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%.
Source: Phillips 66 Investor Presentation
Similarly, 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:
| 10 Year EPS Growth Rate | 2025 Projected EPS | 2025 Projected Dividend | 10 Year Dividend CAGR |
| 4% | $8.51 | $4.26 | 5.4% |
| 5% | $9.37 | $4.69 | 6.4% |
| 6% | $10.30 | $5.15 | 7.4% |
Source: Simply Safe Dividends
In 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.
Source: Phillips 66 Investor Presentation
However, 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.
Additional Links
(1) http://s1.q4cdn.com/175206842/files/doc_presentations/2016/Sept/Investor-Update_September-2016-for-posting.pdf
(2) http://netrightdaily.com/2012/10/north-dakota-to-build-first-u-s-oil-refinery-in-30-years/
(3) http://investor.phillips66.com/investors/news/news-release-details/2016/Phillips-66-Reports-Second-Quarter-Earnings-of-496-Million-or-093-Per-Share/default.aspx
