- PSX appears to be a promising investment opportunity based on a variety of criteria, including impressive free cash flow, reasonable debt, and a sustainable dividend.
- PSX currently possesses an above-average price/free cash flow ratio, which is higher than the industry average, but lower than the broad market average.
- Thanks to a share repurchase program initiated by management, PSX has reduced its total shares outstanding by nearly eight percent over a little more than a year.
- Spin-off companies, on average, tend to outperform the broad market by ten percent a year during the first three years post spin-off execution.
Oil refining is one of the most critical business segments within the energy industry. It's also one of the most misunderstood. When considering the business economics of a refinery business, it's best to approach the topic thinking from a manufacturing perspective, rather than from an exploration or production perspective.
The reason for this is simple: while most oil-related energy companies stand to benefit from rising oil prices, such is not necessarily the case for oil refineries. In fact, rising oil prices may actually serve to hurt these companies, as it increases the cost of raw materials on which this business operates.
Founded in 1875 and headquartered in Texas, Phillips 66 (NYSE:PSX) is a large capitalization energy manufacturing and logistics company that operates in four main business segments: Midstream, Chemicals, Refining, and Specialties. The company engages in the transportation of crude oil to refineries, gathers/processes natural gas, produces/markets various chemical compounds/products, and purchases for resale various refined petroleum products.
Since spinning off from parent company ConocoPhillips (NYSE:COP) in April 2012, Phillips 66 has had a spectacular run. In fact, shares are up more than 130% since the spin-off. With tremendous near-term growth potential still in the works, the company appears to present strong upside potential.
The Statistical Edge of a Spin-off:
Phillips 66 is a spin-off company. This fact alone provides a statistical advantage for shares of the company, as spin-off companies tend to produce positive alpha for several years after a spin-off has been successfully executed. In Joel Greenblatt's popular book, You Can Be a Stock Market Genius, Joel describes this phenomenon in great detail. In his book, Joel states that a Penn State study of twenty-five years of investment history had led to the conclusion that "stocks of spin-off companies [will generally] outperform their industry peers and the Standard & Poor's 500 by about 10 percent per year in their first three years of independence."
It's important to note that these are the average annual returns expected to be generated simply from investing in every single spin-off that occurs in a given year, without any regard to financials or fundamentals whatsoever. Now imagine what could happen if this statistical edge was combined with careful selection and analysis.
Impressive Free Cash Flow:
Phillips 66 has managed to increase its free cash flow over the last year. Since free cash flow is the lifeblood of any business, it is great to see that PSX has been able to steadily increase its annual free cash flow, as this points to a company with strong earnings power.
Shares of PSX currently trade at a P/FCF ratio of 8.0, which is priced above the industry average P/FCF ratio of 6.4. However, it is important to note that this ratio is still well below that of the broad market average P/FCF ratio of 10.9.
Manageable Debt Levels:
In addition to possessing strong free cash flow, Phillips 66 also possesses relatively low debt levels in comparison to both the company's net income and total cash. As of the most recent quarter, PSX possessed $6.6 billion in total debt, $5.40 billion in total cash, and $3.66 billion in net income over the last year.
These numbers are fantastic. With net income at its current level, it would take PSX less than two years' worth of total net income to pay back all of its total debt. This is a very strong financial position, and PSX's strong cash position of $5.40 billion just makes the deal that much sweeter.
Sustainable Dividend & Share Repurchase Program:
With a current payout ratio of only 22%, it is safe to assume that Phillips 66 boasts a pretty sustainable dividend that could very well increase in the future. Currently, the company boasts a modest trailing dividend rate of 2%, or $1.56 per share, but it is likely that this dividend will continue to grow as the company continues to expand and reinvest its earnings.
Thanks to PSX's strong cash position, a continued share repurchase program also seems to be a strong possibility. A share repurchase program would be a great bonus for shareholders, as it would help to reduce the total numbers of shares outstanding, thus increasing ownership stakes and increasing the share price of current shares outstanding. Over a little more than a year, PSX has already bought back roughly eight percent of its shares outstanding, bringing down the total shares outstanding from 635 million shares to 587 million shares. Continued share repurchases will help to boost the EPS for the company, thus helping the company to potentially command a future higher earnings multiple.
Highest Gross Margins in Peer Group:
PSX currently possesses a gross margin of 12%, which compares to Marathon Petroleum Corporation's (NYSE:MPC) gross margin of 7% and Valero Energy Corporation's (NYSE:VLO) gross margin of 5%. This gross margin, however, is below the industry average gross margin of 20%.
From the above-described metrics and pertinent information, it is evident that Phillips 66 conveys the characteristics of a strong high-quality business. Strengths could be seen in multiple areas, including high cash levels, reasonable debt, a marked decrease in total shares outstanding, a highly sustainable dividend, and an impressive free cash flow. For this reason, I would continue to recommend shares of PSX as a buy, despite the more than 130% share price appreciation since April 2012.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.