Originally published Nov. 1, 2017
One of Warren Buffett's best pieces of investment advice is that "it's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
This is why each quarter, when Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) reveals its portfolio via regulatory filings, investors eagerly look to see what companies have the Oracle of Omaha's quality and valuation stamp of approval.
Investors can read analysis of all of Warren Buffett's dividend-paying stocks here.
Starting in 2016, Berkshire began making big acquisitions of refining giant Phillips 66 (NYSE:PSX) and has continued to add shares over the past year. Today, Buffett's company owns 80.7 million shares of Phillips, worth $7.5 billion and representing 15.9% of the company.
Of course, it's never a good idea to just blindly follow along with any large institutional investor no matter how amazing his or her historical performance has been.
So let's take a closer look at Phillips 66 to see why Buffett is such a fan, and more importantly, whether or not this industry leader deserves a spot in a diversified dividend growth portfolio.
Phillips 66's roots go back all the way to 1875, though as a company it was spun off from ConocoPhillips (NYSE:COP) in 2012. It's the nation's second largest independent refiner with 13 refineries in the U.S. and in Europe. However, Phillips 66 is also a highly diversified petrochemical company with a total of four business segments:
Marketing & Specialties (44% of 2016 segment income): Sells refined products through its 7,850 Phillips 66, Conoco, and 76 branded gas stations in the U.S., and 1,306 JET and COOP stations in Europe.
Chemicals (29% of 2016 segment income): A 50% stake in Chevron Phillips Chemical Company LLC (CPChem), whose 32 global facilities and two R&D centers produce specialty petrochemicals that serve the solvents, catalysts, drilling chemicals, and mining chemicals industries.
Refining (19% of 2016 segment income): Refines crude oil into gasoline, diesel, and jet fuel.
Midstream (8% of 2016 segment income): Gathers, processes, transports, and markets natural gas, and transports, fractionates and markets natural gas liquids in the U.S. This segment has a 50% stake in general partnership of DCP Midstream Partners (NYSE:DCP), and a 59% stake in Phillips 66 Midstream Partners (NYSE:PSXP), whose infrastructure services parent company's oil transportation and storage needs.
Management says that "Phillips 66 is committed to paying a regular dividend that is secure, has a competitive yield and increases annually." Now that may come as a surprise since refining is hardly an ideal industry for safe and consistent dividend growth.
That's because it's highly capital intensive and very cyclical, with sales, earnings, and cash flow at the mercy of volatile commodity prices.
Source: Simply Safe Dividends
In addition, the high fixed costs of maintaining its assets (about $1 billion in projected 2017 maintenance costs) mean that profitability and returns on shareholder capital are equally volatile.
The industry is also famous for its low margins, and even with Phillips 66's great economies of scale, which allows for better-than-average profitability, the company is hardly swimming in profits.
Phillips 66 Trailing 12-Month Profitability
Sources: Morningstar, Gururfocus
So what exactly about this company has attracted Buffett's attention and caused him to take such a large position? Well, despite the challenges of the industry, there is actually a lot to like about Phillips 66.
For one, thing the company's vast nationwide infrastructure is tapped into all of the U.S.'s largest shale oil formations, resulting in an ability to source discounted crude for its refineries and achieve higher profitability than many of its smaller, more regional peers.
Source: Phillips 66 Investor Presentation
Another benefit Phillips 66 has, courtesy of its significant geographic diversity, is the ability to tap into America's fast-growing oil and petrochemical export market.
The prolific production growth of U.S. oil over the years, thanks to the shale fracking revolution, has resulted in much lower input costs for U.S. refiners, giving American petrochemical companies a big competitive advantage over rivals in other countries.
This means that cheaper U.S. refined products are finding huge demand overseas, which bodes well for the industry since America's export capacity is only 66% utilized at the moment.
And because the global economy continues to grow at around 3% to 4% per year, demand for gasoline, diesel, and jet fuel continues to increase, especially from fast-growing emerging markets such as India and China.
Since U.S.-sourced refined products are cheaper, they are steadily winning market share and helping Phillips 66 keep its refining utilization rate high (96% in 2016). That's in contrast to global refining utilization rates in the low 80% range, which means that large U.S. refiners such as PSX are able to better offset their high fixed costs with steadily rising sales, resulting in far better profitability.
