Phillips 66 Reports Solid Earnings, Limited Non-Refining Profits

Aug. 2.12 | About: Phillips 66 (PSX)

Prior to the market open on Wednesday, Phillips 66 (NYSE:PSX) reported earnings that smashed estimates. The earnings this quarter were more interesting than normal, as this was the first independent report for the company since splitting from ConocoPhillips (NYSE:COP).

Following completion of this transaction, ConocoPhillips is now a leading refining and marketing (R&M), midstream, and chemicals company. Phillips 66's R&M operations include 15 refineries with a net crude oil capacity of 2.2 million barrels per day, 10,000 branded marketing outlets, and 15,000 miles of pipeline systems.

The company reported a fantastic $1.4 billion in adjusted earnings, or $2.23 per share. This compared to analyst estimates for around $1.78. Most importantly, these numbers set the baseline for the new entity.

Q2 2012 Earnings Highlights

The majority of earnings came from the R&M sector at just under $1.2 billion for the quarter. This leaves limited earnings provided by the midstream and chemicals businesses, where investors hope for growth. Below are the earnings highlights.

  • Adjusted earnings of $1.4 billion or $2.23 per share
  • Successful separation from ConocoPhillips completed May 1, 2012
  • Operating cash flow of $1.4 billion
  • Improved refining and marketing margins
  • Refining capacity utilization of 93%
  • Midstream impacted by lower NGL prices
  • Closed the sale of the Trainer Refinery for $230 million

Strategic Review

The refining business is benefiting from lower feedstocks from domestic oil supplies. In that regard, Phillips 66 is increasing access to domestically produced, advantaged crude oil via rail by acquiring 2,000 rail cars to transport shale oil.

The Sand Hills pipeline is being built to transport 200,000 barrels per day of NGL from the Permian Basin and the Eagle Ford fields to the Gulf Coast. The first phase goes into production in Q3 2012. The Southern Hills project is expected to be in service by mid-2013, with a capacity of 150,000 barrels per day.

The chemicals division is going forward with two major domestic plants. The construction of the world's largest on-purpose 1-hexene plant started recently with anticipated start up during 2014. The other plant isn't scheduled to start construction until 2017, if approved.

The investment potential in Phillips 66 relies on the concept of growth in the pipeline and chemicals businesses, the existing plans provide for very little growth in the near term. Not to mention that the plans for the chemicals plants depend on the cheap natural gas feedstocks that may not exist beyond 2014 as the U.S. plans to export natural gas by then, making the market more global in nature.

Net Payouts

ConocoPhillips remained one of the largest net payout yield (NPY) companies during Q2, so it shouldn't be a huge surprise that Phillips 66 announced a $1 billion share buyback. In fact, the original lack of a buyback program combined with the smaller dividend pointed toward weaker results at Phillips 66.

The dividend remains at $0.20 per quarter, providing for a 2.2% yield. That's small in comparison to the 4.7% dividend provided at ConocoPhillips. Cash provided by continuing operating activities was $1.4 billion. The company also received $230 million in proceeds from the sale of the Trainer Refinery.

The cash flow suggests that the buyback is very doable; plus, the company has over $3.1 billion of cash on the balance. The company has $8 billion of debt at a current weighted-average pre-tax interest rate of 3.5%.

Normally, some preference exists for companies reducing large debt loads instead of repurchasing shares. However, when the interest rate is this low and the stock trades at a low valuation, the buyback appears to be a smart plan.

Valuation

The stock remains cheap, especially considering the cash flow and the ability to fund a much more aggressive shareholder payout plan. Right now, investors are only getting paid 2.2% to wait while the company reduces shares outstanding at these stock prices. The dividend has plenty of room to grow.

Based on the large beat of earnings estimates, the stock trades at roughly seven times the expected updated analyst estimates for 2013. For example, competitors Valero (NYSE:VLO) and Tesoro (NYSE:TSO) trade at a lower six times forward estimates. In fact, Tesoro just reported a big earnings beat as well, making that stock even cheaper.

Conclusion

Phillips 66 remains cheap, especially considering the increasing NPY. Investors are able to find similar -- if not cheaper -- valuation in the refining sector. The stock is a compelling value, but it is not the cheapest in the sector. Until the pipeline and chemicals businesses show stronger growth potential, it will be difficult to get beyond that investment thesis as refining profits swings will dominate this stock for now.

Disclosure: I am long COP.

Disclaimer: Please consult your financial advisor before making any investment decisions.