Conoco Lowered to Underperform

We are downgrading our recommendation on ConocoPhillips (COP - Analyst Report) to Underperform from Neutral, on the back of disappointing first-quarter earnings. Financial leverage also deteriorated with a higher debt-to-total capital ratio and lower cash balance.

ConocoPhillips’ first quarter earnings and revenue came in below the Zacks Consensus Estimate. The earnings of the Exploration and Production segment fell year over year mainly on account of reduced volumes, higher taxes and lower natural gas prices. Additionally, a dip in refining margins during the quarter pulled down the Refining and Marketing segment profits.

In May 2012, ConocoPhillips completed the spin-off of its refining/sales business into a separate, independent and publicly traded company Phillips 66 (PSX - Snapshot Report). This has left ConocoPhillips with a less diversified business. As a result, the business risk profile of the reorganized ConocoPhillips is weaker than that of the pre-spin-off company.

Moreover, given the substantial investment required to augment upstream operations, any strategic change in the composition of ConocoPhillips’ assets will involve considerable capital expenditures, in addition to the planned outlay. This may be significantly burdensome for the company’s future cash flows and put pressure on its already strained balance sheet.

Having already divested $20.2 billion of non-strategic assets last year and $1.1 billion in the first quarter of 2012, and plans to offload $10 billion worth of properties this year, the company’s output is likely to be affected with production shrinking further.

Our bearish investment thesis on ConocoPhillips also takes into consideration ConocoPhillips’ sensitivity to changes in the crude oil price, as well as geopolitical risks associated with international operations and operational challenges. In fact, the pessimism around the stock is well reflected through its estimate revisions.

Currently, the Zacks Consensus Estimate for ConocoPhillips’ second-quarter 2012 earnings stands at $1.49 per share, down 38% year over year. Of the 8 estimates, 2 moved downward in the last 30 days, while no upward revision was witnessed. For 2012, the Zacks Consensus Estimate is pegged at $6.40 per share, down 27% year over year.

Given these concerns, we expect ConocoPhillips to perform below its peers and industry levels in the coming months. As such, we see little reason for investors to own the stock. Our long-term Underperform recommendation is supported by a Zacks #5 Rank (short-term Strong Sell rating).