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Phillips 66: Value & Yield In An Overpriced Market


Published July 26th, 2016

Reasonably safe stocks yielding 3%+ are becoming difficult to find as the market’s price-to-earnings ratio marches ever higher.

The S&P 500 currently has a price-to-earnings ratio of 25.1 and a dividend yield of 2.1%.  Historical averages for these numbers are 15.6 and 4.4%, respectively (yields are down not only due to valuation but also because of the increased prevalence of share repurchases).

Ultra-low interest rates are likely responsible for higher valuation levels.  The market isn’t overvalued when you take into account historically low interest rates.  Adjusting for interest rates, a ‘fair’ price-to-earnings ratio for the S&P 500 is around 28!

Low interest rates increase asset prices.  That’s why we are seeing rapid share price appreciation in slow growth industries.  Take a look at the share price appreciation (not including dividends) of the Utilities SPDR ETF (XLU) below:

XLU Performance

Source:  Google Finance

55.6% share price appreciation over 5 years is quite a bit for a slow growth industry.  Rising valuation levels are driving this growth.

It’s more than just interest rates that are driving growth to utilities and other stable assets.  Baby boomers are retiring or nearing retirement.  This creates a greater demand for ‘safe’ higher yielding securities – at the exact time when they are in short supply due to low interest rates.

This trend is pushing up valuation multiples for blue-chip dividend stocks, bonds, and other income producing assets.

That’s why finding 3%+ yielding businesses with lower price-to-earnings multiples and strong business models is becoming uncommon.

This article takes a look at Phillips 66 (PSX) – one of these ‘uncommon’ businesses that haven’t seen its price-to-earnings ratio fly through the roof.

Phillips 66:  What Immediately Stands Out

A few things jump out about Phillips 66 when you analyze the business.

First, it is the largest refiner in the United States based on its market cap.  The company’s market cap along with its largest peers’ market caps are shown below:

The refining industry’s price-to-earnings ratio has not risen to the dizzying heights that much of the rest of the market has.

Phillips 66 is trading for a price-to-earnings ratio of 11.2.  The company currently has a dividend yield of 3.4%.  Counting its pre-spin-off history, Phillips 66 has paid steady or increasing dividends for 29 consecutive years.

The company’s market leading size, low price-to-earnings ratio and high yield relative to the market, and consistency have not gone unnoticed.  Warren Buffett has been pouring money into shares of Phillips 66.  Berkshire Hathaway (BRK.A) (BRK.B) currently owns around 15% of the refiner.

This has led to some speculation that Berkshire might acquire Phillips 66 outright.  Whether or not this actually occurs is not central to the investment thesis at Phillips 66.  Berkshire taking a large stake in the company shows confidence from one of the world’s smartest investment teams.

Phillips 66 Overview & Current Events

Phillips 66 is not a pure play refinery.  The company has a diversified business model.  The image below shows the company’s 4 business segments:

Phillips 66 Business Units

Source:  May 2016 Investor Update, slide 3

The percentage of total adjusted earnings each segment generated in the company’s 1st quarter are shown below:

Phillips 66’ refining segment saw earnings drop significantly in its first quarter.  The image below shows earnings by segment over the last 5 quarters:

PSX Earnings over the last 5 quarters

Source:  Data from company reports

In total the company’s 1st quarter earnings declined by around 50% versus the same quarter a year ago.  The decline was driven in large part by falling crack spreads.  Crack spreads are the spreads that refiners make on processing oil.

Crack spreads fluctuate.  They tend to fall when oil prices rise and rise when oil prices fall.  A short-term decline in crack spreads does not indicate a long-term loss in market position or competitive advantage for Phillips 66.

The image below shows the company’s sensitivity to various commodity factors.

Phillips 66 2016 Sensitivities

Source:  May 2016 Investor Update, slide 51

Management is showing confidence in the company’s future despite the recent earnings decline.  Just 5 days after announcing the 1st quarter earnings decline, Phillips 66 hiked its dividend 12.5%.  This is not the move a company makes if it is worried about the future.

