New Morningstar Analyst Report for Phillips 66

By: |05-02-2012 | Source:Morningstar
New Morningstar Analyst Report for Phillips 66 5/2/2012 2:42:00 PM 5/2/2012 2:45:00 PM Allen Good, CFA allen.good@morningstar.com +1 312 384-3867 Allen Good, CFA Senior Stock Analyst Allen Good is a senior stock analyst covering the oil and gas industries. Allen Good is a senior stock analyst covering the oil and gas industries. Prior to joining Morningstar in 2008, he performed M&A advisory work for a middle market investment bank. He holds an MBA from the University of North Carolina Kenan-Flagler Business School. Prior to receiving his MBA, Allen spent five years with Black & Decker in various operations management roles. He also holds a bachelor's degree in logistics and transportation from the University of Tennessee. Good earned the CFA designation in 2012. RRC, UPL, RIG, WLL, ADM, Phillips 66 Phillips 66 Phillips 66's near-term fate will largely be determined by the performance of its refining and marketing segment, which contributes the bulk of earnings and has the most invested capital. Refining margins could be at the high point of the cycle, implying greater future earnings risk. The U.S. and Europe remain oversupplied, potentially putting pressure on margins until additional rationalization occurs. Phillips 66 could see capital expenditures rise as it is forced to meet environmental regulations for its refineries in California. Improvement initiatives--divesting underperforming assets, increasing cost-advantaged feedstock processing and increasing exports--should eventually improve Phillips 66's competitive position. The four Mid-Continent refineries with 21% of total capacity are some of the company's best positioned given their access to discount domestic and Canadian crudes. Chemical and midstream assets boast higher returns than refining, add earnings stability, and differentiate the company from its peers. Phillips 66 should be able to grow its attractive dividend while returning excess cash to shareholders through share repurchases. Placing Phillips 66's non-DCP midstream assets into an MLP could boost their value. <p>With an initial cash balance of $2 billion and debt of $8 billion Phillips 66 is well capitalized. Its debt/capital ratio is in line with peers at less than 30%. We project operating cash flow should be more sufficient to cover capital expenditures.</p> <p>Greg Garland, who last served as senior vice president E&amp;P, Americas, will head Phillips 66 as chairman and CEO. He previously held the role of president of CPChem, which should serve him well in his current role. In total, Garland has been with ConocoPhillips and affiliated companies for 31 years. </p> <p>Garland's strategy of emphasizing chemicals and midstream while trying to high-grade the refining portfolio seems like the right course. The refining industry is sure to be in for a bumpy ride in the coming years and limiting Phillips 66 to that volatility will likely benefit shareholders. Early plans to direct capital toward the higher-return midstream and chemicals should result in a an overall higher-return, diversified portfolio in five years.</p> <p>Additionally, management appears focused on shareholder return. The initial dividend yield places Phillips 66 near the top of its peer group. Meanwhile, share repurchases are likely outlet for excess cash. With chemicals and midstream self-funding and refining capital expenditure likely well below operating cash flow, Philips 66 should have plenty of room to grow the dividend and ample cushion to continue payments in the event of a refining downturn. </p> <p>Phillips 66 is an independent refiner with 15 refineries with a total throughput capacity of 2,485 m/d.  Its DCP midstream joint venture holds 61 natural gas processing facilities, 12 NGL fractionation plants, and a natural gas pipeline system with 62,000 miles of pipeline. Its CPChem chemical joint venture operates facilities in the United States and the Middle East, and primarily produces olefins and polyolefins.</p> <p>Success in refining is primarily a function of the difference in the amount the refiner pays for oil and the amount at which it sells the refined product. As such, the short- and long-term risks depend on movements in the prices of crude oil and gasoline. Supply interruptions or increased demand that drive up oil prices, as well as demand destruction or economic slowdowns that depress gas prices, are the primary risks. Any extended turnaround or shutdown because of an accident or weather will also damage financial performance.