The Sustainable Long-Term Advantages Of Phillips 66

| About: Phillips 66 (PSX)


Fifteen percent of the outstanding shares have been repurchased over the last three years, and debt has been retired.

Refining margins are probably peaking but chemical margins and profits are still climbing which will soften the blow of declining refining margins when that happens.

Midstream and the management of the limited partnership provide a steady stream of income which reduces the cyclicality of corporate earnings.

Management has plans to grow average profits about ten percent a year. Share buybacks will increase that growth rate, especially now when the company generates a lot of cash.

There are feed-stock cost advantages as well as proprietary and premium products plus R&D to provide long term margin advantages.

Whenever there is an investment to be made in a company in a commodity industry, the investor needs to figure out what the advantages of one company are over the average company in the industry. Otherwise, the investment case for that company would be at best weak and the hoped for profits may not materialize.

Source: Phillips 66 Investor Update, November, 2015

From the above slide, Phillips 66 (NYSE:PSX) is clearly firing on all cylinders and having an excellent year. Yet the trailing price-earnings ratio is a mere nine-to-one using the closing price on January 15, 2015. The majority of the capital employed is earning excellent returns for the year, last year also, and FY 2013. The company is poised to report very good earnings for the year, and this is not the first time, yet the stock languishes with a single digit price-earnings ratio, as if things cannot get better.

Chemicals and refining are admittedly cyclical and this may well be the top of the cycle for refining. Even the marketing and specialties segments can have a bad year from time to time. But the real test should be is the company growing and are these segments adding value. If so, a long term investment case can be made for those investors who possibly cannot time investments to take advantage of some of these cycles. Plus with the diversification, there is some hope that all the divisions do not have a poor year at the same time, and that hope is probably borne out by the operating history of the company.

Source: Phillips 66 Investor Update, November, 2015

From the above slide, the company definitely has growth plans for each division.

Marketing and Specialties, in particular has very high margins, and those margins may be relatively the most stable of the four divisions. The company supplies lubricants, extenders, and other specialty products or proprietary products that command high margins because they own their own niche. For example:

"When it come to converting heavy crude oil into higher value products, delayed coking remains the industry's leading economical choice. As a licensor that also designs, owns and operates delayed cokers, Phillips 66 is uniquely qualified to offer competitive advantages that others simply cannot match. "

This quote from the company website demonstrates the company dominating a specialty niche. Such niche's are usually very profitable for as long as they last. Since there is a fair amount of heavy crude out there, and probably more on the way in the future, this niche will probably grow. There are excellent economical reasons for producers to want to convert their heavy crude into higher end products.

This division also sells to consumers. That can be a very profitable niche provided the company controls costs, and keep a close eye on consumer (and industry trends). Clearly with the current ROCE, that is happening and needs to keep happening in the future. The company has some of the best research facilities in the industry to maintain the current advantages of its product lines. So many of the tools are in place to earn that superior margin well into the future and to grow the division with new products.

The midstream segment has a lot of fee based income. Not only is fee based income far more stable, than production income, but as often as not, that income goes with fairly long term supply contracts.

Source: Phillips 66 Investor Update, November, 2015

From the above slide, the company intends to expand the division, and along with it the earnings. One of the advantages of building a pipeline, is that it tends to discourage competitors from putting a pipeline in the same area, thereby giving the company an advantage in that area. This division, likewise tends to have fairly steady earnings however, a deep downturn could affect volumes and customer payments, but otherwise, short of a shutdown of the division, earnings should remain fairly steady from one fiscal year to the next. Even the associated plants tend to have fee based products with long term supply contracts that tend to "guarantee" a fairly steady cash flow.

The main risk is pipeline, and plant maintenance downtime, or an accident. Most of the problems can be prevented with a decent maintenance program that is usually standard in this business. This division, with its steady cash flow decreases the cyclical effects of the other divisions on overall corporate earnings.

The chemical business is expanding with the demand for higher margin products.

Source: Phillips 66 Investor Update, November, 2015

From the above slide, the company has some very big expansion plans in mind for chemicals. Crackers have always come under my heading of value added (higher margin) assets as they normally take lower price products and turn them into higher selling (more desirable products). As such, they help companies survive times of oversupply or other industry downturns. With the economies growing, clearly there will be a demand for more petrochemicals, so the company is expanding to meet that demand.

The company also mentions cost advantaged feedstock, which is probably what the crackers are needed to process (as well as other things). A cost advantage is probably a permanent advantage, that means even in a downturn, the company will have an extra edge, and therefore has a much better chance of surviving the downturn with lower losses and larger profits during the good times.

This is basically a commodity business, so the business needs to be built with cost advantages in mind (or finished product advantages). Once the plant is operating, modifications can be fairly expensive and sometimes time consuming.

