- Phillips 66 seems to have been trapped in a sour spot lately.
- Its refining segment benefits from lower oil prices, whereas its midstream segment benefits from higher oil prices.
- Nevertheless, the company is shifting from heavy investment to cash generation.
- This bodes well for the upcoming dividend hike, particularly given the strong balance sheet and the low payout ratio of the company.
Phillips 66 (NYSE:PSX) has lost 12% since it peaked in January. In addition, Buffett recently announced that he was selling almost half of his stake in the company. Therefore, the upcoming dividend hike of the company will offer some consolation to its shareholders. The big question is what dividend hike they should be expecting.
Phillips 66 is a highly diversified company, with each of its segments behaving differently under various oil prices. Since the price of oil began to collapse in 2014, the refining segment has been by far the most profitable segment. When the price of oil is suppressed, the demand for oil products improves and thus boosts the refining margins. Even last year, when the price of oil rallied off its bottom, the refining segment of Phillips 66 still earned as much as the other three segments combined. Nevertheless, as the price of oil currently stands near a 3-year high, the profits of this segment have significantly decreased. To be sure, they decreased 33%, from $550 million in Q3 to $371 million in Q4.
Although the refining segment has been the most profitable in recent years, the management of Phillips 66 has repeatedly stated that the midstream segment is the flagship of the company in the long run. This segment benefits the most from high oil prices. Therefore, it is not surprising that its profits have remained under pressure in the last few years. While the rally of the oil price last year boosted the earnings of this segment from $280 million in 2016 to $464 million in 2017, the midstream segment still generated only 15% of the total earnings of the company.
To make a long story short, when the price of oil is very low, the earnings of the refining segment skyrocket. When the price of oil is high, the midstream segment benefits the most. Unfortunately for the company, it seems to have been trapped in a sour spot during the last few months. In other words, the recent tight range of oil prices, between $55 and $65, results in lackluster earnings in all the segments. Therefore, the company will significantly benefit if the price of oil breaks out of this range. However, thanks to the strong support from OPEC, the price of oil is not likely to revisit levels below $50 anytime soon. And while it is likely to continue to enjoy strong support from the cartel, it is not likely to rally far above its current level, as such a rally would greatly increase the output of the US shale oil producers and would thus render the market oversupplied. All in all, the price of oil seems to have found an equilibrium in its recent range and is not likely to break out of this range anytime soon.
When Buffett announced that he was selling almost half of his stake in the company, some shareholders were alarmed, at least in the beginning. However, the Oracle rushed to calm investors by attributing his sale to regulatory issues. More precisely, he reduced his stake in the company below 10% in order to eliminate regulatory requirements. Nevertheless, it is important to note that Buffett had maintained a stake above 10% for more than two years. Therefore, it is not plausible that he sold his shares only for regulatory purposes. Instead, it is reasonable to conclude that he considers the stock fully valued at prices above $100.
On the other hand, the Oracle has repeatedly praised the management of Phillips 66 and has characterized the quality of this management as a major reason for holding a large stake in the company. Indeed, the management is exemplary in its discipline to invest only in high-return projects. In this way, it has managed to consistently increase the earnings of the company. Most managements tend to be myopic and invest heavily only on their hottest segments. On the contrary, during the past few years, in which the earnings of the midstream segment of Phillips 66 were suppressed, the management continued to invest heavily ($1.5 billion last year) on this segment, as this is the most promising business in the long run. While this way of thinking may seem obvious, very few managements actually have this mindset.
It is also remarkable that Phillips 66 is currently in a positive phase of its investing cycle. As most growth projects in the oil sector take years to start bearing fruit, there is usually a great lag between capital expenses and the resultant cash flows. Fortunately for the shareholders, Phillips 66 has reduced its capital expenses lately, while it will soon start reaping the benefits from its past investments. More precisely, it expects to spend $2.3 billion on capital expenses this year, much less than the $5.8 billion it spent in 2015 and the $2.8 billion it spent in 2016. In addition, it expects total EBITDA growth of $1.5 billion from the projects that are coming on-line in 2017-2018. This shift from heavy investment to cash generation certainly bodes well for the future free cash flows and hence for the shareholder distributions.
Moreover, the management of Phillips 66 has repeatedly emphasized its commitment for a growing, secure and competitive dividend. It has certainly confirmed this commitment during the last four years, as it has more than doubled the annual dividend during this period. Moreover, it has reduced the share count by 20% in the past five years. As a result, it has significantly reduced the financial burden of the dividend, as the latter is distributed to fewer shares. To be sure, while the dividend per share has more than doubled in the past four years, the annual amount spent on dividends has grown only 75%.
Finally, the company has a markedly strong balance sheet. More precisely, its net debt (as per Buffett, net debt = total liabilities - cash - receivables) currently stands at $19.8 billion. This is equal to about 4 years’ earnings, while the interest expense “eats” only 11% of the operating income. Therefore, the company is in a strong financial position, and hence, it can continue to offer generous distributions to its shareholders.
In reference to the most likely dividend hike, it is worth noting that Phillips 66 raised its quarterly dividend by $0.06 per share in 2015 and by $0.07 per share in each of the last two years. Given the expected earnings per share of $7.17 for this year, its current payout ratio is just 39%. Therefore, as the company has a strong balance sheet and has passed the heavy investment phase, it is likely to raise its dividend at the recent pace, from $0.70 to $0.77. Such a hike will result in a 3.3% dividend yield and a healthy payout ratio of 43%.
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