Warren Buffett has accumulated a $5.8 billion position in Phillips 66 (NYSE:PSX). His $5.8B position equates into an approximate 14% ownership of the company. Phillips 66 is an energy manufacturing and logistics company with midstream, chemicals, refining and marketing and specialties businesses. The Chemical segment manufactures and markets petrochemicals and plastics. The Chemicals segment consists of its 50% equity investment in Chevron Phillips Chemical Company LLC (CPChem). The refining segment buys, sells and refines crude oil and other feedstocks into petroleum products (such as gasolines, distillates and aviation fuels) at 14 refineries, mainly in the United States and Europe. The Marketing and Specialties segment purchases for resale and markets refined petroleum products (such as gasolines, distillates and aviation fuels), mainly in the United States and Europe.
Phillips 66 owns 69% of Phillips 66 Partners LP (NYSE:PSXP), a midstream MLP. PSXP will be driver of future growth in the midstream and chemical segments. This partnership contributes most of the midstream earnings growth to Phillips 66 today. The other part of the midstream business is DCP Midstream which is a 50-50 JV with Spectra Energy (NYSE:SE). This JV is expected to contribute $500 million in EBITDA by 2018.
The two largest segments of the company are the refining and marketing segments. These two account for about 97% of total revenues and about 65% of net income.
The majority of the earnings historically have come from the refining segment. However, major investments are being made in the midstream and chemical segments. I would think that investors would welcome the diversification. The refining business is incredibly cyclical and investors saw that play out in 2015. The 3:2:1 crack spread (three barrels of crude oil producing two barrels of gasoline and one barrel of diesel) was very strong in the first three quarters of 2015 but substantially decreased in Q4. The sharp decrease in crack spreads has a big impact on margins and therefore overall earnings. The enhanced diversification of assets with make Phillips 66 unlike any other refining company.
The refining business is known for having very small margins. In addition, these margins can swing based on the 3:2:1 crack spread. Due to the low margin environment that refiners operate in, all of them trade at low P/E ratios (average of 11X).
Returning Cash to Shareholders
PSX has a terrific track record of returning cash to shareholders. They have bought back about 16% of the outstanding shares in the last three years and continue to buy more. The company yields 2.85% and management continues to boost the dividend. In the last three years, the dividend has grown at a 34% CAGR. See chart below.
PSX spent a substantial amount of money in 2015 on growth capital projects in its midstream segment. The company poured about $3.0B into midstream projects which mostly went into building pipelines. In 2016, it is expected that they will spend an additional $1.3B in its midstream projects. Other midstream competitors are having to cut capex spending due to the difficult operating environment caused by low oil prices. Investing heavily in new projects now might give PSX a competitive advantage since current companies in the space are having financial difficulties. PSX has cash flow being generated from the refining segment and they are able to deploy capital into growth segments. The midstream segment could be very important to investors going forward because a lot of the revenues will be fee based. Fee based revenues will stabilize overall revenue and offset the large swings in refining margins caused by fluctuating crack spreads.
PSX is also allocating capital into their chemical segment. The drivers in this segment are CPChem and Phillips 66 Partners LP. CPChem is a chemical company created by a 50-50 JV with Chevron (NYSE:CVX). It is expected to add $1.5B in EBITDA by 2018. Phillips 66 Partners is a small company but it is growing fast. In Q1 2015 they made a $1.1B acquisition that will add $115 million in EBITDA next year. These two companies allow PSX to have exposure in natural gas liquid (NGL) pipelines. This exposure will increase the amount of fee based income which will allow for stable cash flows.
Based on the trailing twelve months earnings of $8.57, the stock is currently trading at 9.1x earnings, compared to the stock’s long term average of 10.5. If the stock was trading at 10.5x earnings it would trade at about $85 which is about 5% above my estimate of $80.49.
The stock is currently trading at a book value of 1.8x versus the historical book value of 1.85x. If the company were to trade at its historical book value, the per-share value would be $80.24 which is in line with my estimate.
It is not completely clear what Warren Buffett is seeing in PSX. Investors are speculating as to whether Buffett has been buying Phillips 66 to hedge his investment in Suncor Energy (NYSE:SU). Suncor Energy is much more exposed to the energy sector but I don’t think PSX is a hedge.
Phillips 66 is in my “too hard” pile. I simply don’t understand all of the different segments they are involved in well enough to have an edge. PSX might be building a moat of diversified assets and maybe that is why Buffett likes it. I don’t have enough wisdom to know what a great moat would like. I do know that there are not any other refiners that will have an array of assets similar to PSX but I don’t know if this will give them a competitive advantage going forward.
No positions in my personal portfolio at the time of this writing.