Source: Phillips 66 Third Quarter 2015 Earnings Presentation

From the above slides, earnings backed off a bit from the second quarter, but ROCE still remained fairly robust. That ROCE figure probably accounts for the company's future expansion plans. If there is a recession in the future, this division will have less earnings, but it also has the means to upgrade products, so in any downturn, it would suffer less than the average chemical divisions of other companies that turn out finished products from the "standard" feedstock.

Management is very bullish that the capacity use will increase and there will be more demand for the products produced by the chemical division. What is even more interesting is that they see increasing demand from the Chinese consumer driving the increase in the demand for the market. That is in contrast with the current market skittishness with the Chinese economy, so an update on that view in the fourth quarter conference call will be interesting. Nonetheless there is money in the capital budget to expand capacity in this division, so management is clearly acting upon that bullish view.

"Phillips 66 (NYSE: PCX ) has begun operations at its new 100,000 barrels-per-day (BPD) natural gas liquids (NYSE:NGL) fractionator located at the company's Sweeny Complex in Old Ocean, Texas. Sweeny Fractionator One supplies purity ethane and liquefied petroleum gases (NYSE:LPG) to the petrochemical industry and heating markets. It is supported by 250 miles of new pipelines and a multimillion barrel storage cavern complex."

In another year or so there is going to be an export terminal nearby built by the company to export some of these products and probably a few other chemicals. So management is very much pouring money into its very bullish view of this industry. Refining may well be at the top of the market but the chemical market is still climbing. Management has guided for capacity utilization in the 90% plus area which bodes well for a positive outlook on pricing.

Specialties is also another byword for higher margined products. It does not take many of these or that much volume to add a percentage or two to the return on investment. Those extra percentages usually go straight to profits and earnings per share (after taxes).

Source: Phillips 66 Third Quarter 2015 Earnings Presentation

From the above slides, the refining division is obviously the current star with absolutely giant contributions to corporate earnings. Still the company has some ambitious plans for this division.

Source: Phillips 66 Investor Update, November, 2015

From the above slide, the company will attempt to enhance the already good returns of this division with some high return projects. Refining is inherently a commodity business, and the margins can even go negative at times. So it is essential to find projects that provide a cushion for those years when refining would otherwise lose money.

The company does market such products that are sensitive to economic activity as asphalt and jet fuel (for example). But in the case of jet fuel, the company has pipelines running to the airports to reduce the transportation cost of the fuel whenever possible, and that would be a significant cost advantage whenever margins for jet fuel are not ideal. So there is ample evidence that management is looking for that extra profit advantage in each division, to mitigate the typical downturns that happen from time to time in cyclical business. Plus one division, the midstream division, is fee based and diversified enough that its earnings are probably fairly steady except in the case of an extreme economic downturn (such as a severe recession or depression).

This division will probably return to the average margins, and sooner or later have a below average year, as the refining business is cyclical, but management is doing all they can to minimize the damage a loss year can do to the division through various value added products, and efficiencies. As noted above management does not yet see a top to the cyclical chemical market, so that division will more than likely pick up some or all of the slack as margins eventually trend down in this division. That is one of the benefits of diversification when it works. Right now it is definitely working.

The company also collects a management fee from Phillips Partners (NYSE:PSXP) and has a significant interest in the relatively small but growing company.

Source: Phillips 66 Investor Update, November, 2015

From the above slide, the division is growing rapidly. To support the division growth, long term bonds have been issued with a weighted average cost of 3.64%. $300 million of these come due in about five years, and then another group comes due in ten years and the last group in thirty years.

The main point would be that the purchased asset has EBITDA of approximately 10.5% that would be decreased by taxes and increased by non-cash charges such as depreciation. As such, the cash flow will certainly be more than the 3.64% average of the debt incurred and therefore, because of the long term fee based contracts will generate positive cash flow from the start. Of course the partnership did sell some partnership units to fund a portion of the purchase price.

However, the big chance to increase profitability is the chance for future organic growth. These internally generated construction (enhancement) projects often provide a greater return than the original purchase price and the partnership did state that it sees possible future expansion projects for these properties that could lead to additional profit growth.

The partnership is seen as a funding vehicle for growth in this market. There is talk that there is too much infrastructure in places. As such, the company has the ability to take advantage of (probably a lot more than it would have without the partnership) distressed sales through this master limited partnership in the future. Since the initial IP, the partnership is off to a fast start, and hopefully will have an above average future.

The partnership itself has increased distributional cash flow by nearly 100% since the partnership went public. Since Phillips 66 manages that partnership, its fee income also increases as well, and it receives a portion of the distributable cash flow through its ownership of partnership shares. It is another diversification move by the company that appears to be doing well.

the company earns a management fee from the partnership regardless of industry conditions. As the master limited partnership grows, so does Phillips 66 fee income. That income remains steady (and right now growing) regardless of industry conditions. Therefore it is another part of the company that reduces cyclicality of the overall corporate earnings.


Source: Phillips 66 Investor Update, November, 2015

From the above slide, the company is wisely looking at the average return for a five year period, rather than concentrating on an exceptional return for this year. It is forecasting growth that the market clearly does not agree with. Admittedly, refining is producing a lot of cash that the company will reinvest, and the market won't know how those investments work out for a while. However, the past track record of the company suggests that the company will find above average returns for its investments.

