By Simply Safe Dividends. Originally published at ValueWalk.
Phillips 66 (PSX): Warren Buffett’s New Favorite Dividend Growth Stock
Warren Buffett is history’s greatest investor, and so when his company, Berkshire Hathaway (BRK.B), takes a major stake in a company the world takes notice.
Investors can read analysis of all of Warren Buffett’s dividend-paying stocks here.
Over the past few months Berkshire has increased its stake in Phillips 66 (PSX), to 79.5 million shares; worth $6.25 billion, and representing 14.8% of the company.
Let’s take a look at why the Oracle of Omaha is so interested in Phillips 66, and more importantly, whether this dividend growth stock could deserve a spot in a conservative investor’s diversified income portfolio.
Business Description
Source: Phillips 66 Investor Presentation
Phillips 66 was spun off from ConocoPhillips in 2012 and operates in four business segments that process, transport, store, and market fuels and other refined products around the world:
- Refining (22% of YTD 2016 adjusted earnings): 14 refineries in the US and Europe with a total daily capacity of 2 million barrels of gasoline, diesel, and jet fuel. Crude oil is processed into these products at Phillips 66’s refineries.
- Midstream (7% of YTD 2016 adjusted earnings): 18,000 miles of natural gas, and oil pipelines, 60 transportation terminals, and 37 storage locations. Also includes: natural gas processing, and fractionation facilities for generation of natural gas liquids, or NGLs, and ownership and GP stakes in two midstream MLPs; DCP Midstream Partners (DPM) and Phillips 66 Partners Partners (PSXP).
- Petrochemicals (32% of YTD 2016 adjusted earnings): Through its CPChem subsidiary, Phillips 66 is one of the world’s largest producers of ethylene, propylene, and other petrochemicals that are used in everything from plastics, to drilling & mining solvents, and pharmaceuticals. It’s 34 facilities, located on three continents, have a net capacity of 34 billion barrels per year of these valuable, high margin products.
- Marketing and Specialties (40% of YTD 2016 adjusted earnings): refined petroleum products sales of almost 2 million barrels per day of: gas, diesel, and jet fuel; sold under a variety of US and European brands, and stations.
Phillips 66 (PSX): Business Analysis
Starting a refinery business is no small task. A single refinery can cost billions of dollars and requires convenient access to pipelines, transportation systems, and feedstock supply.
Few new players have entered the market for this reason. In fact, not a single new refinery was built in the U.S. for 30 years until 2012.
Phillips 66 is particularly well-positioned thanks to its exposure to cheaper oil in areas such as Alberta and the Bakken shale in North Dakota. Lower feedstock costs improve the profitability of Phillips 66’s refining operations.
The company’s large network of pipelines, railcars, and other transportation infrastructure also help it capture pricing benefits by being able to move its feedstock supply and end products around the country more efficiently.
Despite some of the hard-to-replicate assets owned by companies in the petroleum and refining industry, their results can be quite volatile due to unpredictable energy prices.
Thanks to a glut of gasoline over the past few months, Phillips 66 saw its refining margins collapse 40% in the most recent quarter.
This resulted in a 75% reduction in refining earnings, and a 50% overall earnings decline at the company wide level.
In fact, Phillips 66’s refining earnings were so hard hit that this business segment, which is the company’s main bread and butter earnings generator, actually ranked third in total contribution to net income through the first half of 2016.
| Business Segment | YTD 2016 Net Income | % Of Net Income Contributed |
| Refining | $235 million | 26.7% |
| Midstream | $104 million | 11.8% |
| Chemical | $346 million | 39.3% |
| Marketing | $434 million | 49.3% |
| Corporate Costs | -$238 million | -27.0% |
| Total | $881 million | 100% |
Source: Company 10-Q
However, the reason that Buffett seems unfazed by Phillips 66’s recent refining margin troubles is because he understands that great profits aren’t made in a quarter, but over many years (see Warren Buffett’s best advice here).
This is why Berkshire has been using the company’s sharp under performance as an opportunity to buy more of these high-quality shares.
What Buffett realizes that Wall Street might not is that Phillips 66’s long-term value doesn’t necessarily lie in refining, but its other businesses; especially its fast-growing midstream operations.
This gives Phillips 66 access to every major shale oil & gas region in the country, reduces the company’s sensitivity to volatile refining margins, and positions it to benefit from the long-term rise in domestic energy production.
Source: Phillips 66
Simply put, midstream operations are the key to Phillips 66’s cash flow and future dividend growth.
The midstream industry is basically built around moving, processing, and storing oil, gas, and various refined products.
And thanks to the fixed-fee, long-term contracts that are the hallmark of the midstream industry, Phillips 66’s midstream assets can go a long way in stabilizing the company’s cash flows over time; thus offsetting the volatility in refining margins.
Better yet, thanks to Phillips 66’s ownership, and management of its midstream MLP, Phillips 66 Partners, the company has a low cost, tax efficient means of paying for its ambitious midstream growth plans.
Specifically, Phillips 66 serves as the general partner, or GP, of PSXP, which means it owns the incentive distribution rights, or IDRs. This means that above a quarterly payout of $0.24 per unit of Phillips 66 Partners, Phillips 66 receives 50% of the marginal distributable cash flow, or DCF.
Source: Phillips 66 Investor Presentation
Under this symbiotic relationship with its MLP, Phillips 66 can sell its assets to PSXP, which raises external debt and equity capital from investors, to offset the construction costs of its midstream assets.
However, because it still owns 59% of the MLP, and the IDRs, Phillips 66 will still benefit from the fast-growing, and stable, stream of cash flow. Then its world class management team can then reinvest that into further diversifying its operations; as well as reward long-term investors with buybacks, and growing dividends.
Source: Phillips 66 Investor Presentation
Another primary reason why Buffett likes Phillips 66 is the conservative, quality management team led by CEO Greg Garland.
Garland was the former Senior Vice President of ConocoPhillip’s American exploration and production business, as well as President of CPChem. In total, Garland has over 30 years of experience in the petrochemical industry, either with ConocoPhillips, or heading Phillips 66.
It’s his vision that has led to the company focusing its investment dollars on the higher margin, and more stable midstream and chemical businesses, which has resulted in Phillips 66’s impressive, industry-leading profitability, and high returns on shareholder capital.
Key Risks
There are two main risks to keep in mind before becoming a part owner of this business.
First, never forget that refining is a cyclical business, with margins affected both by oil prices, and demand for the refined products.
As the last two years have shown, oil prices can’t be predicted accurately in the short to medium-term, and slowing global growth can ding demand, and thus prices for refined products such as: gas, diesel, and jet fuel.
While Phillips 66 is working hard to diversify its sales, earnings, and cash
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