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Summary

  • Operating just two years as a stand-alone business.
  • Future focus on chemicals, midstream and US exports to reduce reliance upon refining business.
  • Aggressive growth plans requires lots of capex and might actually increase reliance upon US shale boom.

Investors in Phillips 66 (PSX) hardly reacted after the energy downstream business released a solid first quarter earnings report.

Shareholders have been really happy with the company's performance after its shares nearly tripled over the past two years in a more favorable refining environment. The long term opportunities resulting from the US shale boom were a major driver as well.

I doubt however that the company can structurally reduce the cyclicality of its earnings by focusing on its non-refining businesses.

First Quarter Release

Phillips 66 reported a modest fall in its revenues which fell by 2.8% to $41.10 billion. Income from continuing operations took a beating, falling from $2.06 billion to $1.30 billion.

Net earnings actually rose slightly from $1.41 billion to $1.57 billion as a result of net gains of $706 million achieved on discontinued operations related to the sale of its Specialty Products business.

Earnings per share rose a bit quicker as the company repurchased some 6-7% of its shares outstanding over the past year. Income from continuing operations therefore came in at $1.47 per share.

Midstream And Chemical Was Solid, Refining Margins And Downtime Took A Bite Out Of Earnings

Phillips 66 showed a mixed performance throughout its segments. Midstream earnings rose from $111 million to $188 million. Earnings were driven by higher earnings of its 50% investment in the DCP Midstream company. NGL earnings were up as well on higher propane prices as the transportation business benefited from higher rail rates in its interest in the limited partnership Phillips 66 Partners.

Chemical earnings rose modestly from $282 million to $316 million on higher margins and higher earnings at Chevron Phillips Chemical Company's Olefins and Polyoefins business.

An anticipated disappointment occurred at the refining business as earnings fell from $904 million to just $306 million. Higher turnaround and maintenance activities combined with weaker margins were the main driver behind the fall in earnings. The company aims to reduce the impact of the volatility of refining earnings on the company's bottom line by focusing future investments on other segments.

Marketing and specialties earnings fell from $190 to $137 million as higher margins offset an increase in costs and lower volumes.

Valuation

Despite returning vast amounts of cash to its shareholders, Phillips 66 operates with a reasonably solid balance sheet. The company holds $5.3 billion in cash and equivalents while total debt at $6.2 billion results in a net debt position which is less than a billion.

In the first quarter the company repurchased $640 million worth of shares, repurchasing shares at a rate of over 5% per annum at current levels. On top of this comes the appealing quarterly dividend of $0.39 per share providing investors with a yield of 1.9% on top of that. At this pace the company is retiring few earnings to bolster the balance sheet ahead of its ambitious future investment plans.

Trading at $84 the business is valued at nearly $48 billion. This values the company at roughly 13 times last year's earnings of $3.7 billion.

Corporate Developments

Phillips 66 has seen a lot of corporate developments in recent times. Of course this all started when the business was spun off from ConocoPhillips (COP) in 2012. Following this the Phillips 66 Partners LP (PSXP) business with a $5.8 billion valuation has been established last year. The company already made a $700 million acquisition of refined products pipelines and propylene storage assets.

At the end of last year, the company announced to sell its Phillips Specialty Products business in a complicated $1.4 billion share deal to Warren Buffet's Berkshire Hathaway(BRK.A).

For now the focus is on growing the midstream and chemicals business which performed well. Better returns in refining and the growing of these business should improve the diversification of the business.

The company already approved significant investments which total $3 billion. The company will built the Sweeny Fractionator I and the Freeport LPG Export Terminal for exports towards China. The increased export capabilities should boost the potential for exports to 550,000 barrels per day in 2016.

Note that these corporate deals and investments represent just a portion of the company's entire strategic development as will be discussed below.

What Does Phillips 66 Look Like In The Future?

Phillips 66's spin-off took place at relatively low levels as refiners almost immediately benefited from a very favorable US refining environment. Shares rose from levels in the low-thirties to current levels of $84 as investors nearly tripled the value of their investment within a two year period.

While Phillips 66 aims to invest more aggressively in non-refining assets, the performance of these businesses is still positively correlated in general to the refining business. Therefore I am a bit cautious to pay 13 times earnings for the company despite an excellent focus on shareholder value and the strong and decisive pace of strategic developments.

It is not just the cyclicality of earnings, but also the pace of these strategic developments which makes it difficult to obtain a clear picture. Partnerships, direct holdings in non-controlled entities and a myriad of investment decisions, divestitures and acquisitions make it quite difficult to get an accurate view about the true earnings potential of the business.

That being said, the company's ambitions to export and grow its midstream assets are quite big. Capital expenditures are set to increase from just $1.8 billion last year towards $6 billion by 2016. That means that leverage will have to increase, shareholder payouts will have to be trimmed or capital will have to be raised to fund these investments into the future.

While these investments could result in higher and more stable earnings the company is increasing its reliance on cheaper US oil for decades to come. While this could and will most likely be very lucrative, billions of dollars could go to waste if Europe and Asia ignite their own shale revolution.

Phillips 66 has an excellent track record so far, yet it remains to be seen how new projects will be financed without causing dilution and whether the market really is happy to attach a higher multiple to these future earnings as the company appears to be making an even larger bet on the US shale economy.

Source: Phillips 66 - Solid Quarter, But Can Future Midstream Ambitions Really Result In A Structurally Higher Earnings Multiple?