There is the risk that all these cyclical divisions could have a bad year at the same time, however, that usually happens during a recession or depression, and right now neither of those is in sight. There may well be a rough patch where the growth in the economy slows (same for the world economy) but that is not the same as a contraction. Interestingly the chemicals division is seeing strong demand from China, and time will tell whether or not that demand is maintained (or growing as management expects) or decreased (as the market seems to expect).

Much of the projected growth comes from the midstream division where much of the income is fee based and long term. Therefore the income is fairly predictable. Some of these assets are now in a partnership (Phillips 66 Partners) controlled by the company. That partnership has a healthy growth rate but also is now a separate company, so should a downturn manifest itself in that limited partnership, the only effect to the company (Phillips 66, the parent company) would be reduced cash distributions. The company would still collect its management fee. That action has probably reduced the company exposure to the economic effects of the assets in the limited partnership. Plus with the limited partnership as the funding vehicle, the midstream division as a whole can grow profits faster than would be the case without the partnership.

Refining will continue to be sharply cyclical, but the company appears to have found some products and processes that enhance profitability. So the company should be able to get through the economic cycles better than the industry as a whole.

Chemicals is also cyclical, but right now demand appears to be increasing at a rate that justifies expansion of the division. Management appears to be bullish on this segment, in contrast to the current market bearishness in the related stocks.

Source: Phillips 66 Investor Update, November, 2015

From the above slide, the company increased its buyback program to more than nine billion dollars of common shares. About fifteen percent of the outstanding shares had been repurchased over the last three years. It has also retired about $800 million in debt in the last quarter and kept a fairly conservative balance sheet, with debt far less than half the amount of shareholders equity. As shown above, the company has repeatedly increased the dividend. It has also maintained an investment grade rating.

As profits from the refining group accelerated, the share repurchase program also accelerated. Long term, the shareholders should probably not expect the current pace of share purchases to continue. However an additional two percent or three percent can be added to average earnings growth rates for future valuation purposes.

Currently the company has nearly five billion in cash, and has cash flow of more than one billion a quarter. So right now, the company could pay all its long term debt off in less than a year with its cash on hand, and its cash flow.

Sooner or later at least one of the divisions will have a subpar year. However, management has diversified enough that one division having a subpar year will not be a disaster for company earnings. There is even a possibility that the other three divisions would make up the whole shortfall if everything goes right. However, a company with cyclical divisions like this one will probably not have a smooth earnings growth curve, and that should be ok with investors. Some divisions such as midstream have a lot of long term contracts to support a stable earnings pattern and decrease the swing of the corporate cyclicality. Above average profitability, even if it comes in lumps, should lead to superior investment returns for the long term investor. Management has feedstock cost advantages in chemical, and proprietary products in refining, for example to increase profitability.

Currently the dividend yield is nearly three percent, but the stock repurchases add another two to three percent return to for the investor currently. When the management goal to increase average earnings about ten percent a year is added in the investor has a reasonable fifteen percent return for which he only has to pay nine times earnings for. Refining margins are probably peaking, but chemical earnings are probably not. Midstream earnings are steady and growing, and there are specialty products with great margins. So its not like earnings are going to fall completely apart next year. There will be some cyclicality to earnings, but there is growth so there will be more record earnings in the future. Given the current average price earnings ratio of the market, that is a fairly cheap price to pay for a company such as this.

When someone like Warren Buffet looks at a stock, the stellar balance sheet of this company and the cash on hand certainly play a part. But Buffett is also looking for long term advantages that will allow the balance sheet to stay stellar and provide above average returns through all the industry and market cycles.

In the case of this company, it is clear that the company looks for that extra percent and more, wherever it can find it, so that when the downturns comes, it won't be hurt as badly as the competition. That is really the most any investor in a cyclical company such as this one can ask for. The financial strength rating of the company is investment grade, and the credit markets are open to it. But right now the company is retiring debt and buying back stock.

The expansion that was funded during this time of above average profits, should provide a higher floor for earnings in the future. The company has repurchased about five percent of the outstanding stock so far this year (in three quarters). While that pace is probably not sustainable, it provides some breathing room to show growth in per share earnings even if corporate earnings were to decline a little next year. There is always the risk it won't happen, but there is the company's past record during previous downturns that gives investors hope that it will.

The dividend costs the company a little more than a billion a year and that cost decreases as shares are repurchased by the company. Since this amount is a very small fraction of current cash flow, this dividend will probably be very sustainable in any cyclical earnings downturn, especially given the financial strength of the company.

Disclaimer: I am not an investment advisor and this is not a recommendation to buy or sell a security. Investors are recommended to read all of the company's filings and press releases as well as do their own research to determine if the company fits their own investment objectives and risk portfolios.

Disclosure: I/we 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.

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