Phillips 66: Excellent Company, Questionable Valuation

| About: Phillips 66 (PSX)

If you are a patient investor, one of the joys of investing in commodities stocks is that you almost always get your price. Because profits do not grow in a linear fashion year after year, the stock prices of energy companies (particularly the downstream ones) tend to "overshoot" on the way down as it is sensitive to changes in the Brent/WTI spread and often experiences excessive volatility (in both directions) in response to changes in commodity prices.

When you study Phillips 66 (NYSE:PSX), you will likely be impressed by what you see: a firm with shrewd, shareholder-friendly management that is buying back stock, investing in high-quality assets, and is currently in the "dividend rocketship" stage in which the payout ratio is so low that owners will be the beneficiaries of rapid dividend increases in excess of the earnings per share rate as the payout ratio matures past its artificial low following the ConocoPhillips spinoff (NYSE:COP).

Even when you adjust for Phillips 66's rough third quarter (steep decreases in refining profits caused the $2.51 in the third quarter of 2012 profits to fall to $0.87 per share in the third quarter of 2013), this is still a company with a base earnings rate of $6.00 per share going forward (a bit below Phillips 66's profits of $6.48 in 2012).

This is what brings me to my concern about Phillips 66 right now: valuation. With a downstream energy company of average asset quality, you want to find yourself paying between 6x and 9x earnings when trying to determine a range of fair value. It is reasonable to think that a figure close to 9x earnings would constitute fair value because of the low current payout ratio and the presence of less cyclical assets on the balance sheet such as the chemical division which owns a 50% stake in Chevron Phillips Chemical.

Furthermore, even with a dividend that has increased from $0.20 per share in the third quarter of 2012 to $0.39 now (for a 95% total increase in a little over a year), the payout ratio is still quite low. In relation to an earnings base of $6.00 per share, the current $1.56 per share dividend still only constitutes a dividend payout ratio of 26%.

While 10%, 15%, and 20% annual dividend increases are not something you can rely upon for the long-term, Phillips 66 is one of the companies that might be able to pull it off in the short-to-medium term as the combination of stock buybacks (the share count of 623 million this time last year has decreased 597 million now, for a reduction of 4%), organic growth (analysts are predicting 27% total growth over the next 3-5 years), and an escalating payout ratio (which, after the rapid increases, is still only 26%) ought to combine to see the dividend double in the next four to five years or so.

The low payout ratio and high-quality assets lead me to believe that Phillips 66 is worth about 9x its regular earnings, usually the high end of valuations for a downstream company. With a $6.00 per share earnings base, that would imply that the high end of fair value for Phillips 66 would be somewhere in the vicinity of $54 per share (and this is adjusting for Phillips 66's excellent dividend growth potential over the next few years).

As we close upon 2013, the price of Phillips 66 stock is $74.75 per share. The implication would be that Phillips 66 shares are something like 27% overvalued right now. I think what has happened with the pricing in the stock is that it has stopped being priced like a cyclical company; perhaps the realistic promise of high linear growth in the next few years has convinced some investors that the overall profitability of Phillips 66 will march upward in linear lockstep indefinitely into the future. The profits at Phillips 66 will be cyclical over time, but yet it is being priced right now as if that is not the case.

With Berkshire Hathaway buying Phillips Specialty Products Inc. for $1.4 billion, we are not going to see a meaningful change in Phillips 66 operations -- the deal only represents 3% of what they do. However, it does indicate that Buffett likely believes that Phillips 66 shares are overvalued as well because the deal allows him to shed 19 million of the 27 million shares owned under the Berkshire umbrella. This maneuver allows Buffett to bite at a small part of the underlying business while distancing Berkshire's exposure to the overvaluation apparent in the company's shares.

Since January 2nd of this year, the price of Phillips 66 has improved 39%. And over the course of trading in 2012, Phillips went up 82%. Some of that was due to Phillips 66's transition from undervaluation to fair valuation, but at some point, the stock price overshot the high end of fair value by 25-30%. This is quite typical with downstream companies; the prices tend to overshoot in both directions (when earnings reports are bad, the stock price plummets more than warranted. But now, when times are good, the prices increase more than warranted). If you buy Phillips 66 right now, even though the company is excellent, you are incorporating a "negative margin of safety" into your purchase price in that your future total returns over the next 5-10 years will actually lag the earnings per share growth rate of the firm as the valuation reverts to a normalized range in the neighborhood of 8-9x earnings. You might as well be patient and wait to get your price, because with cyclical downstream companies, you almost always get your price if you are patient enough.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

About this article:

Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500.
Tagged: , , , Oil & Gas Equipment & Services
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here