Phillips 66 Investors Are In A Great Place

Summary

• Phillips 66 reported great results in a very challenging first quarter due to the pandemic and the impact of severe weather in the South.
• Nonetheless, while the company burned some cash, it is expected to generate enough free cash flow going forward to cover its dividends and further repay debt.
• The stock is fairly valued and offers investors the opportunity to invest in a cyclical but long-term profitable dividend growth stock.

Photo by StockPhotoAstur/iStock Editorial via Getty Images

In March, I called Phillips 66 (NYSE:PSX), a fantastic dividend stock as I like the company's turnaround potential and its ability to use non-recession years to significantly boost shareholder value through dividends and buybacks. In this article, I get to confirm this call using not only the company's latest quarterly results but also a significantly improving macro environment. While Phillips 66 will remain a volatile, and cyclical stock, I think it's a great way for investors to get access to higher yield without having to sacrifice long-term value growth - in other words, it's not 'dead yield'.

Macro Is Looking Great Again - We're Going Places Again

At this point, I don't think I need to explain why Phillips 66 was in an absolutely terrible position as the most recent recession - unlike all others - did come with an implosion in (global) mobility. That's why I am not afraid of future recessions. These will pressure Phillips 66 and its peers, but it more than likely won't prevent the stock from generating free cash flow - unless it's a pandemic.

Anyway, the weekly refinery utilization rate in the United States has made it to 85.4%, which is a new pandemic high and comparable to the lows during non-recession years (anything between 2009 and 2020).

I expect refinery utilization to reach 88-90% in the third quarter as we will not only see the benefits from a decline in seasonal flu (COVID) cases, but also the benefits from the rapid and efficient vaccination efforts in the United States. The same goes for major economies in Europe, even though vaccinations are slower than in the United States. Source: Worldometers.info

As a result, we will not only see an uptick in road and air travel as people go on vacation again, businesses reopen their offices again, and we get to meet our family again, but we will also see increased energy demand from industrial users as leading economic (manufacturing) indicators are gaining steam (graph below).

Source: ISM

The graph below shows why the ISM matters. While the PSX stock price and the ISM index do not move in lockstep, there is no denying that PSX performs better during economic upswing as this triggers a rotation from safe/defensive stocks to more cyclical stocks that protect investors against i.e., higher inflation.

Source: TradingView (Orange = ISM Index, Black = PSX)

Well, before I dig into the company's quarterly earnings, let me clarify that I don't care that much about economic cycles when I decide to buy a stock for the long term. What matters to me is that a company is able to generate sufficient free cash flow during recessions as this means that we (investors) get to add to our positions at great prices without having to fear that our payout (dividends) suffers.

That's exactly why 1Q21 earnings are so important as PSX is on its way to recovery. Hopefully, after the pandemic, we won't have to encounter a recession that threatens dividend safety for a very long time.

On a side note, PSX management seems to have a similar view on things.

We remain optimistic about the impact COVID-19 vaccines and monetary stimulus will have on economic recovery in the back half of the year. Leading indicators suggests economic growth is accelerating, which supports demand for our products.

So, now let's look at the numbers.

1Q21 Was Tough, But I'm Not Complaining

Phillips 66 had a tough quarter. The good news, however, is that the company reported much stronger than expected numbers. For example, non-GAAP EPS beat expectations by $0.24 while sales improved on a year-on-year basis to $21.9 billion and came in more than $4.0 billion above expectations. That's a big deal.

Source: Seeking Alpha

As estimates already suggested, nobody expected the first quarter to be good. Not only is the company still suffering from the pandemic as nationwide utility rates suggest, but the company also had to deal with severe weather conditions in the South, which pressured utilization rates further and increased maintenance costs.

The bridge graph below shows that the company's operating performance (excluding taxes and noncontrolling interest) benefited from a surge in refinery income while both midstream and chemicals were down. The $68 million gain in refinery operations was caused by an increase to a 74% utilization rate and a $4.36 per barrel realized margin with almost all gains being made in the Gulf Coast as both the Central Corridor and the West Coast largely offset these gains.

Source: PSX 1Q21 Earnings Presentation

With this in mind, let me show you what the company did in terms of free cash flow. I believe that this quarter (1Q21) is the last quarter with insufficient dividend coverage for the reasons mentioned at the start of this article. I am, therefore, happy to see how the company handled cash flows in its first quarter of 2021. First of all, operating cash flow was positive ("CFO"). Unfortunately, capital expenditures ("CapEx") offset these gains, resulting in close to zero in free cash flow. Keep in mind that roughly half of 1Q21 CapEx came from growth projects - the other half was basic maintenance to keep operations going. With this in mind, the company maintained its dividends at roughly $400 million and refrain from buying back shares. As a result, the company had a funding gap, as PSX repaid an additional $500 million in debt. This funding gap was not filled as the company used existing cash to reduce debt and to pay dividends.

Source: PSX 1Q21 Earnings Presentation

I like this decision, and this is why:

Here's What's Next

As you already know what I expect to happen in terms of utilization rates, let me show you why I didn't mind that PSX burned through some cash in its first quarter.

According to analysts, 1Q21 was the last quarter of flat (slightly negative) free cash flow as we are about to witness a significant rebound due to higher operating cash flow (rebounding utilization rates and better pricing) and quarterly CapEx between $400 and $500 million depending on maintenance needs and growth project funding. This guidance (even if it's lowered) indicates that the company has room to maintain its dividend and to reduce its debt load. The company has even room to further hike its dividends.

Source: TIKR.com (Quarterly FCF expectations)

As a matter of fact, analysts expect the company to reduce net debt to roughly $11.1 billion during the summer of next year. As the company is expected to generate roughly $6.0 billion in EBITDA, that would indicate a (net) leverage ratio of less than 2.0x.

It also means that, based on a $35.5 billion market cap, the company is trading at 7.8x 2022 EBITDA. Based on the company's historic valuation range (I excluded 2020 because it messed up the valuation range), this is a good price for investors who aren't long yet, which also means existing investors still have the opportunity to buy more at relatively good prices).

Data by YCharts

Takeaway

I think Phillips 66 (and some of its peers) are must-own stocks as these companies offer investors a great yield and strong dividend growth. The only problem I see is that these companies are very volatile and tend to sell off more than the 'average' S&P 500 stock during recessions. If you, like me, want to own PSX, make sure to keep your exposure limited. I think max 4-5% of your portfolio invested in PSX (and/or its peers) is appropriate if you are not close to retirement. Once you account for volatility and keep in mind that this stock tends to sell off during recessions, I think it's a fantastic long-term investment.

Data by YCharts

In the mid-term, I expect the company to report a significant improvement in its operations and reveal enough free cash flow growth to not only cover dividend payments but also to continue to repay debt.

So far, I own Phillips 66's competitor Valero Energy (VLO), but I'm planning to add PSX this year as well.

(Dis)agree? Let me know in the comments!

Analyst’s Disclosure: I am/we are long VLO. 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.

This article serves the sole purpose of adding value to the research process. Always take care of your own risk management and asset allocation.