Keep An Eye On Phillips 66

| About: Phillips 66 (PSX)

Summary

Rating agencies are concerned about the rising debt levels.

Debt metrics are getting stretched.

Free cash flows available to shareholders are negative.

Debt to EBITDA ratio has deteriorated.

Phillips 66 (NYSE:PSX) is slowly dropping down its midstream assets to its limited partnership, Phillips 66 Partners (NYSE:PSXP). The company has sold some logistics assets to its partnership for $1.3 billion. Phillips 66 Partners will fund this purchase with debt and some units which will be issued to Phillips 66. This is the third major transaction of the year between these two businesses. These sales do not simply drop down the assets, but it has an impact on the ownership structure as well.

The first two sales happened in the first half of the year and included an NGL fractionator and related storage caverns. The partnership assumed some debt associated with the subsidiaries and issued general partners units to Phillips 66 Partners GP. It also issued more than 400k common units to Phillips 66. The general partner units were issued to keep the general partner interest at 2%. The total cost of both these acquisitions was over $1 billion and initially these were funded with a mix of debt and common units for Phillips 66. However, in May, the partnership sold 12.65 million common units to the public in order to pay for the debt assumed at the time of these acquisitions. So, in reality, the common unitholders paid for these acquisitions. This step diluted Phillips 66 common unit holding in the partnership by more than 17%. However, the parent still holds more than 50% common units in the partnership which means the results will be consolidated.

Phillips 66 will still be able to enjoy PSXP's cash flows and future growth from these assets. However, the addition of debt to fund these acquisitions is spooking the rating agencies a little. Moody's changed Phillips 66 outlook to negative but kept its credit rating at A3. A negative outlook means that the things are not too bad at the moment, but further addition in debt or a decrease in cash flows will prompt us to downgrade the company's debt. Their biggest concern is the stress on Debt/EBITDA ratio. This ratio was 1.5x at the end of the last year but it will go up to 2.7x after the completion of this debt offering.

The cash flows ratio is also getting weak. This ratio will also come down to 15% from 33% in 2015. The main concern for cash flows ratio comes from Phillips 66's eagerness to return cash to its shareholders. The company has a robust dividend and share repurchase program. Total cash outflow for dividends and share repurchase was just over $2.7 billion in 2015. Operating cash flows were over $5.7 billion. If we only look at the operating cash flows and the cash paid to shareholders, then it does not look bad. However, Phillips 66 also spends in excess of $5.7 billion on capital projects. This means that the free cash flows available to shareholders are negative and the company is borrowing to pay dividends. Further dilution of interest in Phillips 66 Partners and addition of debt will weaken the cash flows as well as the debt metrics. It is a valid concern from the ratings agencies.

On the flip side, the ratios are not too stretched at the moment despite an increase in debt levels. Retained cash flows to debt ratio of 15% is still healthy and debt to EBITDA ratio of 2.7x is easily manageable. These ratios will start to look weak if the retained cash flows and EBITDA drop in the future. EBITDA figures have been over $7 billion for the last two years. Moody's' estimate for the 2017 debt/EBITDA ratio is based on forward EBITDA. This means that there are no near-term concerns about further deterioration in this ratio. Since Phillips 66 wants to drop down all of its logistics assets to its partnership, we might see a small deterioration in cash flows because of the dilution in ownership interest. However, in the near-term, there is no threat to the debt metrics or the credit ratings of the company. It is still an investment grade rating and it is likely to remain this way in the near future.

For the shareholders, it is certainly something to keep an eye on as this affects the cash flows from one of the best segments of the company. However, the company's willingness to return cash to its shareholders means that the chance of a dividend cut is extremely slim. If there is a need, the company might opt to suspend or decrease its share repurchase program. Phillips 66 still remains a good long-term investment despite these concerns.

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