ConocoPhillips (NYSE:COP) announced a major M&A transaction last week that will see the energy producer merge its business with that of independent petroleum company Marathon Oil Corporation (MRO). The transaction is highly beneficial for shareholders of both companies, but especially ConocoPhillips because of the estimated amount of synergy effects and the potential for accelerating dividend growth. I believe the transaction could create a powerful catalyst for longer-term earnings growth through net production growth in high-impact areas, such as the Permian, which also implies upside revaluation potential for shares of ConocoPhillips. Additionally, since ConocoPhillips’ share price recently trended down, I believe investors are also getting a good deal valuation-wise!

Previous rating

I rated ConocoPhillips a strong buy in April 2024 due chiefly to favorable tailwinds in petroleum markets. These tailwinds were related to OPEC+ countries that aggressively pushed voluntary supply cuts in order to support petroleum pricing: Oil At $85, Buy Or Sell? My rating remains a strong buy following the merger announcement, as the transaction makes economic sense and ConocoPhillips could become a much more attractive capital return play for investors going forward.

Landmark deal significantly enhances COP’s appeal as a capital return play

ConocoPhillips agreed last week to acquire Marathon Oil — a major E&P company with a focus on a smaller number of promising production areas like the Bakken, the Permian and the Eagle Ford basins which I previously covered here — in an all-stock deal worth $22.5B, including debt. Marathon Oil shareholders are set to receive 0.2550 shares of ConocoPhillips for each share of Marathon Oil, meaning ConocoPhillips paid a 15% premium above the pre-announcement price for MRO. The deal obviously makes sense for ConocoPhillips, as both companies have considerable strategic asset overlap and are focused on high-impact areas such as the Eagle Ford or Bakken.

Besides the strategic overlap, a core motivation for companies to pursue acquisitions relates to synergy effects. ConocoPhillips has said that it is looking to capture $500M/year in synergy effects, mainly through the reduction in G&A expenses.

There are a number of deal benefits for shareholders that I believe will work additionally in favor of ConocoPhillips and, over time, could result in a higher valuation for the energy firm’s shares as well:

The strategic core focus on high-impact production areas like Eagle Ford, Bakken and Permian could significantly boost the company’s production and earnings growth rate going forward, potentially allowing COP to trade at a higher earnings multiplier
The merger deal itself is expected to be immediately accretive to ConocoPhillips’ earnings and free cash flow
The transaction strongly indicates that ConocoPhillips has improving appeal for dividend investors due to the possibility of accelerating capital returns.

To sweeten the deal (and gain approval for the transaction from its shareholders), ConocoPhillips already said that it plans to boost its dividend by 34% to $0.78 per-share in Q4’24 which would give the energy company’s shares a forward, annualized dividend yield (FY 2025) of 2.7%.

Conditional on the closing of the transaction, ConocoPhillips also said that it would boost its stock buyback from $5B to $7B in the first year and seek to repurchase approximately $20B of shares in the first three years after the deal. Since ConocoPhillips currently has a market cap of $136B… this proposed buyback volume would allow the company to repurchase a massive 15% of the company’s currently outstanding shares.

In the last three years, ConocoPhillips has reduced its share count by 13% as the company benefited from the increase in petroleum prices after Russia’s invasion of Ukraine. ConocoPhillips has already stepped up its stock buybacks in recent quarters as a means to return free cash flow to shareholders, so I would be delighted to see the energy firm potentially accelerating the pace of its buybacks.

ConocoPhillips’ valuation

The other thing that I like about the transaction is that I believe ConocoPhillips is getting a hell of a good deal from a valuation point of view. Marathon Oil’s shares were trading at a less than an 8X P/E ratio before the merger announcement and are currently trading a 9X forward (FY 2025) earnings. ConocoPhillips itself is trading at a 11X P/E ratio due to its larger size and long operating history. Considering that ConocoPhillips now has the chance to grow its annual (pre-synergy) earnings to ~$13 per-share, I believe that COP represents very good value for value investors, but especially for those investors that look to capture recurring dividend income and stock buyback value. ConocoPhillips is expected to earn $10 per-share next year, based off of consensus estimates, with some growth expected due to the energy firm growing production and a strong price environment providing support. Marathon Oil earns about $3 per-share annually on a standalone basis, which translates to a combined, pre-synergy earnings base of approximately $13 per-share.

In my last work on COP, I said that I see a fair value P/E ratio of 15X for the energy firm in a rising oil market. ConocoPhillips’ shares traded at 15.6X at the height of the petroleum price boom in FY 2022, shortly after Russia’s invasion of Ukraine. Due to the invasion, oil prices surged, resulting in wind-fall profits for production-focused companies like ConocoPhillips (therefore my fair value P/E of 15X).

Applying a 15X multiplier to ConocoPhillips’ combined, annual earnings value of $13 per-share calculates to a fair value of $195 per-share, implying 67% upside (the large upside is in part a result of the recent share price drop for COP). If we were to use a lower multiplier of 14X, shares of COP would have a fair value of $182 per-share. These fair value estimates assume that ConocoPhillips gets approval from shareholders for the transaction and that petroleum prices remain above $70 per barrel.

Risks with ConocoPhillips

The main drawback of an investment in ConocoPhillips relates to the fact that COP is a production-focused enterprise, meaning the company is set to suffer more severely in an energy bear market than its more diversified rivals, such as Exxon Mobil whose portfolio also includes refineries. This means that ConocoPhillips has more attractive earnings upside in a rising petroleum market and more earnings downside in a falling market. A cyclical earnings recession would therefore hit ConocoPhillips much more severely than Exxon Mobil. During the last energy down-turn, ConocoPhillips also cut its dividend, in response to falling petroleum prices and cash flow, which makes COP’s capital returns riskier and potentially less sustainable than those of Exxon Mobil.

Final thoughts

ConocoPhillips is acquiring Marathon Oil, a shale-play with large-scale, established and profitable production operations mostly in the U.S. For ConocoPhillips it makes sense to combine its operations with those of Marathon Oil due to strategic and operational overlap as well as considerable synergy potential. What I believe specifically makes the deal attractive for ConocoPhillips and its investor base is that the company is set for accelerating capital returns, as indicated by the firm’s desire to significantly boost its dividend in Q4’24. The company also indicated that it would raise its stock buybacks. With shares still trading for a moderate 11X P/E ratio and with a higher dividend waiting for investors, I believe a strong buy rating continues to make the most sense!