Phillips 66 will report its 2nd quarter earnings on July 29th, 2016.  The company is expected to report better results than the 1st quarter due to higher average crack spreads in the 2nd quarter versus the 1st quarter of 2016.

Competitive Advantage

The oil and gas industry is cyclical (who knew, oil prices fluctuate?).  Phillips 66’ diverse business model gives it greater stability than other pure play refiners.

This is evidenced by the company’s earnings in its 1st quarter.  The company’s refining segment saw serious declines, but other segments provided significant income and cash flow.  If Phillips 66 were a pure play refiner, the company would have realized almost no earnings in the quarter.

The company’s chemical operations tend to move inverse of oil prices.  Low oil prices reduce input costs, which raise margins.

The refining business’ profit is determined by crack spreads, not the actual price of oil.  Crack spreads tend to rise when oil prices fall, and decline when oil prices rise.

The company’s midstream and distribution assets are also more predictable and less reliant on oil prices than what one would expect from an upstream company – like ConocoPhillips (COP).

Phillips 66:  Total Return Investment Thesis

Phillips 66 is not a rapidly growing company.  The company operates in the mature energy industry.  Still, Phillips 66 should generate above average total returns for investors.

The company has a dividend yield of 3.4% and a payout ratio of just 37.7%.  This leaves plenty of funds left for share repurchases.

Phillips 66 has reduced its share count by 5.3% a year from 2012 through 2015.  The company has spent an average of $1.76 billion a year on net share repurchases each year over the last 3 years.  If the company continues repurchases at this rate, it will add 4.5 percentage points of growth (through share count reduction) per year.

Together, dividends and share repurchases will give investors returns of 7.9% a year at current prices.  At this level, the company would be paying out around 90% of its profits as dividends and share repurchases.  The company generated strong earnings due to favorable crack spreads over the past few years.  Because of this, share repurchases could decline some.  Even if the company were repurchasing ‘just’ $1 billion in net shares a year, that would be a shareholder yield of 5.9% a year.

Even if Phillips 66 doesn’t grow, shareholders will do reasonably well due to the company’s shareholder friendly management and low price-to-earnings ratio.

But there’s a good chance Phillips 66 will grow over the long run.  The company has several projects coming online in its midstream segment.

Midstream Growth

Source:    May 2016 Investor Update, slide 9

The company is also expanding its capacity in its chemicals segment.  The chemicals segment is a 50-50 joint venture with Chevron (CVX).

The company’s USGC Petrochemicals Project will star up in mid-2017.  It is expected to add another billion dollars to annual EBIDTA for Phillips 66.

On top of this, the company is focusing on efficiency gains in its refining segment.  It is likely growth will be slow or stagnant (and entirely dependent upon crack margins) in the refining segment.

In addition to its 5.9% to 7.9% shareholder yield, I expect Phillips 66 to grow its business by at least the rate of inflation, and quite possibly several percentage points higher.  In total, I expect total returns of around 8% to 13% a year for Phillips 66 shareholders.

Final Thoughts

Phillips 66’ low price-to-earnings ratio allows shareholders to get a sizeable shareholder yield from the company’s dividend payments and share repurchases.

The company’s low valuation combined with its above average dividend yield and strong total return potential make it a favorite of The 8 Rules of Dividend Investing.

In addition, the company has 2 ‘long-shot’ return catalysts.  A potential Berkshire takeover would result in a share price spike.  The company could also acquire Chevron’s share of the chemical business, which would boost long-term results.

Ultra-low interest rates alone provide a favorable backdrop for Phillips 66 to see share price appreciation through an upward revision in its price-to-earnings multiple.  The company valuation looks ‘out of line’ with other quality dividend payers.

Whether any of these  scenarios play out is anyone’s guess.  They don’t have to for shareholders to get solid total returns from Phillips 66.

The company could see earnings-per-share weakness in the short-run, but long-term total return prospects are bright at current prices.  The stock is a low downside, high upside investment at current prices if investors have a time horizon measured in years, not months.



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