</p> <p>While primarily an independent refiner, Phillips 66 also holds interests in chemical and midstream assets that boast higher returns, add earnings stability, and differentiate the company from its peers. Despite the attractiveness of these non-refining assets, Phillips 66's near-term fate will largely be determined by the performance of its refining and marketing segment, which contributes the bulk of earnings and has the most invested capital. To Phillips 66's benefit, the refining segment is currently producing strong earnings thanks to a relatively healthy operating environment. While we expect conditions to moderate and earnings to return to midcycle levels, Phillips 66 is in the process of divesting underperforming assets on the East Coast and Gulf Coast and initiating improvement plans which should bolster its overall competitive position. </p> <p>Overall, we think the return improvement initiatives--divesting underperforming assets, increasing cost-advantaged feedstock processing, and increasing exports--should eventually improve Phillips 66's competitive position. As it stands now, we view its assets as a mixed bag. Its Mid-Continent refineries are some of the company's best positioned given their access to discount domestic and Canadian crudes. The three Gulf Coast facilities currently constitute the largest concentration of the company's refining capacity, but will become a smaller portion with the divestment of Alliance. These facilities are some of the most attractive in the portfolio given their size and complexity, however, they have suffered with the relatively high waterborne crude prices and narrow heavy differentials. Adding export capability, and eventual flow of Canadian heavy barrels to the Gulf Coast, should improve the facilities' performance. </p> <p>Meanwhile, two refineries in California are the most complex, but face higher costs and environmental regulation, which lower their value. Efforts to boost cost-advantaged feedstock should help, but in the short term a weak economy, and in the long term regulatory capital spending, will prove to be headwinds. On the East Coast, the company's remaining refinery is low complexity and relies on high-cost imported oil for feedstock while competing with lower-cost imports from the Gulf Coast and foreign refiners. Eventual sale or closure would further high-grade the portfolio and though management has indicated additional asset rationalization may be necessary, they have not mentioned specific facilities. </p> <p>The two European refineries face similar competitive pressures and could also be candidates for divestiture. However, the Humber refinery is the only coking refinery in the U.K. and is the world's largest producer of specialty graphite cokes, while Whitegate is Ireland's only refinery. As a result, the two refineries do posses some competitive advantages. Given the economic weakness in Europe and an overall secular decline in refined product demand, we expect a challenging operating environment to persist.  </p> <p>The size of Phillips 66's midstream segment differentiates it from its independent refining peers who do not hold a comparable amount (or quality) of assets. Phillips 66 primarily conducts its midstream activities through its 50% ownership in DCP midstream, a joint venture with Spectra Energy SE. DCP owns or operates 61 natural gas processing facilities and 12 NGL fractionation plants and owns a natural gas pipeline system with 62,000 miles of pipeline. Phillips 66 also holds midstream assets outside of the DCP structure, including a 25% interest in the REX pipeline and interest in several other fractionation plants. As a result, Phillips 66 is one of the larger gatherers and processors of natural gas and one of the largest producers of NGLs in the United States. Consequently, Phillips 66's midstream earnings are largely tied to the price of NGL, which typically track crude oil prices. </p> <p>Phillips 66 holds its chemical assets in CPChem as a 50/50 joint venture with Chevron CVX. CPChem primarily produces olefins and polyolefins that are used as building blocks for other chemicals, plastics, and fibers. Production capacity is primarily concentrated in the U.S. (80%) and the Middle East, where CPChem can take advantage of low-cost feedstock like ethane. Growth projects are focused in these two regions to take advantage of the anticipated growth in NGL production. The chemicals segment marks another area where Phillips 66 differs from its peers, though like the midstream segment, investors may not properly credit the company for it. However, like the midstream assets, the chemical assets will provide significant earnings contribution and lessen dependence on refining margins, resulting in steadier earnings and cash flow relative to peers. </p> <p>Our DCF-based valuation results in a value for Phillips 66 of $34 per share or 4.5 times our 2012 EBITDA forecast of $6.2 billion and 4.4 times our 2013 EBITDA forecast of $6.3 billion. In our model, we assume currently strong margins persist through 2013 thanks to a continuation of the WTI discount, an improving economy, and a robust export market, all of which should benefit Phillips 66 directly or indirectly. Any change in these assumptions, particularly the WTI discounts and the economic conditions, would threaten our