips plans to increase its ordinary dividend from $0.58 per share to $0.78 in the fourth quarter once the transaction closes. It also expects to increase its annual share buybacks from $5 billion to $7 billion once the transaction closes, aiming for $20 billion in buybacks over the next three years, which would offset the equivalent of all the shares issued for the Marathon Oil transaction.
In addition to an ordinary dividend, ConocoPhillips pays a variable dividend — or what it calls a variable return of cash (VROC) — based on how its business is performing. The VROC has been 20 cents per share for the last few payments, but it has been as high as $1.40 over the last few years.
Even without factoring in the VROC, ConocoPhillips would yield 2.7% based on its current stock price of around $114 per share and $3.12 per share in annual ordinary dividends. That’s a compelling yield, especially considering the full payout is likely higher, and the capital return program consists of substantial dividend payments and buybacks.
ConocoPhillips is still a buy
The FCF focus of the acquisition supports ConocoPhillips’ intentions to boost its capital return program through higher dividends and accelerated buybacks. The plan sounds great on paper, but ConocoPhillips is leaving itself more vulnerable to a downturn.
Its capital expenditures have increased by 142% over the last three years, and it has become more aggressive with increasing production to maximize profits. However, management has an excellent track record of allocating capital and making good decisions.
Admittedly, ConocoPhillips is more risky, but the deal’s pros outweigh the cons, especially considering Marathon Oil’s high FCF yield. ConocoPhillips stock has sold off a few percentage points since the announcement, which makes sense considering it is paying a premium for Marathon. The stock remains a great choice in the E&P space, but investors who want a strong dividend yield with less risk might want to consider an integrated major like ExxonMobil or Chevron instead.