Phillips 66: An S&P 500 Addition With Growth Prospects

| About: Phillips 66 (PSX)

While ConocoPhillips (NYSE:COP) decided to be rid of its downstream refining and marketing, midstream, and chemicals assets by spinning them off into Phillips 66 (NYSE:PSX), the better to concentrate on its upstream exploration and production activities, investors may find that they don't necessarily want to shy away from Phillips 66.

Besides offering the prospect of dividend payments and appreciation through management's growth strategies and share buyback plans, the spun off company has been added to the S&P 500 index. Stocks added to the index have benefited due to higher demand from index-based investors and portfolio managers whose portfolios include the stocks that make up the index. The effect starts when the stock is added to the S&P 500 and tends to last even afterward, giving a boost to the stock price.

Phillips 66 is also likely to benefit from management's plans to grow more in the midstream and chemicals divisions while reducing the current refining and marketing focus of the company. The company's refining and marketing business segment refines crude oil into petroleum products and also markets petroleum products. This segment, with its approximately 15,000 miles of pipeline and 15 refineries, generated a 12% return on capital employed for PSX in 2011.

In comparison, the company's midstream unit produced a 30% ROCE in 2011. PSX's midstream interests are largely in the form of a 50% interest in DCP Midstream, a joint venture with Spectra Energy (NYSE:SE). The midstream business segment gathers natural gas through its pipeline systems and processes the gas to obtain natural gas liquids and residue. It fractionates natural gas liquids into their components, such as ethane and butane, and sells them for various uses, including for use as input material in the chemical industry and for use as fuel. PSX sees opportunities to expand its midstream operations and has about $4 billion of projects in progress, including pipeline projects in Texas, besides seeing opportunities for another $2 billion of projects.

The chemicals segment, which turned in a 28% ROCE for 2011, is made up of PSX's 50% interest in Chevron Phillips Chemical Company, a joint venture with Chevron U.S.A. (NYSE:CVX). This unit uses natural gas liquids and other inputs to produce petrochemicals that it sells for use as input in the production of plastics and chemicals.

Chevron Phillips is engaged in a project to build what it describes as "the world's largest on-purpose 1-hexene plant" in Baytown, Texas, that will produce as much as 250,000 metric tonnes a year of 1-hexene, a material that goes into the production of polyethylene. In addition, Chevron Phillips has other ongoing projects for two Texas polyethylene facilities (with an annual capacity of 500,000 metric tonnes each) and an ethane cracker facility in the Gulf Coast.

While PSX's refining and marketing segment takes up the majority of its capital employed, at 84% as of 2011, management's plan is to gradually redeploy capital into the midstream and chemicals segments so that these higher-return segments account for 50% of its capital employed in the long term. Also, PSX sees scope for growth through exports and through various ventures in the Middle East, such as a chemicals plant in Saudi Arabia.

While there is growth potential if the company successfully moves its capital employed to higher-returning business segments, the company also faces various risks because of the nature of the industry it operates in. For instance, there are various federal and state environmental reporting laws that PSX has to operate under, such as the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA) at the federal level, and greenhouse gas legislation.

In its first standalone quarterly report, PSX reported net income of $636 million for the first quarter of 2012, down 6% from net income of $676 million for the first quarter of 2011. The company blames the decline on higher operating expenses and "impairment of equipment" at its refining and marketing segment.

Regarding the spin-off, ConocoPhillips shareholders received one share of Phillips 66 for each two shares of ConocoPhillips they owned. Phillips 66 started trading on the NYSE on May 1, closing at $32.76. Also, PSX offers the promise of a regular dividend yield, starting off at $0.20 per quarter, with prospects for raises. The stock is trading in the $30 to $32 range, making for a dividend yield of about 2.5%.

As for appreciation prospects, Credit Suisse and ISI Groups analysts see upside potential for PSX, with a target price of as much as $44.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.