Phillips 66 (NYSE:PSX) has become one of my favorite stocks to cover. Overall, I have always enjoyed covering the company because of its significant footprint in the refining and chemical industries.
However, in my last ITEMpublished on December 5th, I covered a major new development involving an activist investor, continuing with the title “60% Earnings Plus Dividends With Phillips 66 If Elliott Is Right.”
Here is part of my submission (emphasis added):
Since my November article on Phillips 66, Activist giant Elliott Investment Management has entered the scene with a $1 billion stake and a letter highlighted on the board.
Identifying key issues such as poor performance and operational errors, Elliott proposed a strategic adjustment. The company responded positively, welcoming the changes.
With a focus on cost reduction, sales and commitment to shareholder valuethe future of Phillips 66 looks promising.
Since December 5, the PSX has returned 14%, beating the S&P 500’s 10% return by more than a comfortable margin.
In this article, we’ll discuss the company’s recently released earnings and new developments that hint at promising value creation.
We’ll also discuss the current risk/reward, as the PSX yields just 3% after its recent rally, which could be a disadvantage for income-seeking investors – especially given that the energy sector is a source of yield often high.
So with all that in mind, let’s dive into the details!
Phillips 66 is poised for growth
In general, all eyes are on cost reduction, core assets and increased long-term return on capital.
This is what I wrote in my last article in light of the possibilities Elliott sees:
- It believes in the company’s target of $14 billion of mid-cycle EBITDA by 2025, with more than $1 billion of improvements from the refining segment, both through operating cost and commercial improvements.
- The company is selling $3 billion in non-core assets.
- The company is increasing its long-term capital return policy.
Having said that, financial results for the fourth quarter showed resilience despite challenging market conditions such as very weak manufacturing sentiment.
Adjusted earnings stood at $1.4 billion, or $3.09 per share. As we can see below, refining was the biggest driver of weakness on a quarter over quarter basis.
While this may seem like bad news, analysts were looking for a number that was $0.71 lower!
Additionally, despite capital expenditures totaling $634 million for the quarter, the company maintained a healthy balance sheet, with a net debt-to-equity ratio of 34% at the end of 2023.
Return on capital employed was reported at 16% for the year, indicating efficient use of resources.
Zooming in on cash a little, the company’s cash flow analysis for the fourth quarter highlights its prudent financial management.
Starting with a cash balance of $3.5 billion, cash from operations, excluding working capital, totaled $2.0 billion.
A working capital gain of $207 million was primarily attributable to a reduction in inventory, partially offset by movements in accounts receivable and accounts payable.
The company financed capital expenditures of $634 million, paid down about $100 million in debt and returned $1.6 billion to shareholders through share repurchases and dividends, resulting in a closing balance sheet of $3.3 billion.
So far, so good.
What matters more than these numbers is the transformation of the company’s business.
During the 4Q23 earnings call, the company explained that its business transformation efforts are geared toward reducing costs to support higher cash generation, which is essentially the core of what activists and shareholders ask for
By the end of 2023, the company had made significant progress in this direction, with a total of $1.2 billion in rate savings. This included $900 million from cost reductions and $300 million from sustainable capital efficiencies.
Notably, working capital, which historically averaged about $1 billion per year, increased by about $200 million due to consolidation of DCP Midstream.
Despite this growth, the company was able to reduce sustainable capital expenditures to below $900 million in 2023, resulting in a $300 million benefit reflected in the 2024 capital plan.
Adding to this, in light of the integration of DCP Midstream, the company noted that sustainable cash generation from the Midstream business has increased to a level that covers the company’s key capital priorities, including supporting capital funding and dividend.
Additionally, regarding capital expenditures, the company emphasized its disciplined approach to capital allocation, which has resulted in an average return on capital employed of 13% since its inception in 2012, nearly double the its cost of capital!
This approach ensures that capital is directed towards projects and initiatives that provide the highest returns, thereby maximizing shareholder value.
