PSX - Phillips 66 Could Fuel Greater Portfolio Returns

Summary

• Phillips 66’s share price has been outperformed by the broad market and its peers over the last five years.
• Nevertheless, the business is very profitable, and has a resilient business model.
• The FCF and the business itself are trading at attractive multiples.
• Senior management is incentivised to create shareholder value.

Phillips 66 (PSX) has built a strong, profitable business at a time in which the oil and gas industry has been shunned by many investors. Despite this, the share price has not, over the last five years, been able to outperform the broad market. The business model is strong, has protections against the boom and bust cycle of the oil and gas industry, and the FCF and the business itself are trading at attractive values.

Lackluster Stock Price Performance

Over the last five years, Phillips 66 share price has declined 2.69% compared to a rise of 41.46% for the S&P 500. However, thanks to the power of dividends, the total shareholder return ((TSR)) of the company is 20.74% over that span of time.

Phillips 66 did not stand out among its peers over the last five years. Its Peer Group consists of Delek US Holdings, Inc. ( DK ); Dow Inc. ( DOW ); HF Sinclair Corporation (DINO); LyondellBasell Industries N.V. (LYB); Magellan Midstream Partners ( MMP ), L.P.; Marathon Petroleum Corporation ( MPC ); MPLX LP ( MPLX ); ONEOK ( OKE ), Inc.; PBF Energy Inc. ( PBF ); Targa Resources Corp. ( TRGP ); Valero Energy Corporation ( VLO ); Westlake Chemical Partners ( WLKP ); and The Williams Companies, Inc (WMB). Among this group, inclusive of Phillips 66, the equal-weighted average TSR was 43.82%.

Phillips 66 competes with its Peer Group along its various segments - which will be described more fully later on. In the Midstream industry, its crude oil and product pipelines face competition from similar pipeline companies, as well as integrated oil companies and independent oil gathering and marketing companies. The main factors in this competition are the quality of customer service, competitive pricing, proximity to customers and market hubs. Additionally, the company competes with integrated petroleum companies and natural gas transmission and distribution companies in delivering natural gas components to natural gas markets, and the primary methods of competing include securing the right to purchase raw natural gas, managing system pressure, operating efficient processing plants, and securing markets for produced products.

In the Chemicals segment, CPChem, is ranked in the top 10 producers in many of its major product lines based on average 2021 production capacity. The products, including petroleum products, petrochemicals, and plastics, are typically sold in worldwide commodity markets. Its Refining and M&S segments primarily compete in the United States and Europe, where Phillips 66 is one of the largest refiners of petroleum products. The drivers of competition in these segments include product improvement, new product development, low-cost structures, ability to use advantaged feedstocks, and efficient manufacturing and distribution systems. In the marketing portion of the business, competitive factors include product properties, reliability of supply, customer service, pricing, credit terms, advertising and sales promotion, and development of customer loyalty to branded products.

Strong Financial Performance

Between 2018 and 2022, revenues rose from $$111.46 billion to $175.7 billion at a 5-year compound annual growth rate ((CAGR)) of 9.53%. According to Credit Suisse’s ( CS ) “The Base Rate Book” , in the 1950 to 2015 period, 24.2% of firms had a similar rate of revenue growth over a 5-year period. The mean 5-year revenue CAGR for the period was 6.9% and the median 5-year revenue CAGR of 5.2%, with a standard deviation of 12.3%.

Operating revenues emanate from the company’s four operating segments: midstream, chemicals, refining, and marketing and specialities (M&S). This segment primarily operates within the United States and provides a range of services related to crude oil, refined petroleum products, natural gas, and natural gas liquids. These services include transportation, storage, terminaling, fractionation, processing, and marketing. The segment includes several entities, such as Phillips 66 Partners LP (a master limited partnership), DCP Midstream (an equity investment in which the company has a 50% stake), and NOVONIX Limited (an investment in which the company holds a 16% interest). NOVONIX is a company that specializes in developing technology and providing materials for lithium-ion batteries.

