Phillips 66 (PSX) has a diversified business model that reduces earnings volatility and delivers steady cash flows. As such, it has been able to raise its dividend every year for the last seven consecutive years. The stock offers a solid dividend yield of 3.4% along with a high probability of dividend increases and price appreciation. In this article, we dig deeper to ascertain the sustainability of dividends and also the company’s growth prospects. We review the health of the business, cash flow position, balance sheet flexibility, valuation, risks, dividend safety, and conclude with our opinion about why PSX may be worth considering if you are a long-term income-focused investor.
Overview:
Phillips 66 is a diversified energy manufacturing and logistics company engaged in processing, transportation, storage and marketing of petrochemical products. Phillips 66 was spun off from ConocoPhillips in 2012. The company operates via four segments:
Refining segment refines crude oil and other feedstocks into petroleum products such as gasoline, distillates and aviation fuels.
Midstream segment which gathers, processes, transports, and markets crude oil, natural gas, and other petroleum products in the U.S. The segment has a 50% stake in the general partnership (“GP”) of DCP Midstream Partners (DCP), and a 55% stake in Phillips 66 Midstream Partners (PSXP);
Chemicals segment manufactures and markets petrochemicals and plastics worldwide. It consists of its 50% equity investment in CPChem.
Marketing & Specialties segment markets refined petroleum products such as gasoline, distillates and aviation fuels, mainly in the United States and Europe.
Refining accounted for nearly 60% of PSX’s pre-tax earnings in FY18 making it by far the most important segment of the company. However, refining can be an extremely volatile business as it is tied to commodity prices. In contrast, the other non-refining businesses (chemicals, midstream and M&S) provide much more predictable returns on capital and cash flow, thereby helping to smooth out volatility from thr refining segment. This is where PSX’ diversified business model is extremely advantageous.
Secure, Competitive and Growing Dividend
We note that PSX has delivered strong annual dividend growth since its listing in 2012, raising its dividend for the last seven consecutive years. The dividend has grown from $0.90 (annualized) in 2012 to $3.50 in 2019 representing a CAGR of ~21% during 2012-2019. At today’s price nears $105, PSX’s current yield equates to ~3.43%. For perspective, the chart below provides a look at the historical dividend yield over the last seven years.
(*Note: 2012 figure annualized. source: Company data)
The dividend looks extremely solid and safe in our view. During Q319, PSX generated a healthy $1.7 billion in cash flow from operating activities, which was more than enough to cover nearly $402 million it paid out in dividends. During its 2019 Investor Day, PSX sounded extremely optimistic on its cash flow generation potential and expects to generate nearly $7 billion in operating cash flow in 2020. Backing out the cash capex of $3.3 billion (as guided by management), PSX will be left with $3.8 billion which can be allocated to shareholder returns. Thus, for 2020 we are likely to see another year of dividend increases by the company.
In addition to the strong dividend yield, investors also reap further benefit from PSX’s share buyback program. Since listing, PSX has repurchased and exchanged 202 million shares or 32% of shares initially outstanding. This represents a return of over $16 billion through share repurchases and exchanges. It recently announced a new $3 billion share repurchase program, further returning more capital to shareholders. During 2020, PSX intends to buyback shares worth $1.5-$2.5 billion.
Diversity of Earnings – A Key Competitive Advantage
PSX’s diversification strategy has been a key reason earnings are so stable even though the underlying refining business can be volatile. PSX generated nearly 50% of its earnings from the Refining segment in 2018, which is also its most cyclical and volatile segment (as shown in chart below).
(source: PSX’s 10-k and 10-q)
In order to reduce cyclicality, PSX has been investing significantly in growing its other business, especially the Midstream segment. For 2020, PSX plans to invest nearly $2 billion in its Midstream business, the highest among all its segments. The major Midstream capital projects for 2020 include Sweeny Fracs 2, 3 and 4, the Red Oak and Liberty crude oil pipelines and the South Texas Gateway Terminal. While Refining continues to be an important and significant source of cash generation, we can clearly see the impact of the growth investments (see chart below). 2015 and the last 12 months through third quarter 2019 had very comparable realized crack spreads in Refining. Over this time period, operating cash flow increased from $5.7 billion to $7.3 billion, with a significant portion of the increase coming from Midstream growth. Additionally, the company plans to take the surplus FCF refining generates and use that to fund growth in other businesses.
(source: Company Presentation)
Strong Balance Sheet
PSX’s balance sheet is very strong with no major debt maturities on the horizon, plenty of available liquidity and low leverage. PSX’s debt maturity profile extends almost 30 years. The debt maturities are very manageable, without significant refinancing risks in any given year. In fact, the company intends to pay off the 2020 and 2021 maturities without refinancing. As of the end of Q3, PSX had access to ~$8 billion in liquidity comprising $2.3 billion of cash balance and $5.7 billion of capacity under its revolving credit facilities. This provides flexibility to continue to pursue its aggressive expansion plans across business segments. Additionally, leverage is low and allows PSX the flexibility to expand the balance sheet if any opportunity arises. The consolidated debt to capital ratio has been in the range of 25%-30% for PSX since 2015.
