Why Phillips 66 Has Excellent 5-Year Dividend Potential

| About: Phillips 66 (PSX)


Phillips 66 has quietly bought back over 5% of its stock since spinning off from Conoco in the middle of 2012.

The company is aggressively investing in midstream projects to boost production.

At 23%, the dividend payout ratio is still quite low and has room to expand in the next few years.

The best friend of the dividend growth investor is a high-quality company that is both growing earnings at a high rate and raising its payout ratio to reflect its increasing maturity. Those types of companies are generally difficult to find ahead of time, but Phillips 66 (NYSE:PSX) seems to be a ripe candidate for consideration.

CEO Greg Garland seems to be doing an excellent job of making it clear that I'm a bonehead for trading in my Phillips 66 shares for more Conoco (NYSE:COP) shares after the 2012 spin-off. Since becoming independent, he has been able to work wonders at improving the company's operating margins by engaging in cash-cow projects and following intelligent hedging strategies. The operating margins have increased 15%, from 9.1% to 10.5% since the middle of 2012, giving the company power to quietly buy back shares with the excess cash flow on hand.

When Phillips 66 became a publicly traded company in the middle of 2012, the company had 623 million shares outstanding. Now, it's already down to 590 million shares. That quick reduction of 5.29% of the shares outstanding is a nice augment that gives the company a running start in achieving at least 10% annual returns.

A principal source of optimism for Phillips 66's future growth are plans to significantly increase midstream projects. The Business Wire report gave a nice summary:

Phillips 66 announces plans for $2.7 billion of capital expenditures in 2014, approximately 40 percent higher than its 2013 capital target. The increased spending reflects the company's strategy to grow its Midstream segment. Including the company's share of expected capital spending by joint ventures DCP Midstream, Chevron Phillips Chemical Company (CPChem) and WRB Refining, its total 2014 capital program is expected to be $4.6 billion.

In Midstream, Phillips 66 plans $1.4 billion of investment in its Natural Gas Liquids (NGL) Operations and Transportation business lines. This represents an increase of more than $800 million over 2013. In 2014, the company expects to begin construction of a 100,000 barrel-per-day NGL fractionator and a 4.4 million-barrel-per-month liquefied petroleum gas export terminal on the U.S. Gulf Coast. In addition, several rail offloading facilities and other crude handling projects will increase the company's access to advantaged refining feedstocks. Phillips 66 Transportation is also developing pipeline expansion and connection projects that will grow capacity and allow for greater refined product exports.

This is why you're seeing analysts doing things like predicting 12%-14% earnings per share growth for Phillips 66. Given that downstream energy companies are notoriously volatile (this isn't the place to look for linear, year-after-year earnings per share growth), Phillips 66 is doing a good job exhibiting blue-chip leadership by tempering the vicissitudes of being a downstream refiner in three ways: (1) it is buying back shares to constantly stimulate the earnings per share figure, (2) it is investing heavily in new midstream projects each year to offset periods of lower refining margins, and (3) it is building a diverse collection of assets that are more recession-resistant, such as investing a little over $1 billion into its joint chemical-division project with Chevron.

What makes Phillips 66 so intriguing is the fact that not only is the company an excellent business with rapidly growing margins and growth projects at its midstream division underway, but it is also in the process of increasing its dividend payout ratio.

When Phillips 66 was first spun off, it announced an artificially low dividend of $0.20 per share. Given that downstream companies can typically take on dividend payouts in the range of 40% of profits (in a normal environment), the $0.80 annual payout represented just 12% of the company's profits.

That very low payout ratio gave the company room to engage in many of the midstream investments mentioned above, but it also gave the company room to announce a series of dividend increases in the past two years - in its seven quarters as a publicly traded company, the company will be approaching its fourth dividend increase. It went from $0.20 to $0.25, then from $0.25 to $0.313, and then from $0.313 to $0.39. And now we're poised for an increase again, and the current $1.56 payout ratio is still only 23% of the company's estimated profits for 2014.

The dividend has almost doubled in the past two years, and it's not done gliding upward. Essentially, the company has the long-term capacity to pay out $2.66 per year in dividends (based on current profits), but the company is taking the gradual approach of giving investors a sustained series of generous hikes that also grant the company excess profits to make capital expenditures that will increase earnings per share even more in the future. This puts Phillips 66 in the "dividend growth sweet spot", as the maturing payout ratio leaves room for both high dividend growth until the company reaches the 40% mark, while giving the company the ability to use profits to engage in growth projects in the meantime.

You don't have to make the same mistakes that I do. You're free to be a much better investor than I am. Phillips 66 is one of the rare companies that can offer 10%-15% dividend growth for the next five years, as the company is growing earnings per share by boosting production and buying back stock. The cherry on top is the payout ratio that is a transition from a 23% rate toward the 40% direction. The current 2% yield isn't all that impressive, but if you follow Wayne Gretzky's advice of skating to where the puck will be, you should have a tidy yield-on-cost with your Phillips 66 shares five years from now.

Disclosure: I am long COP. 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.

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