valuation. Long term, we assume a return to midcycle margins, specifically in the Mid-Continent, as a result of planned pipeline capacity. This should significantly reduce the current WTI discount. </p> <p>We think Phillips 66's planned improvement projects and closure or sale of underperforming facilities should result in better companywide midcycle margins relative to historical levels. Continued low natural gas prices should keep operating expenses from rising significantly. Considering the notorious volatility of refining margins and that the refining segment contributes the bulk of Phillips 66's earnings, we assign the company an uncertainty rating of very high. </p> <p>For the midstream segment, we anticipate earnings to grow over our forecast period.  Higher oil prices and growth projects should support earnings, though lower oil prices could pose a threat to our estimates. We expect volume growth thanks to DCP expansion projects like Sand Hills and Southern Hills. We think the midstream segment would likely garner a higher valuation as an independent entity than it would as part of Philips 66. As a result, we think management will eventually push forward with an MLP structure for Phillips 66's non-DCP midstream and transportation and logistics assets. </p> <p>For the chemicals segment, we forecast continued earnings growth for the next few years as the global economy recovers and volumes rise with the startup of additional capacity at Cedar Bayou Chemical Complex. CPChem should also benefit in the near term from low-cost sources of feedstock in the United States. However, earnings moderate toward the end of our forecast as we assume a return to midcycle levels. Beyond our forecast period, though, CPChem should benefit from continued capacity additions in the U.S. and the Middle East. </p> -1 Large chemicals and midstream operations set PSX apart from its peers. <p>While primarily an independent refiner, Phillips 66 also holds interests in chemical and midstream assets that boast higher returns, add earnings stability, and differentiate the company from its peers. Despite the attractiveness of these non-refining assets, though, Phillips 66's near-term fate will largely be determined by the performance of its refining and marketing segment that contributes the bulk of earnings and has the most invested capital. However, Phillips 66 is in the process of divesting underperforming assets and initiating improvement plans that should bolster its overall competitive position. At the same time, invested capital will decline in the refining segment and grow in the midstream and chemicals segments, allowing those segments to become larger contributors of companywide performance. </p> We value Phillips 66 at $34 per share or 4.5 times our 2012 EBITDA estimate of $6.2 billion and 4.4 times our 2013 EBITDA estimate of $6.3 billion. Midstream assets that gather and process NGLs and produce NGLs result in earnings tied to oil prices. Development of domestic unconventional resources offer ample opportunity for future growth projects. With forecast strong free cash flow, Phillips 66 should be able to grow its attractive dividend while returning excess cash to shareholders through share repurchases. <p>For our scenario analysis, we vary our forecasts two different ways to identify potential valuations for Phillips 66, and capture the volatility of refining margins. First, we change our long-term refining margin forecasts in our DCF valuation based on historical ranges. This analysis often produces extreme valuations, but considering that we are assuming the unlikely scenario that cyclically high or low price persists indefinitely, we find it a useful exercise to identify when markets are discounting unreasonable expectations. Second, we vary our short-term margin forecasts to derive potential valuations using a multiple of our 2013 EBITDA estimate. </p> <p>In our high-case scenario, we assume long-term refining margins remain at currently elevated levels or rise to historically high levels, depending on the region, in our DCF forecast. Working under this assumption, we value Phillips 66 at approximately $59 per share. We also apply a high-case scenario to our 2013 refining margin assumptions, in which we increase our current forecast by 20%. In this case, we estimate 2013 EBITDA of $8.1 billion. Using DCF implied multiple of 4.4 times, Phillips 66 could trade at $46 per share.   </p> <p>In our low-case scenario, we assume long-term refining margins sink to the lower levels reached at the bottom of the cycle in late 2009-early 2010. Using these lower refining margins in our DCF forecast, we value Phillips 66 at approximately $19 per share. We also apply a low-case scenario to our 2013 refining margin assumptions, in which we decrease our current forecast by 20%. In this case, we estimate 2013 EBITDA of $4.6 billion. Using DCF implied multiple of 4.4 times, Phillips 66 could trade at $22 per share.