The investment grade credit rating A3 (Moddy’s) and BBB+ (S&P) provides PSX with easy access to capital markets and plenty of capital at lower rates. The chart below highlights PSX’s well-laddered debt maturity profile and low leverage.
(source: Company Presentation)
Robust EBITDA Generation and Peer Leading ROCE
Over the last 12 months, PSX’s adjusted return on capital employed (ROCE) is 16%, well above its peer group average. It is important to note that this comparison is not only against just other refiners but a broader peer group including Chemical and Midstream players. PSX generated a record $10.1 billion of adjusted EBITDA in 2018 and EBITDA generation continues to be strong this year. Its highly diversified portfolio provides it with a competitive advantage versus peers and allows to generate strong EBITDA through the market cycles. The continued growth of fee-based earnings from the Midstream business enhances the stability of the results. PSX expects to increase its EBITDA by over $2 billion to reach $11 billion by 2022 driven by various growth and return projects.
(source: Company Presentation)
IMO 2020 – Tailwind for Refiners
PSX noted that IMO 2020 will be a tailwind for refining margins. IMO 2020 which went into effect from January 1, 2020 is a new UN regulation that lower the maximum sulfur content of shipping fuel to 0.5% from 3.5%. Thus, shipping companies are forced to buy more heavily refined, lower sulfur fuel for their ships. This regulation will significantly benefit high complexity refiners such as Phillips 66 relative to low complexity refiners. The crack spreads are widening which should improve profitability. The diesel crack which has averaged about $13 a barrel over the last 10 years is now indicating almost $18 a barrel crack for 2020, almost 4.5 a barrel wider. Every $1 per barrel change in the diesel crack is about $300 million a year of incremental EBITDA for PSX’s Refining segment.
History of Outperformance
Phillips 66 has a history of delivering superior returns to its shareholders. PSX has meaningfully outperformed all its peers as well as S&P 500 index since becoming a publicly listed company in May 2012. Since listing, PSX has delivered total returns of nearly 328% to its shareholders – more than 2x the total returns of its peer group and nearly 2.2x the total returns of S&P 500 index.
(source: Company Presentation)
Valuation:
We believe there is scope for more re-rating given PSX’s diversified business model which provides operational synergies and brings stability to earnings. We believe the market is incorrectly valuing PSX more like a refiner (which has volatile earnings and lower valuation mutiples) rather than an integrated and diversified downstream energy business (which has more stable earnings, and deserves higher valuation mulitples). Management has been focused on pursuing aggressive expansion of other businesses (Midstream and Chemicals). While Refining is expected to continue to generate a significant share of operating cash flow, we expect contributions from Midstream and Chemicals will increase over time. As it happens, we expect the market to assign a higher multiple to PSX. This means that investors can expect share price gains as management delivers on its strategy. From its own historical average standpoint, PSX’s EV/EBITDA has oscillated between a range of 3.1 to 14.8 since listing in 2012. So, the current EV/EBITDA of 7.2x is almost midway between that range. Thus, from a historical average perspective, there is more scope for multiple expansion (i.e. the share price should rise).
(source: Thomson Reuters)
Risks:
Delays in Projects: PSX undertakes any capital project with the expectation that it will deliver an acceptable level of return on the capital invested. The project economics are based on best estimate of future market conditions. Most large-scale projects take several years to complete. During this multi-year period, market conditions can change from those forecasted earlier, and it may not be able to realize the expected returns. This could negatively impact results of operations, cash flows and the overall return on capital deployed.
Execution risk: The company is in undertaking an ambitious and aggressive growth program. This includes expansion plans across its business segments primarily Midstream and Chemicals. PSX’s future earnings and cash flows are therefore dependent on the ability of management to execute. Investors should be encouraged by the fact that management has done a commendable job so far (i.e. they have a track record of proven success).
Conclusion:
Phillips 66’s diversified downstream and midstream operations help reduce the volatility of the company's earnings and cash flow. This allows it access to a steadier stream of funds to invest in expansion projects as well as to return cash to shareholders through dividend and share buybacks. The company has grown its dividend at a CAGR of ~21% over the past 7 consecutive years, increasing it every single year during that timeframe. Additionally, we see strong potential for capital gains. If you are a long-term income focused investor, PSX is an exceptionally attractive stock to own considering its current valuation, ongoing dividend increases and powerful long-term price appreciation potential. We are currently long share of PSX.