Phillips 66's Volatile 'Crack Spreads' Pose Risk To Long-Term Holders

| About: Phillips 66 (PSX)
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Phillips 66 plans to grow its portfolio primarily in the higher-value Midstream and Chemicals segments, and its capital spending program reflects this focus.

Phillips 66's US downstream operations have been advantaged in the current energy-resource-price market downturn. It benefits from low feedstock costs, low energy costs, and scale and complexity.

However, the months-long windfall from cheap and plentiful crude oil for US refiners has shown signs of running out as of late. Many are betting on favorable conditions to continue.

Let's take a look at the firm's investment considerations as we walk through the valuation process and derive a fair value estimate for shares.

By The Valuentum Team

Phillips 66's Investment Considerations

Investment Highlights

• ConocoPhillips' (NYSE:COP) separated its downstream businesses into an independent, publicly traded entity, Phillips 66 (NYSE:PSX). The company operates in the following segments: Midstream (DCP Midstream, Phillips 66 Partners LP), Chemicals (Chevron Phillips), and Refining. The separation took place in 2012 and is headquartered in Houston, Texas.

• Phillips 66 plans to grow its portfolio primarily in the higher-value Midstream and Chemicals segments, and its capital spending program reflects this focus. Enhancing its returns in refining will also absorb the company's efforts in coming periods.

• Phillips 66's US downstream operations have been advantaged in the current energy market downturn. It benefits from low feedstock costs, low energy costs, and scale and complexity. The firm is targeting $9.3 billion in adjusted constant margin EBITDA by 2018, with a large portion of its growth coming from its investments in its midstream business.

• However, the months-long windfall from cheap and plentiful crude oil for US refiners has shown signs of running out as of late. Multiple refiners have announced output cuts, and Phillips 66 was forced to offload crude at distressed prices in early February. Crack spreads, an indicator of profits from gasoline and other crude distillates, were as high as 33% in March 2015, but have since fallen to ~12% as product inventories hit record highs.

• As of the end of 2015, cash and cash equivalents were $3.1 billion and debt was $8.9 billion (which includes over a $1 at Phillips 66 Partners). Free cash flow generation has deteriorated materially in recent years and was negative in both 2014 and 2015. We aren't expecting a return to historic levels in the near term.

• Phillips 66's management is very shareholder friendly. For example, in 2015, alone, the firm returned more than ~$2.7 billion of capital to shareholders through dividends and share repurchases. The board continues to hike its dividend.

Business Quality

Economic Profit Analysis

In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.

The gap or difference between ROIC and WACC is called the firm's economic profit spread. Phillips 66's 3-year historical return on invested capital (without goodwill) is 21.3%, which is above the estimate of its cost of capital of 9.7%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.

In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Companies that have strong economic profit spreads are often also solid free cash flow generators, which also lends itself to dividend strength. Phillip 66's Dividend Cushion ratio, a forward-looking measure that takes into account our projections for future free cash flows along with net cash on the balance sheet and dividends expected to be paid, is 0.4 (anything above 1 is considered strong).

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Phillips 66's free cash flow margin has averaged about 1.1% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM.

The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Phillips 66, cash flow from operations decreased about 33% from levels registered two years ago, while capital expenditures expanded about 122% over the same time period.

In 2015, Phillips 66 reported cash from operations of ~$5.7 billion and capital expenditures of ~$5.8 billion, resulting in free cash flow of approximately negative $50 million. While this is a slight improvement over 2014, it is the second consecutive year the company reported negative free cash flow. Excluding the $1.5 billion DCP Midstream (NYSE:DPM) contribution, however, free cash flow was positive.

Valuation Analysis

This section is the true fuel of our analysis. Below we outline our valuation assumptions and refine them into a fair value estimate for shares.

Our discounted cash flow model indicates that Phillips 66's shares are worth between $59-$99 each. Shares are currently trading at ~$88, in the upper half of our fair value range. This indicates that we feel there is more downside risk than upside potential associated with shares at this time.

The margin of safety around our fair value estimate is derived from the historical volatility of key valuation drivers. The estimated fair value of $79 per share represents a price-to-earnings (P/E) ratio of about 11.1 times last year's earnings and an implied EV/EBITDA multiple of about 6.9 times last year's EBITDA.

Our model reflects a compound annual revenue growth rate of -2.6% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -6.5%. Our model reflects a 5-year projected average operating margin of 6.2%, which is above Phillips 66's trailing 3-year average.

Beyond year 5, we assume free cash flow will grow at an annual rate of 5.9% for the next 15 years and 3% in perpetuity. For Phillips 66, we use a 9.7% weighted average cost of capital to discount future free cash flows.

Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $79 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.

Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Phillips 66. We think the firm is attractive below $59 per share (the green line), but quite expensive above $99 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Phillips 66's fair value at this point in time to be about $79 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Phillips 66's expected equity value per share over the next three years, assuming our long-term projections prove accurate.

The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.

The expected fair value of $99 per share in Year 3 represents our existing fair value per share of $79 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Wrapping Things Up

Warren Buffett certainly may disagree with us, given his near-14% stake in Phillips 66, but we've always been cautious of the volatile crack spreads that define the refining business. Not only are feedstock costs difficult to predict, but end-user prices can also squeeze margins at times. The long term is incredibly difficult to forecast on a normalized basis, and we're quite surprised Mr. Buffett believes he has a leg up on predicting commodity-price spreads to take such a large stake.

That said, Phillips 66 is a great refiner -- one of the best. It is generating strong cash flow from operations and put up more than $4 billion in earnings during 2015. The company continues to raise its dividend, but the Dividend Cushion ratio is suggesting income investors should take caution, not only in light of the company's balance sheet and capital-intensity, but also due to the company's cyclical end markets. We think the firm's investments in its Midstream and Chemicals segments should be monitored closely as it expects a large portion of its adjusted EBITDA growth through 2018 to come from such investments.

All in, we've included Phillips 66 as a dividend growth idea in the past, but we're not interested in Phillips 66 as an investment idea at the moment (due to the many factors mentioned above). We love its resiliency in the face of weakening commodity prices, but in addition to our concerns about volatile "crack" spreads altogether, we'd like to see shares trading at a material discount to our fair value estimate before considering a position in the company. Unfortunately, they aren't. Phillips 66 currently registers a 3 on the Valuentum Buying Index.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

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.