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
captureSource: 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.

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.

[ad#Google Adsense 336×280-IA]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.

captureHowever, 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.

captureSimply 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.

captureSpecifically, 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.

captureUnder 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.

captureAnother 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.

[ad#Google Adsense 336×280-IA]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 flow away from this more volatile industry, refining will continue to be the dominant swing player in the company’s earnings for quite some time.

The second risk stems from the business model of Phillips 66 Partners. Being an MLP, it pays out the majority of its DCF to investors, including Phillips 66. However, that means that it needs to constantly be tapping external debt and equity markets for the majority of its growth capital.

Since Phillips 66 is counting on PSXP to buy its midstream assets, including the billions in new midstream assets it’s currently constructing, there is a risk that fickle investors may lose their taste for midstream MLPs. This is what happened to many partnerships during the darkest days of the oil crisis.

If PSXP finds itself cut off from equity markets due to an irrationally low unit price, then it might find itself unable to buy all of the midstream assets that Phillips 66 is looking to sell it.

This in turn might force management to slow the pace of its midstream growth ambitions; hurting its forward cash flow, dividend growth potential, and valuation.

A major decline in North American energy production would not be good for the company’s midstream growth plans either.

Investors can read more about the risks of investing in MLPs here.

Dividend Safety Analysis: Phillips 66
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. Phillips 66’s dividend and fundamental data charts can all be seen here.

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

captureWe wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their track record has been, and how to use them for your portfolio here.

Phillips 66’s Dividend Safety Score is 48, which indicates that the safety of its current dividend payment is about average.

The company’s payout ratio has increased since it started paying dividends in 2012.

captureThanks to the most recent poor performance from its refining segment, the trailing 12-month EPS payout ratio has increased to 41%, which still provides a nice safety cushion for the payout despite the cyclicality of the refining industry.

captureInvestors can further take heart that the upcoming quarters may see refining margins improve, thanks to refiners cutting back on capacity in face of the gasoline glut, and its commensurate lower margins.

Another protective backstop for the dividend is the company’s strong balance sheet, which holds $2.2 billion in cash. That alone is enough to pay the current dividend cost for nearly two years.

The company’s total debt load could also be covered using cash on hand and less than 1.5 years’ worth of earnings before interest and taxes (EBIT).

It’s no wonder why Phillips 66 maintains investment-grade credit ratings from S&P (BBB+) and Moody’s (A3). These ratings help keep borrowing costs low, reducing the refiner’s cost of capital and helping keep profitability high.

With over $7 billion of available liquidity as well, the company is in a good position to execute on its growth projects while continuing to pay dividends.

captureThe company’s conservative management has been extremely careful to ensure that Phillips 66 doesn’t take on an excessive amount of debt.

Given the volatile nature of the refining business this is very good news for investors, as is the fact that the company can easily service its interest payments even in today’s difficult refining environment.

Phillips 66’s Dividend Safety Score is primarily being lowered by recent business results. As I mentioned above, the slip in refining margins is hurting growth.

The company’s sales have declined by at least 20% year-over-year for six straight quarters, and future commodity trends are very difficult to forecast.

captureOverall, Phillips 66’s dividend payment looks quite safe today. The company’s strong balance sheet should help it weather the current energy storm while providing flexibility to continue returning capital to shareholders and investing for growth. PSX’s payout ratio also looks reasonable, and the company’s strong returns on invested capital highlight its underlying quality.

Dividend Growth Analysis
Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

Phillips 66’s Dividend Growth Score of 28 suggests that the company’s dividend growth rate could slow over the near term.

The company has increased its dividend six times since its formation in 2012 with a 33% compound annual growth rate. The most recent dividend increase was a 12.5% raise earlier this year.

However, slumping earnings and the most recent low refining margins will likely weigh on dividend growth over the next year or so.

Of course, recent trends shouldn’t be extrapolated far out into the future.

Personally, I expect closer to 6% to 7% annual dividend growth over the next 10 years, due to Phillips 66’s continued aggressive push into the higher margin midstream and chemical industries.