As I briefly mentioned, the company ended the year with a full year ROCE of 16%.
In terms of strategic priorities and achievements, the company provided an overview of its progress in implementing its plan to grow mid-cycle adjusted EBITDA and increase shareholder distributions.
The company aims to grow mid-cycle adjusted EBITDA by 40% to $14 billion by 2025, with a significant portion of that growth expected to come from the non-refining area.
Additionally, notable achievements include the distribution of $8.3 billion through share repurchases and dividends as of July 2022, with a target of $13 billion to $15 billion by the end of 2024.
The company also highlighted improvements in Refining’s operating performance, with crude oil utilization rates consistently above the industry average for four consecutive quarters.
Regarding its dividend, the company increased its dividend by 8.2% on February 8, 2023. Since then, the company has paid $1.05 per share quarterly, which translates to a yield of 2.9%, protected by a payout ratio of between Gamma -20%.
The five-year dividend CAGR is 12.8%.
Given the company’s ambitious shareholder distribution plans, investors remain in a fantastic place, which is why its dividend is much more attractive than it might seem.
Additionally, analysts expect the company to generate $6.0 billion in free cash flow this year, which translates to 9.6% of its $62.6 billion market cap.
This opens the door for aggressive acquisitions and sustained dividend growth in the high single to low double digits.
Because of the company’s promising growth rates, I believe it is fair to stick with the valuation I used in my previous article, which is based on Elliott’s estimate that PSX could generate approximately $9.0 billion in free cash flow in the middle of the cycle.
Using a 10% free cash flow yield (10x FCF multiple), the company has a fair market cap of $90 billion.
The current market cap is $62.6 billion, which implies roughly 44% upside from the current price and a price target of $209.
With that in mind, I believe that if the company is successful, the market will apply an 8-9% FCF yield estimate, which could pave the way for even more upside.
It should also be said that the market has finally recognized the company’s turnaround potential.
The chart below shows the ratio between the PSX share price and the VanEck Refinery ETF (CRACK). Including dividends, PSX has outperformed the CRAK ETF with increasing momentum since Elliott got involved.
- Over the past three months, PSX is up 30%, excluding its dividend.
- During this period, CRAK has grown by only 8%.
Going forward, I expect the strong performance to continue as I am confident in PSX’s ability to become a more efficient and profitable refinery player in the years to come.
Phillips 66’s strategic initiatives have strengthened financial resilience and shareholder value.
Despite market challenges, the company’s focus on cost reduction and efficient capital allocation has yielded impressive results.
With $1.2 billion in savings achieved and a strong long-term growth plan, including increased shareholder distributions and ambitious EBITDA targets, the company is well positioned for continued success.
Analysts predict strong free cash flow generation, supported by aggressive acquisitions and dividend growth.
With significant upside potential in the valuation, Phillips 66’s trajectory reflects a promising outlook for investors, underscoring its transformation into a more profitable player in the refining sector.
Pros and cons
- Strategic Transformation: PSX’s focus on cost reduction and efficient capital deployment has led to $1.2 billion in savings, increasing profitability.
- Strong finances: Despite market challenges, PSX maintains a healthy balance sheet, with a net debt-to-equity ratio of 34% and a solid return on capital employed of 16%.
- Shareholder value: The company’s commitment to increasing shareholder distributions, supported by dividend increases and aggressive returns, makes it an attractive investment option.
- Growth potential: With ambitious targets to grow mid-cycle adjusted EBITDA by 40% and strong free cash flow generation, PSX offers promising growth prospects.
- Market volatility: PSX operates in a volatile market prone to fluctuations in crude oil prices and refining margins, which may affect its financial performance.
- Dependence on refining developments (Big Picture): The company’s reliance on the refining segment exposes it to risks associated with this industry, such as regulatory changes and geopolitical developments.
- Assessment uncertainty: Despite promising growth rates, valuation uncertainty remains, with potential growth dependent on market sentiment and the execution of strategic initiatives.