Phillips 66 Posts Stellar 2018 Performance But Tricky Road Ahead

Summary

• Covering Phillips 66's financial performance last year, which saw impressive growth across each income generating division.
• Midstream expansion is how management plans to grow Phillips 66 in ways that aren't dependent on crack spreads.
• Overall, a great report.
• Another big dividend increase is planned for 2019.

Phillips 66 (NYSE:NYSE:PSX) posted a solid earnings report for the final quarter of 2018 that rounded out what was a great year for the firm. Wall Street clearly liked the news and bid the shares up 2% by the end of the trading day on Friday. Note that Phillips 66 consolidates its performance with its core midstream spin-off Phillips 66 Partners LP (NYSE:PSXP). Phillips 66 is popular with many income-oriented investors because it yields 3.4% and has continuously raised its payout. Let’s dig in.

Source: Phillips 66

Financial overview

When viewing Phillips 66’s year-over-year performance, it is important to keep in mind the firm recorded a massive income tax benefit of $2.6 billion in the fourth quarter of 2017 (due to the tax cut/reform law getting passed and signed into law in the United States). On a net income basis, Phillips 66 saw its bottom line grow by 10% to $5.6 billion in 2018 versus 2017 levels.

However, on an operating income basis (note this metric excludes debt and interest expenses, which the firm lumps together with its operating expenses in its income statement), Phillips 66 posted 99% year-over-year growth as its operating income climbed to $7.9 billion. That growth is made even better when including debt and interest expenses, as Phillips 66’s profit before corporate income taxes grew by 109% year over year to $7.4 billion in 2018.

This is stellar growth and a clear sign that management’s plan to grow across the board (midstream, refining, petrochemical, and retail) is paying off nicely. A 9% reduction in Phillips 66’s diluted share count in 2018 versus 2017 helped the firm grow its diluted EPS from $9.85 in 2017 to $11.80 last year.

Phillips 66 experienced growth across all four of its income generating divisions while costs were down at the corporate division. Midstream operating income was up 85%, its Chemicals operating income was up 43%, its Refining operating income was up 118%, its Marketing and Specialties operating income was up 53%, and its Corporate and Other operating loss was down 5%. This is all on a year-over-year basis in 2018.

Phillips 66’s ability to realize very strong refining margins in Q4 2018 also played a key role in its outperformance. During the firm’s conference call, management noted:

“The 3:2:1 market crack for the fourth quarter was $9.11 per barrel compared with $14.21 in the third quarter. The realized margin was $16.53 per barrel, and resulted in an overall market capture of 181%. Market capture was impacted by the configuration of our refineries. We made less gasoline and more distillate than premised in the 3:2:1 market crack. The gasoline crack spread declined by $8.75 per barrel during the quarter, while the distillate crack improved by $2.20 per barrel.”

Significantly stronger financial performance enabled Phillips 66 to generate $7.6 billion in net operating cash flow last year, up 108% from 2017 levels. That easily covered $2.6 billion in capital expenditures, $1.4 billion in dividend payments, and $0.2 billion in distributions to non-controlling interests, making room for $4.6 billion in share buybacks in 2018 (partially funded by cash on hand).

Phillips 66 exited 2018 with $11.2 billion in debt and $3.0 billion in cash, and it likely won’t be until the firm publishes its 10-K SEC filing for 2018 that more information will be made available regarding the status of its balance sheet. As Phillips 66 generated $10.1 billion in adjusted EBITDA last year, its debt to adjusted EBITDA came in at a sustainable 1.11x in 2018, or 0.81x when using net debt.

A manageable debt load is essential to outperforming in this market. Heavily indebted energy companies (particularly in the oil & gas industry) have performed very poorly during the downturn due to the lack of financial flexibility and the colossal drain interest expenses can have on cash flow and net income generation.

Phillips 66 plans to reward its shareholders by distributing part of these gains back to investors through dividend increases and strategic share buybacks. This is part of the firm's ongoing strategy as Phillips 66 increased its payout by 14% in 2018. During its latest conference call, management stated (emphasis added):

"Disciplined capital allocation is a priority, and we're committed to a secure competitive and growing dividend. As we look to 2019, we expect to deliver another double-digit dividend increase. Through our ongoing share repurchase program we continue to buy shares when they trade below intrinsic value as demonstrated by our fourth quarter pace of repurchases."

Midstream expansion ahead

To keep the momentum going, Phillips 66 sanctioned the expansion of its Sweeny Hub along the US Gulf Coast. Sweeny might be a small town in Texas, but it is still home to an enormous oil & gas industry, with numerous pipelines connecting the area to major producing basins that are primarily located in Texas (the Eagle Ford and the Permian Basin are the two big ones).

Phillips 66 plans to build two additional natural gas liquids fractionators in this area, which will complement Phillips 66 Partners’ existing 100,000 bpd fractionator and export terminal capable of handling 200,000 bpd of LPG (liquefied petroleum gas, butane and propane). Nearby at Phillips 66 Partners’ Clemens Cavern, Phillips 66’s operations will be supported by 9 million barrels of NGLs storage capacity. This is a direct bet on America’s rising natural gas liquids production and its emergence as a global NGLs/LPG exporting juggernaut.

When the expansion is complete, the two new facilities will each add 150,000 bpd in fractionation capacity to the hub along with an additional 6 million barrels of NGLs storage capacity. This $1.5 billion endeavor is expected to be completed by the end of 2020. DCP Midstream Partners LP (NYSE:DCP) has the right to purchase a 30% stake in those fractionators, keeping in mind Phillips 66 has a large economic interest in its DCP Midstream joint venture. Its partner in that venture is now Enbridge Inc. (NYSE:ENB) due to Enbridge purchasing Spectra Energy. Regardless if DCP Midstream does or does not decide to buy in, there is a very good chance Phillips 66 will likely drop down its remaining interest in these facilities to Phillips 66 Partners (as it has already done with its existing Sweeny Hub assets).

What a NGLs fractionator does is separate out the different purity products within a Y-grade NGLs stream (otherwise known as a “mixed stream”), including propane, butane, isobutane, and natural gasoline. Ethane is a key natural gas liquid, but usually in America that is separated out when the raw natural gas stream is processed by a cryogenic processing plant (which is also where the Y-grade NGLs volumes are separated from the “dry” gas stream).

By growing its midstream income, Phillips 66 is targeting developments that are immune from crack spreads (gross refining margins) due to midstream assets being more like utilities than volatile oil & gas operations. As its midstream investments continue to grow the importance of this division in its financial statements, Phillips 66 should be able to perform better over the long haul due to greater stability in its cash flow generation. At least in theory.

Final thoughts

Phillips 66 had a great 2018, but now questions are emerging over how the downstream industry (North American refineries in particular) will handle the narrowing WCS-WTI gap (heavy Canadian crude isn’t as great of a bargain as it used to be) and losing access to heavy oil supplies from Venezuela, all while OPEC+ output is moving lower. That is the real test of strength for Phillips 66’s management team, let’s see how the firm performs in 2019. Thanks for reading.

Analyst’s 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.