DuPont's decision to spin off Conoco oil and gas subsidiary

¶ … 1998, and DuPont is considering spinning off Conoco, an oil and gas company, of which DuPont presently owns 100%. The spinoff would likely be the largest IPO in history if the entire company was sold. There are, however, a number of things that need to be taken into consideration. DuPont may wish to retain some interest in Conoco, perhaps even controlling interest. How much should be spun out is an important consideration. Further, there needs to be an appraisal of the market, to determine what the value of Conoco might be on the open market, and if this is fair value to DuPont for the company. The IPO market needs to be able to handle the Conoco IPO in order to extract the highest price possible for the shares. Further, there needs to be financial considerations, such as how such a deal would affect DuPont's share value. There are also strategic considerations to be taken into account, given that DuPont is a conglomerate, but also that Conoco is a major part of the company at this point. This paper will address these issues and other issues relevant to the decision to spinoff Conoco or not. The paper will be written from the perspective of the CFO. At present in the scenario, other executives disagree about the potential for such a deal and each has his own opinion about how much, if any, of Conoco should be spun out.

Background

The decision focuses around the possibility of DuPont divesting itself of its Conoco subsidiary. The CEO wants to know how much of Conoco should be divested, if any. Further, there needs to be a process by which the divestiture is executed. While the three options are to divest nothing, a percentage or 100%, the former option needs no financial analysis. The nothing option is the default. The value to DuPont shareholders would not change under such a scenario, and the divestiture discussion need not ever reach the public. Of the possibilities for partial divestiture, it has to be considered whether the company wants to retain majority or minority interest in Conoco. The Executive VP for R&D feels that DuPont should maintain a majority stake, perhaps as high as 60%, so that will be the working figure for this alternative.

Conoco is an oil and gas company, focused on finding and producing both oil and natural gas. The company operates in over 30 countries (ConocoPhillips.com, 2013). DuPont is a conglomerate with a wide range of businesses, but oil is not normally one of them. Conoco had become part of DuPont as the result of a power struggle between potential buyer Seagram and Conoco, with DuPont entering as a white knight for the oil company. Thus, DuPont had not initially purchased Conoco with a specific intention to enter the oil and gas business. Strategically, therefore, spinning out Conoco makes sense for DuPont, especially as the cash would allow the company to focus on investments for its core businesses. The environment at the time in 1998 is that the Internet is transforming how companies do business, but it is also providing substantial opportunities for companies that are well-financed and have good ideas for leveraging the new technology. DuPont has an interest in another hot area, biotech (Chang, 1998). In January 1998, the price of crude is low, just over $10 per barrel (Wtrg.org, 2013). Thus, the rate of return for DuPont in its core businesses leveraging new technology and high growth rates is likely higher than it is in the oil business. However, the low prices for crude is also likely to leave hydrocarbon companies undervalued on the market, barring a reason to expect that oil prices are going to increase in the near future.

Qualitative Considerations

In building financial models, there are a number of qualitiative considerations that must be included. The state of the oil market and the other opportunities in the investment market are two of them that were just mentioned. The state of the IPO market is also important, since any spinout of Conoco is going to be massive, well over $1 billion. Thankfully, the IPO market at the beginning of 2008 is healthy, and this means that there is ample capital to purchase this stock, should it be issued. This is important because a weak IPO market is going to mean that the company will extract a lower price for the Conoco shares; a stronger market means that the price can be higher. This should help to counteract the low value of oil on the market, which will act as a depressant for the value of Conoco shares.

The recent history of divestitures shows that several are in the works for the next couple of years, including some in the billion-dollar category. Some are asset sales, a couple are spinoffs and a few small ones are equity carve-outs. An equity carve-out is when a parent company divests only part of a subsidiary, in contrast to a spin-off, which is a 100% sale.

Method of Divestiture

There are two types of divestiture once a carve-out has been decided upon. There is a one-step or a two-step. In retrospect, DuPont executed a two-step carve-out. The first 30% was sold in October of 1998 and the remaining 70% in 1999. The benefits of a two-step carve-out are numerous. The first is that DuPont could retain an interest in Conoco, perhaps as a hedge against changing market conditions. While DuPont had hoped to benefit from volatility in the oil market with Conoco, that volatility never materialized. However, it is not unreasonable that its shareholders might feel that selling in 1998 was selling at the rock bottom of the oil business, with oil prices approaching $10/barrel, a level that had not been seen since the original oil crisis. Surely, shareholders might think, oil prices were on their way up. While selling Conoco at the bottom might make it an easy sell for a company looking to divest billions in assets, it also extracts the lowest value for DuPont shareholders.

