Phillips 66: Warren Buffett’s Newest Pick

A few weeks ago, I wrote an article about Phillips 66 (NYSE: PSX) and its competitive advantage and valuation that makes it a great buy, both as a company and as a stock. Warren Buffet seemed to agree, as he announced that Berkshire Hathaway is selling shares of ConocoPhillips (NYSE: COP) to buy those of Phillips 66. PSX jumped 5.8% from that news and is up a total 6.25%, while the S&P 500 has remained flat since my article was published.  PSX is currently trading around $35, which is still a cheap price and a great entry point for the stock, especially before second quarter earnings are reported on August 1st.

My previous article gave a background on PSX’s operations and advantages. But plain and simple, this is why PSX is worth the money:

  1. It is valued like a refiner but is divesting its low return refineries and focusing more on obtaining advantaged crudes.
  2. Its midstream operations in North American natural gas and natural gas liquids (NGLs) are benefiting incredibly form substantial exposure to shale gas.
  3. Its chemicals segment capitalizes on very low NGL feedstock costs in the US and globally and has plans for very aggressive growth
  4. Both PSX and DCP Midstream (in which it has a 50% stake) have assets that could be dropped down into a Master Limited Partnership (MLP) that has tax advantages that would substantially benefit the bottom line
  5. Phillips 66 is dedicated to returning excess free cash flow to shareholders via dividends and share buybacks.

Phillips changing business model is key to understanding what makes PSX stand out. The critical theme since early 2011 has been unprecedented discount in WTI crude prices relative to Brent. WTI is a lighter crude compared to Brent (measured by how much sulfur is in it), making it easier and cheaper to refine into petroleum products. Though logically, WTI should be more expensive because of this, it is currently cheaper because infrastructure has not been able to catch up with US oil product. The WTI discount, which has been supporting refining margins, is expected to decrease from $15/ barrel to $3 – $5 in the long haul. Furthermore, gas prices aren’t seen experiencing any substantial increases in years ahead. Refining margins are going to get slammed in foreseeable years.

Clearly, this is bad news for US refiners. But Phillips 66 is really the only major refiner taking the right steps for long-term success. Refining and marketing constitutes 60% of earnings, while Valero (NYSE: VLO), the next closest refiner, has earnings comprised 90% of refining. Valero is even looking to continue growing its refining footprint in Europe and the Gulf Coast.

Phillips is working hard to divest its refining segment and focus on obtaining advantaged crudes while pumping capital into midstream and chemicals. $1.2B of capital expenditure will be used in 2012 for improving refining margins instead of volumes, especially focusing on obtaining more light and sweet crudes and fewer heavy/ acidic crudes. Moreover, refining and marketing has a segment leading 40% distillate yield, which is key as distillate demand is growing fast than gas demand.

From 2003 to 2010 Phillips sold off more than $6B of downstream assets. It is now actively looking to divest its Belle Chasse and Whitegate refineries, which will add between $750M and $1.05B to the balance sheet. Phillips’s targeted portfolio mix will have 50% capital employed in R&M, 25% in CPChem, and 25% in DCP.

CPChem will experience earnings growth of higher than 25% per annum from cheap natural gas feedstock. CPChem is also building the world’s largest 1-hexane plant in Texas and it is eyeing a $5B ethane cracker in the Gulf Coast. This is key as US ethane is on the low end of the cost curve, meaning higher margins. Additionally, the ethane cracker would increase CPChem’s ethylene capacity by over 40% and leverage the development of shale gas in the US.

The midstream segment could also experience double-digit growth in the next year. PSX currently has the capacity to extract 460,000 barrels per day, though it only runs about 110,000. PSX expects to increase this amount of natural is runs by 50% in 2012 and to 200,000 barrels a day by 2015. Moreover, DCP Midstream is pushing its historical $500M capex to $2B a year to build the most extensive and cost effective infrastructure to service the shale boom. In early December, we will hear Phillips’s plans about creating a Master Limited Partnership (a publically traded, petroleum company that is granted tax advantages by the US government) for its transportation logistics assets. MLPs usually trade at 10-12X multiples, which would add an additional $5/ share to Phillips’s intrinsic share price.

From the spinoff, Phillips had $2B in cash and $8B in outstanding. Management is moving the company to $3B in cash and $6B in long term debt, while maintaining a strong BBB/Baa1 rating.  This puts PSX at a net debt to cap ratio of around $20 ratio, which is lower than the 32% average among peers. After capital, dividend, and debt reduction measures are met, management is dedicated to share repurchases and dividend increases. A few weeks ago, PSX announced a $0.80 (2.5%) annual dividend, with plans to raise it 5% annually. And in a few weeks from now, Phillips 66 is going to hold its first earnings call. Clearly, it is the perfect time to buy PSX shares and hold onto it as the market realizes its true intrinsic value of at least $42/ share!

Disclosure: The author has no holdings in the stocks mentioned in this article and has no plans to initiate any positions within the next 72 hours.  He does, however, have the intention of rating these stocks on WealthLift.com, a social media website where investment ideas are shared openly and free.

Simon Osipov is a WealthLift Finance Columnist majoring in economics, with a finance and business minor at Johns Hopkins University. On campus, he is the co-portfolio manager for the Alpha Kappa Psi business fraternity and a securities analyst for the Investment Team. In his spare time, Simon enjoys photography, both for the school newspaper and just for fun.

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