Phillips 66 (PSX)

[Enterprising Investor]

Buffett Refines His Taste for Phillips 66 (9/05/15)

Why Phillips 66 shares could rise 35%.

Warren Buffett has rediscovered the appeal of the country’s top independent oil refiner, Phillips 66. Buffett’s Berkshire Hathaway recently disclosed that it has taken a 10.8% stake in the company, now valued at $4.5 billion. Berkshire held a smaller interest in Phillips until 2013, when it swapped most of that stake, some $1.35 billion of Phillips stock, for a chemical business owned by Phillips that was folded into Berkshire’s Lubrizol division.

Phillips (ticker: PSX) has been a big winner since it was spun out of ConocoPhillips (COP) in 2012, more than doubling in value while its former parent has languished, falling 15% due to the sharp drop in oil and natural-gas prices. Barron’s has been bullish on Phillips 66 from the start (“The Right Spin on Phillips,” May 7, 2012) and earlier this year (“Phillips 66 Shares Could Rise Sharply,” Jan. 19).

Phillips shares, which were flat last week after the Berkshire (BRKA) disclosure, still look appealing. They trade for about 12 times projected 2015 earnings of $6.65 a share, a premium to rivals Marathon Petroleum (MPC) and Valero Energy (VLO), which both fetch about eight times expected 2015 profits. Evan Calio, an energy analyst at Morgan Stanley, has an Overweight rating on the stock and a price target of $105, from a recent $77.20. The Street sees $7 a share in 2016 earnings.

A shareholder-friendly management team led by CEO Greg Garland has sought to expand and highlight the company’s nonrefining businesses, notably chemicals and “midstream,” which involves energy pipelines and other infrastructure. These carry higher valuations than refining, which has been lucrative in recent years but subject to volatile margin swings. Lately, refining margins based on so-called crack spreads have tightened sharply from wide levels. Refining accounted for 60% of Phillips’ earnings in the second quarter. Garland’s aggressive goal is to drop that to about a third by 2018. The greater diversity of Phillips’ profit accounts for its valuation premium versus peers.

Phillips created an MLP, Phillips 66 Partners (PSXP) in 2013, and the company has been selling, or “dropping down” midstream assets into the partnership, taking advantage of the valuation arbitrage between the highly valued midstream segment and the lowly refining sector. Calio sees $18 billion of possible asset dropdowns to the MLP through 2018 although the sharp pullback in the MLP sector this year could reduce that potential. Phillips also has an attractive chemicals joint venture with Chevron, and a group of gas stations and other businesses.

The company has used its ample cash flow to boost its dividend, now 56 cents a share quarterly, up from 20 cents initially after the spinoff, and repurchase stock. Phillips’ shares outstanding are down 14% since the spinoff.

Phillips probably is the kind of business that Berkshire would like to own, but the company’s market value of $42 billion probably makes it too large for Berkshire, considering the premium it would have to pay, Berkshire’s recent $32 billion deal for Precision Castparts (PCP), and Phillips’ multiyear plan to develop its nonrefining businesses. Buffett evidently believes he’s in good hands with Phillips management. That looks like a good bet.

-- Andrew Bary

http://www.barrons.com/articles/buffett-refines-his-taste-for-phillips-66-1441430423?cb=logged0.6283610163212693