For example, in the second half of 2017 Phillips 66 is scheduled to bring online two chemical plants capable of producing 2.5 million metric tons per year of ethylene and polyethylene. These alone are expected to boost the company’s EBITDA by $1 billion, or 16.7%.

captureSimilarly, between 2016 and 2018, management expects another $1.3 billion, or 21.7% EBITDA growth, to come from its growing midstream business. All told, Phillips 66 is expecting 38% EBITDA growth (an 11.4% CAGR) just from these two business segments.

Using a conservative, likely, and optimistic 4%, 5%, and 6% 10-year EPS CAGR that I expect to result from further long-term growth in these businesses, as well as a 50% payout ratio that the more stable cash flows should be able to support, a forecast calling for at least mid-single digit dividend growth appears reasonable:

captureIn fact, there’s a decent chance that Phillips 66 will be able to beat even my optimistic growth assumptions, thanks to the fast rate at which management has been buying back shares, reducing its share count, boosting EPS, and reducing the cost of the dividend.

Now obviously, with refining margins down so severely at the moment and resulting in far less cash flow than in previous years, I don’t expect the pace of future share reductions to match the 4.3% CAGR achieved over the past four years.

captureHowever, given that management has shown itself to be extremely shareholder friendly, as seen in its generous capital return program thus far, I expect that we may see ongoing 1% to 2% CAGR reductions in shares via ongoing buybacks over the coming years. That’s especially true given that Phillips 66 is potentially undervalued relative to its long-term growth potential.

All of these factors suggest that mid-single digit earnings and dividend growth is attainable over the long run, which helps the stock’s total return potential.

Valuation
Given Berkshire Hathaway’s activity in the stock, it goes without saying that some of the brightest investors in the world see value in PSX at today’s price.

Phillips 66’s current valuation multiples are distorted because its earnings and cash flow are being suppressed by low refining margins, which are cyclical.

Because the company is also focusing so much on its more stable and higher-margin midstream and chemical segments, we need to look further out to get a better sense of PSX’s value. Based on analysts’ earnings per share estimates for 2016, 2017, and 2018, PSX trades at forward-looking price-to-earnings (P/E) multiples of 23.2, 13.8, and 12.1, respectively.

Refining companies don’t command very high P/E multiples because their profits are cyclical and they generally don’t earn a great return on invested capital. For example, Valero’s five-year average P/E multiple is just under 10.

The market seems to be giving PSX some credit for its midstream growth plans, but I think it’s hard to argue that the stock is overvalued today, especially if management executes. PSX also earns a higher return on invested capital than its peers and should enjoy more stable profits as its mix becomes more midstream-oriented.

If PSX can deliver mid-single digit earnings growth, which doesn’t seem unreasonable given the company’s growth projects and share repurchases discussed above, the stock appears to offer annual total return potential of 7-10% (3.2% dividend yield plus 4-7% earnings growth).

Conclusion
Phillips 66 represents a seemingly undervalued, best-in-breed refiner whose growing diversification means solid dividend safety and strong growth potential for years to come.

With that said, you should never simply buy a stock because a famous money manager is doing so. However, when it comes to the most successful investor in history, Buffett’s recent huge investments into Phillips 66 certainly means it’s worth doing your research into whether or not the Oracle of Omaha is onto something.

When you dig down into the company’s business model, future growth plans, management team, and balance sheet, you find an extremely well-run business with several competitive advantages that is likely to see larger and more stable cash flow in the coming years.

That in turn should mean nice dividend growth on top of an already generous and secure payout. Investors with a long time horizon and an appetite to gain some exposure to the beaten-down energy sector without taking on undue risk should consider giving Phillips 66 a closer look.

Brian Bollinger
Simply Safe Dividends

Simply Safe Dividends provides a monthly newsletter and a comprehensive, easy-to-use suite of online research tools to help dividend investors increase current income, make better investment decisions, and avoid risk. Whether you are looking to find safe dividend stocks for retirement, track your dividend portfolio’s income, or receive guidance on potential stocks to buy, Simply Safe Dividends has you covered. Our service is rooted in integrity and filled with objective analysis. We are your one-stop shop for safe dividend investing. Brian Bollinger, CPA, runs Simply Safe Dividends and previously worked as an equity research analyst at a multibillion-dollar investment firm. Check us out today, with your free 10-day trial (no credit card required).

Source: Simply Safe Dividends