We believe Phillips 66 (NYSE:PSX) is fairly valued at $66 while providing significant opportunity for value creation.
Phillips 66 is at the crossroads of an energy revolution in North America and CEO Greg Garland has all the makings of an excellent capital allocator.
I) The Record
To say that shares for PSX have done well over the year is an understatement. Shares has doubled from $32 to $65 since the spin-off. There is no question that returns for investors today will not match the returns of shareholders from May 2012. However, it is sometimes advisable to not look back but look forward when valuing a business and making a decision on whether the rate of return on the investment over next decades will meet one's return expectations. For example, Warren Buffett invested in Coco-Cola (KO) in 1988 when it was trading at an all-time high and his recent purchase of IBM in 2011 is another example.
PSX One Year Chart:
II) Business and History
Phillips 66 was spun off from Conoco Phillips (NYSE:COP) in May 2012. It does not have a long history. The following is the information from the company website.
“Phillips 66 is an advantaged downstream energy company, with segment-leading Refining and Marketing (R&M), Midstream and Chemicals businesses. The company’s R&M operations include 15 refineries with a net crude oil capacity of 2.2 million barrels per day, 10,000 branded marketing outlets, and 15,000 miles of pipeline systems. In Midstream, the company primarily conducts operations through its 50 percent interest in DCP Midstream, LLC, one of the largest natural gas gatherers and processors in the United States, with 7.2 billion cubic feet per day of gross natural gas processing capacity. Phillips 66’s Chemicals business is conducted through its 50 percent interest in Chevron Phillips Chemical Company LLC, one of the world’s top producers of olefins and polyolefins with more than 30 billion pounds of net annual chemicals processing capacity across its product lines.”
PSX Business Overview:
PSX Global Assets and Locations:
III) Operations and Competitive Advantages
Philips 66 operations consist of three divisions: Refining and Marketing; Midstream and Chemicals. Below is some relevant information from the company website.
Refining and Marketing
The Refining and Marketing segment purchases, refines, markets and transports crude oil and petroleum products, mainly in the U.S., Europe and Asia, and also engages in power generation activities, lubricants and other specialty products businesses.
We are one of the largest petroleum refiners in the U.S. and around the world, with a domestic net crude oil processing capacity of 1.8 MMBD, and a global net crude oil processing capacity of 2.2 MMBD. We own or have an interest in 11 refineries in the U.S. (all of which we operate) and four international refineries (two of which we operate).
Our refined petroleum products are sold at approximately 10,000 outlets in the U.S. and Europe, primarily under Phillips 66®, Conoco® and 76® in the U.S. and JET® in Europe. Nearly all the U.S. outlets are marketer-owned or -supplied, while our international operations include both company-owned and dealer-owned sites.
We own or lease various transportation assets to provide strategic, timely and environmentally safe delivery of crude oil, refined products, natural gas and NGL. These assets include pipelines and terminals, marine and inland vessels, railcars and trucks.
Marketing & Specialities:
"We conduct our Midstream business primarily through a 50 percent equity investment in DCP Midstream, LLC, a joint venture with Spectra Energy. DCP Midstream is a leader in its sector as one of the largest natural gas gatherers and processors, NGL producers and NGL marketers in the United States. DCP Midstream’s extensive asset base is located in many of the legacy natural gas producing regions of the United States, including the Rocky Mountains, Midcontinent, Permian, East Texas/North Louisiana, South Texas, Central Texas and the Gulf Coast. In addition, DCP Midstream is entering high-growth regions of the United States, including the Niobrara, Eagle Ford, Barnett and Granite Wash plays, allowing for substantial growth opportunities.
"DCP Midstream’s assets include 62,000 miles of pipelines, 61 gas processing plants and 12 NGL fractionators. In 2010, DCP Midstream signed agreements that will enable it to become the anchor shipper of growing Eagle Ford shale gas production on a portion of the Trunkline Gas pipeline system. DCP Midstream is also planning construction of the Sand Hills Pipeline to provide NGL transportation capacity for producers in the Permian and Eagle Ford basins to gain access to market centers along the Gulf Coast.
"Phillips 66 directly owns and operates interests in three NGL fractionators and gathering systems at important NGL hubs in the United States. We also own a 25 percent interest in the Rockies Express (REX) natural gas pipeline.
Midstream DCP NGL Assets:
Midstream DCP Strategy:
"We conduct our Chemicals business through a 50 percent equity investment in Chevron Phillips Chemical Company LLC (CPChem), a joint venture with Chevron U.S.A. Inc., a wholly-owned subsidiary of Chevron Corporation. CPChem has a number of large petrochemical facilities in the U.S. Gulf Coast region and has significant international operations through its investments in the Middle East that offer access to advantaged feedstocks, as well as access to large, growing markets for its products, such as Asia. CPChem is one of the world’s top producers of olefins and polyolefins, and a leading supplier of aromatics and styrenics.
"CPChem is evaluating a number of additional growth projects globally, including proposed construction of a world-scale ethane cracker and two polyethylene facilities at or near one or more of its Texas Gulf Coast sites. With an expected annual capacity of 3.3 billion pounds, the proposed ethane cracker would increase CPChem’s U.S. ethylene capacity by over 40 percent and allow CPChem to leverage the development of significant shale gas resources in the United States.
Chemicals Growth Strategy:
"These are some of the competitive advantages and differentiators:
1. PSX is valued similar to other pure play refiners (PE of 8) by the market but it is diversifying from highly volatile and historically low return refining into higher return midstream and chemical businesses.
2. PSX is divesting low return refining assets and focusing more on obtaining advantaged crudes to improve the profitability of its refining segment.
