Phillips 66: Potential Multiple Expansion Should Outperform Refining Peers

Mar.24.14 | About: Phillips 66 (PSX)

Summary

At 9.9x consensus 2015 EPS, PSX only trades at a slight premium over its refining peers.

PSX should see multiple expansion as it diversifies into midstream and chemicals businesses which should command a higher valuation relative to refining.

Future M&A activities and healthy growth in cash distribution should help realizing the multiple expansion story.

Over a long term, value downside would be limited by management's commitment to separate refining operations from midstream and chemicals should share price trade below their estimated asset value.

The share price of Phillips 66 (NYSE:PSX) has appreciated by 36% over the past 6 months, considerably outperforming a return of just 10% for S&P 500 Index. Looking forward, I believe there remains significant price upside as the company continues to expand its midstream and chemicals businesses while price downside is somewhat limited by management's commitment to preserving shareholder value.

Continuing to deploy capital in midstream and chemicals businesses while maintaining limited investment in refining business would still be management's long-term focus. Management's plan is to derive approximately two-thirds of total EBITDA from the midstream and chemicals segments in 5 years. PSX now trades at 9.9x 2015 consensus EPS estimate, which is at a slight premium over its refining peers (see chart below).

(click to enlarge)Click to enlarge

I believe the company should see its valuation multiple expand and outperform the peer group in the next few years given the following reasons:

  1. Gulf Coast refiners continue to benefit from a structural improvement in the region's industry landscape whereby the Gulf Coast crude discount is expected to be sustainable and even widen. The lower feedstock cost is expected to improve refiners' earnings power and even allow the US refiners to capture export market share from Europe and Asia. The recent strong results from Valero Energy (NYSE:VLO) and Marathon Petroleum (NYSE:MPC) are reflective of this trend. Nevertheless, I would not expect PSX to outperform pure-play Gulf Coast refiners such as VLO and MPC on the refining front given the company's continued effort to diversify away from the business. However, I do see PSX as a less volatile play for the improving Gulf Coast refining trend given its relatively more diversified business mix.
  2. In addition, midstream and chemicals businesses tend to command higher valuation multiples given that 1) profitability for these businesses are generally higher as reflected by the higher net profit margin for PSX's midstream and chemicals segments relative to its refining segment (see chart below) and 2) the outlook for the US O&G transportation and chemicals space continues to be solid.

Aside from the attractive transformation story, I also expect the share price of PSX to benefit from the following near to medium catalysts:

  1. Management has identified a few non-core assets to be divested in near term and plans to deploy the sales proceeds in the midstream and chemicals expansion. According to management, the refining operation in California is considered to be a non-core asset. Although the bids for this asset has failed to meet management's expectation by far, management does see value in the asset given its capability of generating steady cash flow stream and that the asset's earnings power would improve over time as discounted crude enters the California refining market in the next few years. The company believes the asset would be able to command a higher bid by then. In addition, PSX is now actively marketing the Whitegate refinery in Ireland and its 47% interest in the Melaka refinery in Malaysia. Other non-core assets include the Humber refinery and MIRO refinery in Europe, which are available for bidding.
  2. In terms of cash distribution to shareholders, it is believed that the structural improvement in the Gulf Coast refining market and solid prospects of the US O&G logistics and chemicals segments would support a steady cash flow stream for PSX. PSX has seen continued improvement in operating cash flow since 2010 (see chart below). Given the industry tailwinds and that total funds spent on dividend and share buyback in 2013 only represented less than 75% of total free cash flow, it is expected PSX has sufficient capacity to sustain the current share repurchase size and continue growing dividend. It should be noted that the company's strong balance sheet with $5.4B cash and just 0.2x net debt to EBITDA leverage is another supporting factor.

Management has stated that they will consider a spin-off or sale of PSX's refining operations over a long term if the share price continues to trade below the company's estimation of the underlying asset value. I believe this commitment would meaningfully limit the share price downside over a long term.

In summary, shareholders of PSX are going to benefit from a multiple expansion potential as the company continues to derive value from better dynamics in the refining market but also penetrate into the more profitable midstream and chemicals businesses. Future M&A activities and healthy growth in cash distribution should help realizing the valuation multiple growth. Hence, PSX is a strong buy.

All charts are created by the author, and data used in the article and the charts is sourced from S&P Capital IQ, unless otherwise specified.

Disclosure: I am long PSX. 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.