The one-step method would allow DuPont to divest the entire 100%. This removes the hedge factor from the thinking and allows DuPont to have all the cash at once to make its own, higher-ROE, investments. DuPont will benefit as well because the entire sale will be behind it, giving certainty to the value of DuPont. This should benefit shareholders. The downside of the one-part divestiture is that DuPont will not benefit should the price of oil (or of Conoco) increase in the near future.

Amount of Divestiture

There are both strategic considerations and financial ones to determining how much of Conoco should be divested. The strategic considerations are not really within the scope of a financial analysis. From a financial perspective, the divestiture will provide DuPont with cash. According to pro forma information, Conoco is worth $4.228 billion in equity. DuPont can also sell off the Conoco debt securities, which carry a value of a further $5 billion in senior debt and commercial paper. How much of this cash DuPont needs is a strategic consideration, but it will need to be invested relatively quickly in order to generate a return on investment that is higher than what Conoco is currently earning for DuPont.

There is no way to tell in advance whether it is better to divest all of Conoco today or as a two-step divestiture. The two-step method is basically a hedge against either a weak IPO market or against rising oil prices, the former of which would lower the value of the spinout and the latter of which would increase the value of Conoco. In either case, the value of selling a second portion of Conoco at a later date is unknown and entirely speculative. The IPO market in early 1998 is beginning to pick up steam, but mainly in the Internet space. There is no direct connection between the Conoco spinout and the Internet space, so it remains to be seen what the public's appetite for a conventional IPO is. Further, the price of oil is still trending downwards. While it is at a low, the further it drops the lower the price can be expected for Conoco. If DuPont sees value in spinning out Conoco at all, it should consider that waiting might improve the value that shareholders will receive for Conoco, given that oil prices are more likely to rise than fall, and the IPO market is trending upward at the moment.

$1.55 billion

The table shows that as the percentage divested declines, the amount that DuPont can expected for each share will decrease. The market for IPOs is moderate right now, and investors will be wary of buying an oil play in a struggling oil market, especially if Conoco is going to be run exactly the same as it is now, under DuPont's leadership. If there is the opportunity for the investors to affect change at Conoco to improve the oil company's performance, they will pay more for the each share.

Valuation Methodology

There are many factors that will contribute to the pricing of the issue. The underwriters will gauge the market for the issue. The strength of the market will determine in part whether DuPont ultimately does a two -- stage divestiture or a one-stage. If the market is weak, the value that DuPont extracts for Conoco will be lower, especially if it discounts in order to sell out an entire $4 billion-plus issue.

There are numerous valuation methodologies that can be used for Conoco, which has been privately-held for many years. The price/earnings ratio is one method. Conoco does not have such a ratio, but there are many similar oil companies that would. This methodology holds that Conoco is likely worth roughly the same P/E as its peers, applied to its earnings. As a distinct unit, Conoco has specific earnings that can be communicated in the pro-forma. Using industry P/Es, Conoco's value should be in the range of $18-24 per share.

Another valuation methodology is to undertake a thorough financial statement analysis of Conoco in order to determine its health and value going forward. This method would also be part of the P/E analysis to see where Conoco fits with its peers. The balance sheet and income statement would be analyzed, as would the cash flow statement, to identify the book value of the equity, the financial condition of the company, and any major issues that might be in the financial statements. The price-to-book and price-to-cash-flow ratios can be used in a manner similar to the P/E ratio, the former more if Conoco is sold for liquidation purposes (it's not) and the latter if cash flow is deemed more important than economic earnings.

Conclusion

Conoco is valued at $4.3 billion. DuPont should extract this full total, but should do it in two stages. There is risk associated with the two-stage process, in that it costs more with higher underwriting fees and there is the risk that the first issue will have a lower-than-expected valuation because it is only a minority stake. The risks are arguably larger for the one-stage divestiture, however, since the value of Conoco could increase, or the conditions for IPOs could weaken. However, the IPO market is expected to remain strong. The value of Conoco is likely to increase. This points to DuPont selling a minority stake now in order to extract some immediate cash from Conoco, and then selling the rest at a later date when oil prices begin to move upward.

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