3. PSX has substantial Midstream Operations in North American in natural gas and natural gas liquids and are benefiting incredibly form substantial exposure to shale gas.
4. Its chemicals segment capitalizes on very low NGL feedstock costs in the US and globally and has plans for very aggressive growth.
5. Both PSX and DCP Midstream (in which it has a 50% stake) have assets that are being spun off as a MLP (PSXP) in 2013 H2. This will lead to tax advantages and likely trade at higher valuation as part of PSX.
6. Phillips 66 is dedicated to returning excess free cash flow to shareholders via dividends and share buybacks."
IV) Balance Sheet and Profitability
Phillips 66 has a strong balance sheet with $7 billion of debt and $4.75 billion of cash.
Balance Sheet 2013 Q1:
WTI Brent Differential Chart:
V) Management[/b][b]Greg Garland, President and Chief Executive Officer
Greg G. Greg Garland is chairman and CEO of Phillips 66. A chemical engineer, Garland has more than 30 years of industry experience in technical and executive leadership positions within the oil and natural gas and chemicals industries.
Previously, Garland had served as senior vice president, Exploration and Production, Americas for Conoco Phillips since 2010. Prior to joining Conoco Phillips, Garland was president and chief executive officer of Chevron Phillips Chemical Company which is now a joint venture between Phillips 66 and Chevron. Before his election to that position, Garland served Chevron Phillips as senior vice president, Planning & Specialty Chemicals. His prior experience includes serving as general manager of Qatar/Middle East for Phillips, a position he assumed in 1997. From 1995 to 1997, he served as general manager of natural gas liquids after serving as manager of planning and development in planning and technology. From 1992 to 1994, he was manager of the K-Resin® business unit.
Garland began his career with Phillips in 1980 as a project engineer for the Plastics Technical Center. He later worked as a sales engineer for Phillips' plastics resins, business service manager for advanced materials, business development director, and olefins manager for chemicals.
Garland received a bachelor of science degree in chemical engineering from Texas A&M University in 1980. He is also a member of the Chemical Engineering Industrial Advisory Board for Texas A&M University.
Use of Cash Flow 2013:
Capital Investments 2013:
VI) Value and Price
Philips 66 has been trading in $50 to $70 range over the last six months. One share of PSX was distributed for every two shares of CPO during the spin-off in May 2012.
Mritik Capital projects a share price of $90 to $100 over the next four-to-five-year period based on certain assumptions listed below. This would imply a 14% annual return over the next five-year period to 2017 if shares are purchased around $60 on pullback. In order to have a sufficient margin of safety Mritik Capital suggests selling Jan 2015 puts for the $65 strike price which provides $13 premium on a maximum risk amount of $65 per share. This provides an entry price of $52 and increases total annual return potential to 18% over the next five-year period to 2017. If the put is not assigned then seller makes a 12.5% return on at risk capital of $6,500. Another option is to sell January 2015 $60 puts for a $10 premium. This allows an entry price of $50 and allows for total annual return of 20% over the next five-year period to 2017. If the put is not assigned then the seller makes a 10.5% return on at risk capital of $6,000.
There may not be too many immediate catalysts in the next few months except for the MLP spin-off. However, I can think of the following catalysts over the next three years.
1. PSX is divesting underperforming assets and engaging in Improvement initiatives, increasing cost-advantaged feedstock processing and increasing exports to improve Phillips 66's competitive position.
2. The four Mid-Continent refineries with 21% of total capacity are some of the company's best-positioned given their access to discount domestic (Bakken) and Canadian (Oil Sands) crudes.
3. Excess light crude in North America should support rail shipments to the East and West coasts, expanding the availability of discount crude for Phillips 66's refineries.
4. Chemical (CPChem) and midstream (DCP) assets have higher returns than refining and add earnings stability and differentiate the company from its peers. They also offer organic growth opportunities with good risk adjusted reward.
5. Phillips 66 should be able to grow its attractive dividend while returning excess cash to shareholders through share repurchases. Management plans to return all excess cash flow beyond capita needs. CEO Greg Garland has indicated that company wants to look back 10 years later and say that it has increased dividends every year for 10 years in a row.
VIII) Specific Risk
As in any investment there are some risks associated with an investment in Phillips 66. The following are some of the risks:
1. Oil refining is a very volatile and competitive business. Refining margins may be at a cyclical peak and if crack spreads decline profitability and cash flow could decline substantially.
2. The U.S. and Europe remain oversupplied, potentially putting pressure on margins until additional rationalization occurs.
3. Phillips 66 could see capital expenditures rise as it is forced to meet environmental regulations for its refineries in California.
4. Phillips 66 is making significant capital investments in midstream and chemicals over the next few years. If these investments do not succeed in the years the intrinsic value of the company will not grow significantly.
IX) Why Is This Cheap?
I see the following reasons for cheap valuation relative to peers.
1. The market is skeptical that the favorable crack spreads over the last year are not sustainable.
2. Given the strong performance of the stock over last year market participants are hesitant to buy a stock that has already doubled in 12 months.
3. Oil refining stocks performed very poorly during the last recession with most of them falling 75%. This is in the minds of investors.
I own shares of PSX. I have sold January 2015 $60 and $55 puts on PSX.
Comments and questions welcome.
1. PSX Investor Relations
2. Crack Spreads
4. DCP Midstream
I have used information from the PSX company investor relations, presentations and financial reports. I have referenced information from Morningstar, Value Line, Wealthlift, U.S. EIA, Yahoo Finance.
About the author:
Please note that investing offers both risks and rewards. Before investing do your own due diligence and consult your financial advisor.