You May Not Want To Follow Buffett Out Of Phillips 66

February 19, 2018 6:00 am

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Over the past couple of days, Berkshire Hathaway (BRK.A) (BRK.B) surprised investors with a number of developments. Between increasing its stake in Apple (AAPL) by 23.3%, dumping nearly all of its shares in International Business Machines (IBM), and buying $ 358 million worth of Teva Pharmaceutical Industries (TEVA), there’s a lot to discuss, but as an investor heavily involved in the energy space, what drew me most was Warren Buffett’s decision to part ways with a sizable stake in Phillips 66 (PSX). With shares having risen and Buffett reducing his company’s ownership in the refinery and energy wholesaler by nearly half, investors might think that now is the time to bail on Phillips, but the picture isn’t quite that simple. Despite Buffett’s move away from the firm, there could still be attractive upside for investors over the long haul.

A look at the deal

Berkshire first reported a large stake in Phillips, from what I could trace back, to September of 2014 when the firm stated in a Form SC 13G that it owned 57.98 million shares, or roughly 10.8% of the business’ outstanding stock. In February of 2016, Berkshire increased its stake in the firm by 3.51 million shares, representing 11.5% of Phillips’ outstanding units, and in February of 2017 it announced the addition of a further 19.20 million shares. This brought Berkshire’s total ownership in Phillips to 80.69 million shares, or about 15.5% of the shares outstanding at the time. Due to corporate decisions within Phillips that led to a reduction in share count, Berkshire’s stake eventually rose to 16.1%.

*Taken from Phillips 66

Over the past several years, the management team at Phillips has done well to allocate its capital toward growth endeavors. As you can see in the image above, the firm, between 2013 and 2017, spent approximately $ 16 billion toward capital expenditures. It should be noted that some of this was not from Phillips itself, but instead from Phillips 66 Partners (PSXP). In 2018, the company expects consolidated capex to be around $ 2.3 billion, up from last year’s $ 1.8 billion. Now, in the image below, you can see how cumulative distributions have changed over time.

*Taken from Phillips 66

During the same few years ending in 2017, management spent $ 16.4 billion toward distributions to shareholders (which includes buybacks mostly, but also dividends). This means that just over half of spending was put toward its distributions. In the three years ending in 2017, though, we saw a bit of a change. While the longer timeframe looked at involved a similar reinvestment into the business as what was paid out in the form of distributions, the past three years have seen a 60/40 split in favor of reinvestment.

The end result has been positive for shareholders. As Phillips saw its distribution grow from $ 1.33 per share to $ 2.73 per share during this timeframe, shares have soared. Since Berkshire reported its 10.8% stake in the firm in 2015, shares of the business have skyrocketed 30.2%. Most of this growth, accounting for appreciation for units of 21.1%, has come in just over the past 12 months as energy markets have rebounded and as the stock market has jumped.

Likely to realize some of this value, Berkshire was able to strike a deal with Phillips wherein Phillips could make a single, large transaction in order to reduce share count. The end result was the agreement that, in exchange for 35 million shares, priced at a modest premium from February 15th’s closing price, Berkshire would receive a cash payment of $ 3.3 billion. This translates into a per-share purchase price on the stock of $ 93.725.

Following this move, Berkshire will still own an impressive 45.7 million shares, valued at approximately $ 4.24 billion. Given the number of Phillips shares currently outstanding, 501.5 million, and the retirement of the 35 million units the firm is acquiring, Berkshire’s ownership in the business will shrink to 9.8%.

This is not a sign to sell

It’s legitimate to believe that Buffett has partially cashed out to benefit from the upside experienced in Phillips’ shares over the past few years. However, this doesn’t mean that owning a stake in the business is now a bad idea. If anything, now might be an attractive time to consider buying into the business. To illustrate why, all I need to do is point you to the chart below.

*Created by Author. Note: $ are in Millions

As you can see, net income and operating cash flow generated by Phillips has done well in recent years. Yes, due to fluctuations in various parts of its business, such as margins tied to the 3:2:1 crack spread, the business’ profits and cash flows have been volatile. However, in the five years starting with 2013 and ending in 2017, cumulative net income for the firm totaled $ 19.38 billion, and operating cash flow totaled $ 21.88 billion. Due in part to increased borrowings in order to fuel growth, the firm’s book value of equity (including Phillips 66 Partners) has expanded 22.5% from $ 22.39 billion to $ 27.43 billion as well.

Using 2017’s figures, shares in Phillips look quite attractive compared to the broader market. Assuming that shares remain unchanged in price following the completion of the stock purchase from Berkshire, 2017’s operating cash flow of $ 3.65 billion places a price/operating cash flow multiple on the business of 11.9 on it. Using the five-year average operating cash flow, the multiple stands slightly lower at 11.2. If, instead, we use 2017’s net income of $ 5.11 billion, the multiple on the business is 8.5, or 9.9 using the five-year average earnings. At these levels, I wouldn’t call Phillips a deep value play by any measure, but it’s certainly low enough to draw my attention.

Buffett seems to understand the business’ potential, probably better than anybody on this planet. In a statement regarding the transaction, he said the following: “Phillips 66 is a great company with a diversified downstream portfolio and a strong management team. This transaction was solely motivated by our desire to eliminate the regulatory requirements that come with ownership levels above 10 percent. We remain one of Phillips 66’s largest shareholders and plan to continue to hold the stock for the long term.”

This doesn’t mean, though, that owning shares in Phillips will be smooth sailing. As you can see in the image below, there are a lot of moving parts that can affect the profitability of the business in any given year. In particular, even a $ 1 change per barrel in gasoline margins would affect income by $ 260 million for 2018, while an identical change in distillate margins would impact results by $ 230 million. Seeing the volatility experienced in energy markets since 2014, it’s impossible to know what kind of profits and cash flow will be generated by the firm this year, let alone over the long run. However, with a strong, solid asset base, and a history of attractive performance, results should even out over any long period of time.

*Taken from Phillips 66

Takeaway

Warren Buffett’s decision to divest of nearly half of Berkshire’s stake in Phillips is not unreasonable. Given the huge run-up in share price, combined with the reduced regulatory burden Berkshire will have to deal with, it’s okay to take some cash off the table. What matters is that Berkshire continues to own a sizable chunk of Phillips and, absent a deterioration in the business, intends to keep it that way. With how affordable shares are, this could also be an attractive time for investors who don’t currently own any of the business to consider a stake as well.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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