The midstream segment has three business lines: transportation, NGL and Other, and DCP Midstream. The Chemicals segment consists of the firm’s 50% equity investment in CPChem, a company which manufactures and markets petrochemicals and plastics globally. The results from this segment are reported through two business lines: Olefins and Polyolefins (O&P) and Specialties, Aromatics and Styrenics (SA&S). The Refining segment operates through 12 refineries in the United States and Europe, refining crude oil and other feedstocks into petroleum products and renewable fuels. Finally, the M&S segment buys refined petroleum products and renewable fuels, which it then sells mainly in the United States and Europe. The segment also engages in the production and promotion of specialized items like lubricants and base oils. Outside of that, Corporate and Other manages the firm’s general corporate overhead, interest expense, investments in new technologies and other activities.

From those segments, the business generates refined petroleum products, crude oil resales; NGL, and services and other. Between 2019 to 2021, refined petroleum products were responsible for an average of 79.64% of the firm’s total revenues. The United States is the biggest market for the firm’s products, buying an average of 77.57% of Phillips 66’s revenues between 2019 to 2021.

Gross profitability rose from 0.2 in 2018 to 0.23 in 2022. While this is still short of the 0.33 gross profitability threshold that Robert Novy-Marx found was attractive, the trajectory does show that the company’s ability to make money has risen over time.

Operating income declined from $7.94 billion in 2018 to $14.34 billion in 2022, at a 5-year operating income CAGR of 12.55%. Operating margin rose from 6.95% to 8.52%. In the energy industry between 1950 and 2015, the mean operating margin for the energy industry was 11.6%, and the median operating margin was 12.1%, with a standard deviation of 3%. The operating margin is far from the top tier of operating margins in the industry.

Income before taxes was $7,45 billion in 2018 to $14.64 billion in 2022, for a 5-year income before taxes CAGR of 14.48%. Net income rose from $5.87 billion in 2018 to $11.39 billion in 2022, at a 5-year net income CAGR of 14.17%. That gives us a base rate of 20.3%, and a mean 5-year net income CAGR of 7.3% and a median 5-year net income CAGR of 5.9%.

The firm grew operating cash flow from $7.6 billion in 2018, to $10.8 billion 7.38%. Free cash flow ((FCF)) rose from $4.93 billion in 2018 to $5.79 billion in 2022, at a 5-year FCF CAGR of 3.23%. In that 5-year period, the firm earned $15 billion in FCF. With an enterprise value of $60.35 billion, the firm has an FCF yield of 9.59%.

Phillips 66 calculates an adjusted return on capital employed ((ROCE)), which grew from 16% in 2018 to 22% in 2022.

Competitive Forces are Driving Industry Profitability

Phillips 66’s anemic stock market performance is understandable when you consider the performance of the energy sector as a whole, across that period. The MSCI World Energy Index delivered gross returns of 6.81% per year over the last five years, compared to the MSCI World Index, which delivered gross returns of 7.05%. Indeed, the energy sector’s underperformance relative to the broader market extends back to the Great Recession of 2008. Since that time, the MSCI World Energy Index has only beaten the MSCI World on five occasions, with two of those years being 2021 and 2022.

The deterioration in returns has been driven by a combination of factors. The most well-known factor is the influence of environmental, social & governance ((ESG)) based investing, which has led to an exodus of investors and their capital, from fossil fuel producers, even very profitable ones. Norges Bank Investment Management, which runs Norway’s sovereign wealth fund, which is heavily invested in oil, has, for example, been set a goal of net-zero emissions from the businesses it has invested in. This suggests, of course, that it will be forced to exit investments in oil companies that do not reach its targets, regardless of their profitability. The second reason that the industry has struggled over the years is due to the lingering effects of the collapse of the boom during the Great Recession. The energy sector is highly fragmented, with no single player enjoying anything like pricing power. When a producer invests in capex, there is a long lag between that decision and future production and the observation of future prices. So, for instance, a firm may invest $100 million in a new facility, which will come online in five years. Underpinning that investment, are a set of assumptions about the range of future oil prices. Regardless of how hard firms try, during booms, it is very easy to be overly optimistic about future prices, and during busts, it is very easy to be overly pessimistic about future prices

Given the fragmentation of the industry, when a producer makes a production decision, especially one that involves investments in capex, they will not be able to control future prices so that those prices justify the investments they have made. So, there is a tendency to overshoot or undershoot in terms of supply, leading to a boom and bust cycle, with capital ebbing and flowing through the industry. The retrenchment in the industry post-2008, led to a growing sense of caution among managers, a rise in bankruptcies and M&A activity, all of which resulted in greater capital discipline. With capital leaving the industry thanks to ESG investors, and capital discipline due to consolidation, the sector has enjoyed its most profitable period over the last few years, while ignoring the temptation to spend heavily on capex, despite strong prices.