Another positive factor for Phillips 66 is that cheap U.S. natural gas is resulting in an abundance of low cost ethane, a key input into its various chemical products. This too results in strong export demand for low cost U.S. petrochemicals such a propylenes, which are the base constituent into all manner of plastics and other global products.
These increased sales from its far more stable chemical and midstream segments have helped to turn things around for Phillips 66 in recent quarters, with both its top and bottom line returning to strong growth.
Importantly, Phillips 66 is working hard to diversify itself away from more volatile refining and towards higher margin chemical and midstream operations.
For example, since 2014, the company's single largest investment has been a $6 billion joint venture with Chevron (NYSE:CVX) to construct a massive new ethane cracker that is slated to be completed by the end of the year.
That cracker will increase PSX's ethylene and polyethylene capacity by 33%, boosting sales and margins for the company.
Phillips 66 is also investing the majority of its growth capex budget into midstream projects, such as the $3 billion Sweeny Fractionator One and Freeport LPG Export Terminal in Texas.
The company also partnered with Energy Transfer Partners (ETP) to invest $4.8 billion into two pipelines linking North Dakota's Bakken shale formation with export terminals on the Gulf Coast.
To help fund all these billions of new assets, Phillips 66 has set up a midstream MLP called Phillips 66 Partners, of which is owns a 59% stake and the lucrative incentive distribution rights (IDRs).
PSX also has a joint venture with Spectra Energy, now owned by Enbridge (NYSE:ENB), to be the general partners of DCP Midstream Partners, and there too it enjoys a large limited partnership stake and 50% of all IDR fees.
The way it works is that midstream MLPs raise debt and equity capital from investors to buy transportation, storage, and processing infrastructure from their general partners (PSX in this case).
Their infrastructure comes with long-term, fixed-fee, volume insensitive contracts (i.e., take or pay), helping ensure many years of consistent and recurring cash flows.
These are used to fund their generous and fast-growing distributions (a form of tax advantaged dividends).
Phillips 66 Partners Payout Growth Over Time
In other words, MLP general partners like Phillips 66 get to monetize their existing infrastructure in a tax-efficient manner to raise further growth capital. But since they own a large portion of the MLP, the fast-growing cash flow these stocks generate goes back to them, allowing them to have their cake and eat it too in a sense.
Best of all, midstream MLPs such as PSXP can then grow organically ($381 million in organic growth spending in 2017) through expanding their assets or acquiring new assets outside of Phillips 66's asset base.
And thanks to their IDRs, 50% of the marginal cash flow growth this generates ends up in its own pocket. This results in not only a fast-growing cash flow stream, but one that is very highly predictable and can help offset the volatility of its refining business.
All told, Phillips 66's large investments over the last few years are about to start paying substantial dividends, including a 40% increase expected in adjusted EBITDA from 2016 to 2018, and an even larger boost to free cash flow, which is expected to rise from $464 million in the last 12 months to $3.2 billion by the end of 2018.
Add to that another $1 billion to $2 billion in fresh drop downs to PSXP, and Phillips 66 expects to be flush with cash with which to pay its much stronger dividend (FCF payout ratio of 44% expected in 2018 compared to 300% over the trailing 12-month period).
The bottom line is that Phillips 66 appears to be one of America's highest quality and fastest-growing refiners. Most importantly, management's focus on diversifying into higher margin and more predictable chemical and midstream segments should not only boost the company's free cash flow over the coming years but also greatly decrease its cash flow volatility, making it a more appealing dividend growth stock in the future.
While Phillips 66 certainly has many appealing qualities, it's very important for investors to be aware of several major risk factors.
First, while management is working diligently to diversify the company's operations away from the highly volatile refining segment, PSX will still remain highly dependent on this segment for much of its sales, earnings, and cash flow for the foreseeable future.
Refining margins are so volatile because they are based on the spread between input prices and final product prices, both of which are set in unpredictable global markets that management has no control over.
As a result, investors can't expect the dividend to be anywhere near as safe as many of today's most popular income investments, especially those that make up the core of low-risk income portfolios that are designed to allow investors to live off dividends in retirement.
Next, a rising interest rate environment affects refiners such as Phillips 66 since they could face higher debt refinancing costs in the future, resulting in higher costs of capital and potentially lower margins on new investments.
The Federal Reserve has indicated that it plans to raise interest rates about six to seven times in the next three years or so, and its plans to unwind its balance sheet (by allowing its Treasury and Mortgage bonds to mature without reinvesting them) could put even more upwards pressure on long-term interest rates.
