Following the approval of ultra light crude oil exports by the U.S. Department of Commerce all of the refining companies including Phillips 66 (NYSE:PSX) have come under pressure. However, compared to its industry peer Valero Energy Corporation Phillips 66 is less affected by this news as the company has a well-diversified portfolio with three other segments.
This article will focus on assessing each segment's performance in the latest quarter as well as the future outlook to check the overall expected financial performance of Phillips 66.
In the second quarter of 2014, Phillips 66's refining segment's net margin dropped more than 14% despite an increase in the revenues as a result of lower realized refining margins. This was a result of decreased market crack spreads that were partially offset by widening crude differentials.
Source: SEC Filings
However, the differentials have begun narrowing down and it is expected that the trend will continue as the U.S. has lifted its ban on the export of ultra light crude oil. Thus far in the third quarter of 2014 discounts on most crude oils have narrowed compared to the third quarter of 2013. The year-to-date difference between Brent and WTI in 2014 has fallen to $7.41 compared to $11.73 in the same period in 2013. The export of ultra light crude oil will further drive up the prices of sweet and sour crude oils consequently narrowing the crude differentials as well as the company's margins.
Therefore it is expected that the refining segment, Phillips' largest revenue-generation segment, will continue to add pressure to the company's bottom line in the future due to the absence of any cost advantages.
Marketing and Specialties Segment
Like the refining segment, the marketing and specialties segment also experienced declining margins as a result of gasoline prices rising at a faster pace than wholesale "rack" prices. The segment already had an inadequate net margin of 1.2% in the second quarter of 2013 but in this quarter the net margin was only 0.54%.
Source: SEC Filings
The future outlook for this segment is now very favorable as well. The refined products prices are currently increasing and are expected to continue increasing but at a slower pace. The trend will slightly expand Phillips' revenues base but the company will be facing margin problems due to higher wholesale "rack" prices. Currently, the crude oil prices are anticipated to continue declining as the geopolitical problems in Lebanon and Iraq improve. The falling global demand for crude oil is also improving. Generally, during a period of decreasing crude oil pricing trends, refined product spot prices increase at a slower pace than the corresponding wholesale "rack" prices. Therefore the segment's costs will grow at a faster rate compared to the segment's revenues growth consequently hurting the bottom line.
Unlike the refining and M&S segments, the revenues in the midstream segments declined but the net earnings showed a considerable improvement. The segment's net margin jumped approximately 330 basis points to 9.35% in the second quarter of 2014 compared to 6.08% in the second quarter of 2013.
Source: SEC Filings
The natural gas prices in the second half of 2014 and 2015 will be higher compared to 2013 and this would add profitability in the segment. Another favorable factor for the segment is the growing demand for propane and the trend is projected to continue up until 2015. Therefore we can expect that the segment's revenues and profits in this segment would expand in the second half of 2014 and in 2015.
The only segment that proved highly profitable for the company was the chemicals segment that experienced year-over-year growth of 79%. The growth was primarily driven by improved ethylene and polyethylene realized margins, higher volumes of these products, lower turnaround activity costs, and unplanned power outages. The profitability is anticipated to continue in the future as the current U.S. ethylene margins have hit their highest levels since February 2013 due to several ongoing cracker issues creating supply tightness. Since this segment contributes the least amount to the top line it will not add any significant growth to the company's future revenues. However, the bottom-line effect will be significantly profitable for Phillips 66.
Balance Sheet Position
Unlike Phillips' income statement, its balance sheet portrays the strong financial position of the company. The company has a very strong liquidity position with $5 billion of cash and $5.4 billion of unused and available committed credit facilities that will enable the company to easily meet its short-term obligations and pay returns to the investors without any delay.
Recently, Moody's upgraded the company's senior unsecured debt from Baa1 to A3 reflecting the company's improved ability to pay debt.
Returns to Shareholders
Despite the deteriorating net margin Phillips 66 is still in a position to meet its obligations including making returns to investors. In the second quarter of 2014, the company's per share dividends surged 60%. The trailing annual yield offered by Phillips 66 is 2.10% whereas the forward looking annual dividend yield is 2.40%, indicating company's willingness to offer higher future profits to the investors. Both the trailing and forward yields offered by Phillips are better than its industry peers: Valero Energy Corporation (NYSE:VLO) and Marathon Oil Corporation (NYSE:MRO). The forward dividend yields offered by Valero and Marathon Oil are 2.20% and 2% respectively compared to 2.4% offered by Phillips.
Moreover, the company has also authorized additional share repurchase program of $2 billion in July 2014 for total authorization of $7 billion since 2012. Through the second quarter, Phillips has bought back 60 million shares and ended the quarter with 559 million shares outstanding.
Phillips 66's largest revenue-generating segments disappointed investors due to the deteriorating margins. Now it is expected that the same performance will continue in the second half of 2014 due to narrowing crude oil differentials and lower projected crude oil prices. The trends would affect the company's margins and eventually adversely affect the bottom line. In contrast the outlook for the other two segments is quite favorable but since the revenue contributed by these segments is less significant to the top and bottom lines compared to refining and M&S segment this improvement would not play a major part in improving the company's profit margin.
According to the analysts estimates, per share earnings would remain almost the same in the third quarter compared to the second-quarter 2014, but the earnings would decline in the fourth quarter. Projected EPS for third quarter is $1.56 per share and for fourth quarter it is $1.45 per share compared to $1.51 per share in the second quarter.
But as the company is offering handsome profits to the investors, both in the form of dividends as well as share repurchases, therefore I would recommend buying the stock. The company's strong liquidity position ensures future cash returns.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: The article has been written by APEX Financial Consultants. This article was written by one of our research analysts. APEX Financial Consultants is not receiving compensation for this article (other than from Seeking Alpha). APEX Financial Consultants has no business relationship with any company whose stock is mentioned in this article.