Phillips 66's Hidden Source Of Value

| About: Phillips 66 (PSX)

This article is part of an ongoing series that highlights specific companies that are on sale. It helps me to document my thought processes when I add to my holdings or initiate new positions. Please provide your feedback in the comments section below.

Phillips 66 (NYSE:PSX) is currently offering investors an opportunity to buy portions of the company at $75/share. The stock had been steadily rising for about three months, but has recently pulled back since reaching its 52-week high and may now provide a good entry point. Right now, PSX is about five percent off the 52-week high, hit this month at about $79 per ownership interest. This few week pullback provides long-term investors with a good opportunity to initiate a position.

Phillips 66 has a business model that is simple and sustainable. Though it is grouped with refiners, this company does much more than just refining. In its Q3 earnings report, Phillips 66 actually reported a refining loss of $2 million. However, the company was still very profitable for the quarter, due in part to its Chemicals division, which includes a joint venture with Chevron (NYSE:CVX) called CPChem. In addition to the joint venture, Phillips 66 does refining, operates pipelines, markets natural gas to power companies, and manufactures plastics. Additionally, it has initiated its strategy of dropping assets down into an MLP called Phillips 66 Partners LP (NYSE:PSXP). The MLP was spun off, with Phillips 66 retaining about 75% of the ownership. This MLP has already started paying regular distributions to Phillips 66, which is expected to grow. Phillips 66 may also place additional assets into the MLP.

Despite the growth, I believe that Phillips 66 trades at a discount to its true valuation. PSX currently trades at 13 times ttm earnings and under 11 times projected next year earnings. EPS is expected to grow over 21% next year, which is a huge jump. PSX appears to be heading in the right direction as a company, and I am content to accumulate shares at this perceived discount.

Also, Phillips 66 is a cannibal! PSX has been buying back its own stock at a pace that affects the bottom line. Just one year ago, four short quarters, there were 635 million shares outstanding of PSX. Today, there are under 600 million diluted shares. In one year, Phillips 66 has retired almost six percent of its outstanding share volume! The company has indicated on many occasions that returning cash to shareholders via share buybacks is an important goal for management. They are using their free cash flow to buy out other shareholders, which further adds to the gains of the remaining shareholders.

With Phillips 66 buying so much of their outstanding shares, let's look at how that will affect earnings. Analysts are expecting a consensus EPS of $1.12 for the next quarterly earnings release, with the lowest estimate coming in at $0.80. For reference, PSX reported EPS of $2.06 for the same quarter last year. It doesn't appear that analysts are expecting much, if anything, from Phillips 66. With PSX's large share buyback activity, it wouldn't have to make more in total earnings to affect the bottom-line EPS. Even if profits stagnate, EPS will increase due to the share buyback. I believe that Phillips 66 will have a positive surprise, and this is the catalyst that will cause PSX to reverse its recent downward trend and close substantially higher at the end of 2014.

Let's take a quick look at a couple of PSX's competitors, Marathon Petroleum (NYSE:MPC) & Valero Energy (NYSE:VLO). PSX has the highest dividend yield of the three at 2.1%, versus 1.96% & 1.77%. Phillips 66 also has better lower debt-to-equity and higher gross margins. Lastly, PSX's quick ratio is much more favorable, being 38% higher than both of the competitors. Phillips 66 is the type of company that I want to own for the long haul, and this appears to be an opportune time to add to my position.

Speaking of yield, Phillips 66 also has a solid yield for such a new company. You literally get paid to wait. PSX has a current yield of about 2.1%. Though this might not be as large a yield as many DGIs are used to, Phillips 66 is due to raise its dividend again this year, which drives price appreciation. Ever since being spun off from ConocoPhillips (NYSE:COP), Phillips 66 has never cut its dividend. In fact, it has raised the dividend three times in less than two full years of being its own entity! Management has said that growing shareholder distributions is one of their five strategic priorities. From the company's profile book:

"We believe shareholder value is created through consistent and ongoing growth of regular dividends, supplemented by share repurchases. Regular dividends demonstrate the confidence our management has in the company's capital structure and its capability to generate free cash flow throughout the business cycle. At the discretion of our board of directors, we plan to increase dividends annually and fund a share repurchase program while continuing to invest in the growth of our business."

Phillips 66 will become a Dividend Challenger in the next couple of years as it continues this trend of increasing its distributions. Its dividend growth rate of 25% is at a much faster pace than inflation. That means that if you are relying upon dividend income to sustain you, you would not lose purchasing power over time. In fact, it would grow. PSX is both a buyback king and a dividend king!

Combined with its sales growth and share buyback activity, there is one other thing to mention. Its Q3 earnings release, which included a refining loss for the quarter, was based on a WTI-Brent spread that was negligible, sometimes just a couple of dollars. As soon as Q4 started, the spread started widening, increasing Phillips 66's refining margins. The spread at the end of Q4 was over $11. It appears that the refining division should post quite a turnaround for Q4, which would cause Phillips 66 to substantially increase their earnings, and I welcome the opportunity to add to this position.

As always, this article represents my opinions at the time of writing. You should do your own due diligence before making any decisions. However, I believe that Phillips 66 represents a quality company that is trading hands at a discount.

Disclosure: I am long PSX, COP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.