Phillips 66 [PSX] was spun out of ConocoPhillips [COP] in April at $32 a share. It has three segments: oil-refining, chemicals, and midstream. The two nonrefining segments are worth roughly the current stock price, which is $31. The refinery business has sub-segments that, if recognized, would trade at much higher P/E ratios than the four to six times earnings refiners get today.
The chemicals division consists of Phillips' 50% share of a joint venture with Chevron [CVX] called CPChem. The JV makes ethylene and polyethylene from ethane and naphtha. It has a proprietary process that produces a higher-quality product at lower cost. It also licenses this technology to competitors. The business has an advantage in having 80% of its capacity in the U.S. because its main feedstock, ethane, is in oversupply. With increased production of natural gas and the build-out of fractionation plants to separate ethane and other liquids, the price has fallen dramatically. CPChem sells into the world market, where competitors are using higher-priced naphtha. It earns a healthy spread.
What does that mean for Phillips?
Phillips' 50% of PCChem could earn $1.30 a share this year. These earnings deserve to be valued at a 10 multiple, or $13 a share. The midstream segment owns and operates natural-gas processing facilities and fractionation plants, and a large and valuable natural-gas pipeline system. It also owns 50% of a master limited partnership. It should have free cash flow of $1.20 to $1.30 a share and about a dollar in earnings once it finishes up a couple of projects. It is worth 17 times free cash flow, or more than $20 a share.
So you get the refining business free?
Right. Refinery operations earned $4.17 a share in 2011 and could earn $3.75 in 2012. There are three segments. The specialty-marketing business, which operates gas stations, earns about $500 million after taxes. Then there is an extensive pipeline asset base separate from the midstream segment, which, if spun out into an MLP, could earn $400 million. Combined, these businesses earn about $1.40 a share and should have a trading value of $20. That leaves the basic refinery operation, which is over-earning.
How so?
Its midcontinent refineries use West Texas Intermediate oil as a feedstock, which is trading at a big discount to Brent crude, given the lack of capacity to move WTI out of Cushing, Okla., to the Gulf of Mexico. For at least a couple of years, until more pipelines are built, midcontinent refiners will have a big cost advantage. Then that will shift to the Gulf, benefitting Phillips' refineries there. The remainder of the refining business is worth at least $10 a share, and possibly much more. Add up the pieces and subtract $9 a share of debt, and you get a target price of $50 for Phillips.
One more thing: I liked Brian Rogers' line from the January Roundtable that "the world doesn't end that often." People get caught up in worrying about big-picture things, but when valuations are cheap and the world population is growing, companies with good assets and low-cost production advantages, like Gildan and Phillips 66, will do well. Perhaps they will get cheaper, but you want to buy when you see a good price, not when you have perfect economic certainty.
Good advice. Thanks, Meryl.