Finally, there is always the risk that a black swan event, such as a hurricane or explosion at one of its facilities, could result in significant business disruption. While PSX has insurance against such unfortunate events, it can still result in cash flow disruption that, if it occurs during an industry downturn, could put the dividend at risk.
Phillips 66's Dividend Safety
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.
Our Dividend Safety Score answers the question, "Is the current dividend payment safe?" We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
Phillips 66's Dividend Safety Score is 40, indicating slightly below average payout safety relative to most other dividend stocks today.
However, it should be noted that in its industry, PSX's payout is among the safest. In addition, management has shown a remarkable dedication to consistently growing the dividend, although the track record is relatively short.
Of course, no matter what management may say now, ultimately Phillips 66's ability to sustain, much less grow its dividend will come down to whether or not its earnings and free cash flow can cover the payout.
As you can see, PSX has struggled to sustain its dividend out of free cash flow, and in the past year, the payout ratio has been over 10%. The good news is that the company's recent large-scale investments are about to start generating returns.
If everything goes as planned, the resulting free cash flow will make the payout well covered in 2018 and beyond.
Until then, the company is having to fund the shortfall with spare cash and debt. Fortunately, PSX has a strong balance sheet that allows this.
At first glance, you might not think this is the case. After all, PSX has a large net debt position, and its free cash flow in 2016 was paltry; nowhere near enough to fund the dividend.
However, remember that in a highly capital intensive industry such as this one, large debt levels are to be expected and need to be kept in context.
While Phillips 66 has a lot of debt, compared to its peers its financial position is actually very strong, thanks to: a below average leverage ratio (Debt/EBITDA), below average debt to capital ratio, and a strong current ratio (short-term assets/short-term liabilities).
And thanks to a very high interest coverage ratio, along with strong future EBITDA and free cash flow growth prospects, it enjoys an investment grade credit rating that allows it to borrow cheaply (3.8% average interest rate) to continue funding its future growth while also maintaining and growing its dividend.
Phillips 66's Dividend Growth
While Phillips 66's dividend growth history is extremely limited, PSX's dividend growth since its 2012 spin off has been exceptional. The company's dividend has more than tripled since 2012 and was increased by another 11% earlier this year.
However, even with a strong push into higher margin chemicals and cash-rich midstream assets, investors can't expect anywhere close to this level of payout growth in the future.
The good news is that based on management's 2018 organic free cash flow guidance (not including the PSXP drop down cash), Phillips 66 should have a highly secure free cash flow payout ratio of approximately 44% in 2018.
As a result, the company's dividend should be capable of growing close to the rate of Phillips 66's underlying EPS growth.
Over the next decade, analysts expect PSX's bottom line to grow at about 10% annually, which means that 8% to 9% dividend growth could be a reasonable expectation.
That forecast assumes of course that management continues to execute well on its chemical and midstream growth and diversification plan.
However, keep in mind that because of the highly cyclical nature of the refining business (and to a lesser extent the chemical business), Phillips 66's payout growth may end up highly lumpy in the coming years.
Over the past year, Phillips 66 has performed about in line with the S&P 500, returning 18%. As a result, the stock is no longer as great of a deal as when Buffett bought most of his shares last year.
However, that doesn't necessarily mean that the stock is significantly overvalued today. After all, while PSX's forward P/E ratio of 16.4 is higher than the industry median of 12.8, as well as the stock's historical median of 11.7, it is lower than the S&P 500's 17.9.
More importantly for income investors, PSX's dividend yield of 3.1% is about 50% higher than the S&P 500's 1.9%, and also significantly greater than the stock's historical norm near 2.5%.
Investors who are comfortable with the inherent profit and cash flow volatility of the refining industry, as well as management's forecast for much-improved free cash flow generation over the next year to support the dividend, may find PSX to be an interesting income investment to consider.
There's a lot to like about Phillips 66, so it's not a surprise that Warren Buffett would take such a large position in one of America's largest and best run downstream energy companies.
That being said, it's never a good idea to blindly follow any investor, even the greatest in history. After all, Berkshire's needs, risk tolerance, and time horizon are very different than most people's.
Which is why Phillips 66, despite all its competitive advantages, seems to be a higher risk dividend growth investment, and not one suitable for a conservative retirement portfolio.
Investors interested in income and capital preservation can review some of the best high dividend stocks here instead.