</p> <p>While Phillips 66 holds a greater amount of moatworthy assets--chemicals and midstream--than its peers, we do not think they contribute a large enough portion to justify an economic moat. Given the industry's competitive dynamics, we do not consider refining to have a moat. Independent refiners have little control of the prices of its two primary production inputs: oil and natural gas. They produce neither of these, nor do they have much control over pricing. Additionally, refiners have little influence as to what they can charge for their production. As a result, refiners' profits can be negatively affected when markets do not value a barrel of refined product as highly as a barrel of crude oil. In recent years, this has often been the case as oil prices, set at a global level, soared while refined products priced regionally lagged. While recent dislocations in price (for example, WTI/Brent spread) have created margin enhancement opportunities, these effects are ephemeral in nature and unsustainable. </p> <p>Furthermore, while refiners used to enjoy some benefit from high barriers to entry and lack of threat of substitutes, both these advantages are eroding. While regulatory hurdles and high costs conspire to prevent the construction of a new refinery in the U.S., refining capacity has still grown as refiners de-bottleneck and expand existing facilities. At the same time, international construction remains robust. Also, while gasoline and diesel continue to dominate the market for transportation fuels, biofuel usage is expanding. Meanwhile, improved fuel efficiency and adoption of hybrids are reducing overall demand. As a result, the U.S. refining market is oversupplied, resulting in closure of lower quality refineries. </p> <p>Refiners can have some competitive advantages relative to peers, that can somewhat blunt the impact of market forces. These advantages include the ability to process heavy, sour cost advantaged crudes, access to cost advantaged feedstock or access to protected markets that offer premium margins. Phillips 66 does hold the first two advantages thanks to its high complexity facilities on the Gulf Coast and its Mid-Continent refineries. However, these advantages have failed to consistently deliver excess returns as they only allow Phillips 66 to capitalize on favorable market conditions, which are volatile. As a result, Phillips 66 fails to deliver excess returns over the cycle</p> <p>We also assign Phillips 66 a negative moat trend despite some initiatives that should improve companywide returns. We think the industrywide headwinds facing the refiners, such as declining demand and oversupply, will continue to pressure returns and margins. Also, as less competitive, higher-cost facilities close in the wake of reduced margins, support for higher margins will be removed. Meanwhile, existing facilities will likely find themselves at the higher end of the cost curve. Furthermore, Phillips 66 asset rationalization efforts will likely result in additional facility closures or sales at unattractive valuations. These effects should outweigh the company's attempt to shift capital toward higher returns segments. However, if Phillips 66 is able achieve its goal of 50% of capital employed in chemicals and marketing quicker than we anticipate, enabling those segments to be the primary driver of returns, then we would revisit our moat and moat trend ratings. Also, if portfolio rationalization is greater than we currently estimate or at attractive valuations, then our moat ratings may be reconsidered. We could also revisit our ratings if current market conditions (for example, discount Mid-Con crudes) become structural, exports support higher margins, or rationalization of U.S. refining capacity results in permanently tighter market conditions.   </p> <p>With modest capital expenditure plans (about $1.5 billion per year with sustaining capital at $1 billion) and the chemicals and midstream segments self-funding, we anticipate Phillips 66 should generate significant free cash flow. The free cash flow should go toward shareholder returns as debt repayment remains a relatively low priority given the company's low cost of debt and target debt/capital ratio of 25%-30%. With a dividend of $0.80 per share and an implied yield of 2.2%, Phillips 66 compares favorably with peers. The relatively low capital spending and strong cash flow generation should ensure the dividend remains intact in the event of a drop in refining margins while allowing management to grow it at about 5% per year. In contrast, peers who are solely reliant on refining may have to cut their dividend if conditions deteriorate. Meanwhile, share repurchases will be the preferred mechanism to return excess cash to shareholders when the refining environment is particularly strong.</p> We think the return improvement initiatives should eventually improve Phillips 66's competitive position. /im/dot_clear.gif /im/dot_clear.gif