Forecasts of global energy sector capex spending suggest that global energy capex for the 2021 to 2025 period will grow by 18% compared to the 2016-2020 period. The biggest beneficiary of that capex will be transmission and distribution, upstream oil and gas and renewable energy. Downstream capex spending is not likely to see much growth during this period. This adds strength to our notion that Phillips 66 is operating in a market wherein capex spending growth is in retreat, and where capital discipline and overall caution are the defining qualities.

This is even more remarkable when you consider that the industry has been called upon to help find solutions for the European energy crisis and dependence on Russian and Saudi oil and gas, at a time in which oil and gas prices have been very strong. The post-pandemic period did see a rise in spending in 2021, after the collapse in 2020, but much of that rebound has not gone downstream, nor is there an expectation that this will be so in the next decade.

This message of capital discipline is clear from the company’s own financial disclosures, which show that capex grew from $1.83 billion in 2018, to $2.19 billion in 2022, at an anemic 5-year capex CAGR 3.67%.

Downstream Operators Have Some Margin of Safety

Broadly, upstream companies are primarily focused on exploration and production of crude oil and natural gas, midstream companies are primarily focused on the transportation and storage of energy products, and downstream companies are primarily focused on the processing and delivery of finished energy products to end-users. As we discussed in our analysis of the financials, a large amount of the company’s revenues come from the refining business. This insulates the firm from much of the downsides of the boom and bust cycle of the oil and gas industry. This is because, as refiners, Phillips 66 earns what is known as a “crack spread”, which is the spread between the price of crude and the price of the refined product that it will buy from an upstream company and produce. While this does provide some protection, it did not, of course, prevent the company from earning a loss in 2020. However, it does provide more certainty for the business and its earnings. However, 2020 was a very exceptional period, not just for the company, but for the world, and under more normal circumstances, the firm can be relied upon to earn a profit.

Management is Paid for Growing Economic Value

In Phillips 66's 2021 Proxy Statement , the Compensation Discussion and Analysis (CD&A) explains that its ideal compensation plan is “linked to Company performance and directly aligned with shareholder value creation, a significant portion of NEO compensation remains at risk and based on performance metrics aligned with the execution of our corporate strategy.” Under its P66 Omnibus Plan, senior management is granted restricted performance share units (PSUs) each year, which have three-year performance periods and vest when approved by the Human Resources and Compensation Committee ((HRCC)) on the grant date. A quarter of the PSUs are tied to absolute ROCE and another quarter to ROCE relative to the company’s Peer Group (listed earlier). These PSUs are classified as liability awards, and compensation expense is recognized from the authorization date to the vesting date. When settled, PSUs are paid in cash based on the fair value of the awards, determined by the market prices of the company's stock at the end of the performance periods. The HRCC must approve the performance results before payout, and dividend equivalents are not paid. In contrast, PSUs granted under previous incentive compensation plans were classified as equity awards, and they are settled at retirement by issuing one share of common stock for each PSU held, with dividend equivalents paid on these awards.

The better the company's financial performance over the vesting period, the more likely it is that the PSUs will vest, providing an incentive for senior management to focus on improving the company's financial metrics, including ROCE.

Valuation

With an FCF yield of 9.59%, the company’s FCF is trading at an attractive yield. This is larger than the 1.8% FCF yield of the 2000 largest firms in the United States, as measured by the financial services firm, New Constructs. In addition, the company has a price-earnings (P/E) multiple of 4.56, compared to a P/E multiple of 21.37 for the S&P 500. This suggests that not only are the firm’s FCF undervalued, but the firm itself is undervalued with respect to the broad market.

Conclusion

Investors in Phillips 66 have not been able to take advantage of investing in a profitable company. The share price performance has trailed the market and its peers over the last five years. The broad, industry-wide trends support future profitability, and the business model gives the company a large measure of protection against the ebbs and flows of the industry. The company’s fundamentals are strong, its FCF is trading at an attractive multiple, and the business itself is cheap relative to the market. This suggests that the business should be a long-term investment for investors.

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