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Phillips 66 (PSX): Warren Buffett’s New Favorite Dividend Growth Stock

Warren Buffett is history’s greatest investor, and so when his company, Berkshire Hathaway Inc (NYSE: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 (NYSE: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.

Warren Buffett
Warren Buffett
Berkshire Hathaway

Business Description

Phillips 66 PSX Dividend

Source: Phillips 66 Investor Presentation (1)

Phillips 66 was spun off from ConocoPhillips (NYSE:COP) 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 (2).

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 (3).

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.

Business Segment YTD 2016 Net Income % Of Net Income Contributed
Refining $235 million 26.7%
Midstream $104 million 11.8%
Chemical $346 million 39.3%
Marketing $434 million 49.3%
Corporate Costs -$238 million -27.0%
Total $881 million 100%

Source: Company 10-Q

However, 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.

Phillips 66 PSX Dividend

Source: Phillips 66

Simply put, midstream operations are the key to Phillips 66’s cash flow and future dividend growth.

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