Phillips 66: Buffett Dividend Stock On Sale

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About: Phillips 66 (PSX)
by: Sure Dividend
Summary

Phillips 66 shares have lost 25% since the peak of roughly four months ago. The stock is now trading at a discounted valuation.

The company will benefit from high-return growth projects and new international marine rules.

With a low valuation, future earnings growth, and the 3.5% dividend yield, investors can earn strong returns from this Buffett stock.

Written by Aristofanis Papadatos for Sure Dividend

Oil refiner Phillips 66 (PSX) has lost 25% since it peaked, about four months ago. The move of the stock has been in tandem with the move of the other domestic refiners, such as Valero (VLO) and Marathon Petroleum (MPC), and is partly justified as a correction to the breathless rally the major refining dividend stocks enjoyed until last summer. Nevertheless, after the recent steep decline of Phillips 66, the big question is whether the stock has become a bargain.

Business overview

Phillips 66 is one of the four major U.S. refiners. It operates in four segments: refining, midstream, chemicals and marketing. It is a diversified company, with each of its segments behaving differently under various oil prices. Thanks to the suppressed oil prices in the last four years, the refining segment has become by far the most profitable segment, as low oil prices tend to boost the demand for oil products and thus enhance refining margins.

This is clearly reflected in the contribution of each segment in the total earnings in the first nine months of the year:

Segment

% of Total Earnings

Refining

48%

Midstream

17%

Chemicals

17%

Marketing

18%

Source: Latest Earnings Report

As shown above, the refining segment currently generates almost half of the total earnings of Phillips 66.

Growth prospects

Phillips 66 has steadily grown its earnings in its refining segment via a long series of low-cost, high-return projects. The company still has promising growth prospects in this segment, as it has a backlog of approximately 30 small-scale, high-return growth projects.

Source: Investor Presentation

Moreover, the company will greatly benefit from the new international marine standard, which will come in effect in January, 2020. According to this standard, all the vessels that sail in international waters will be forced to burn low-sulfur diesel instead of heavy fuel oil. As the former is much more expensive than the latter, it will provide a great boost to the refining margins. In fact, this is the primary reason behind the breathless rally of the U.S. refiners until last summer.

In October, domestic refiners incurred a sharp decline due to a rumor that the U.S. government was trying to postpone the implementation of the new international marine rules in the U.S. However, it is doubtful whether the U.S. government will be able to gain such an exception. Even if the government succeeds in postponing the implementation of the new rules, it is likely to do so for just one or two years. Therefore, domestic refiners will almost certainly benefit from the new rules in the years ahead.

Moreover, the recent plunge of the oil price, from $75 in early October to $50, is a great gift for domestic refiners, as it has a positive impact on the demand for refined products and hence on the refining margins. On the negative side, this plunge has triggered production cuts in Canada and hence it will tighten the spread between WTI and WCS, thus adversely affecting the refining margins of Phillip 66, which uses Canadian crude as a significant part of its refinery input. Nevertheless, as long as the oil price remains below $75, refining margins will remain elevated thanks to the healthy demand for refined products.

Finally, Phillips 66 will continue to boost its earnings per share via meaningful share repurchases. The company has repurchased its shares at a 5% average annual rate in the last six years and management has confirmed its intention to continue to repurchase shares at a similar pace. Therefore, this will be another growth driver for the bottom line of the company in the upcoming years. Over the long-term, we view 4% annual earnings growth as a reasonable expectation.

Valuation

Phillips 66 is currently trading at a price-to-earnings ratio of 10.4. This is much lower than its historical average of 14.1 and is certainly attractive given the above mentioned growth prospects. If the stock reverts to its average valuation level over the next five years, it will enjoy a 6.3% annualized boost thanks to the expansion of its price-to-earnings ratio. Therefore, the recent plunge of the stock has resulted in a markedly cheap valuation, which is likely to significantly boost shareholder returns in the upcoming years. It is also worth noting that the cheap valuation of the stock renders the share repurchases especially efficient in enhancing shareholder value.

Warren Buffett’s transactions

Berkshire Hathaway (BRK.B) purchased a major stake in Phillips 66 in 2015, at prices between $70.5 and $84.5. Thanks to the share repurchases of Phillips 66, the stake of Berkshire Hathaway approached 10% at some point. Buffett expressed his great confidence in the management of Phillips 66, which he characterized as exemplary for its long-term perspective and its discipline to invest only in high-return projects.

Nevertheless, Berkshire Hathaway has significantly reduced its stake in Phillips 66 in every quarter this year. All the sales occurred at stock prices in the range of $94-$123. As Buffett is well-known for his focus on valuation, it is safe to assume that he decided to drastically reduce his stake due to the rally of the stock.

It is thus critical to note that the recent plunge of Phillips 66 has led the stock much closer to the purchase zone of Buffett. If the stock continues to slide, towards the mid $80s, it is possible that Buffett could repurchase the stock.

Final thoughts

The recent 25% plunge of Phillips 66 has presented a great investing opportunity. Thanks to the favorable conditions for U.S. refiners and the discipline of management to invest only in high-return projects, Phillips 66 is likely to continue to grow its earnings significantly year after year. Given the expected earnings growth of 4% per year, the 6.3% annual boost from valuation expansion, and its 3.5% dividend yield, the stock is poised to offer nearly 14% annual returns in the upcoming years.

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.