Phillips 66 Shareholders Can Sit Back and Enjoy the Ride

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As a long time Conoco Phillips (NYSE: COP) shareholder I was not exactly thrilled with the idea to spin off Phillips 66 (NYSE: PSX).  I wasn’t really sure if two would be better than one and I especially wasn’t too interested in owning the refinery business being spun off.  However, as I dug deeper into the assets I’d own in the newly spun off company came away impressed by the future of their chemical business.  When I added up the refining and midstream businesses to the chemical business I thought it would be an equation for success. 

While it is still early, I have to admit I’m very glad I kept my shares of Phillips 66.  It certainly doesn’t hurt that shares are up nearly 38% since the spin off nor is there any reason to complain about their recently announced 25% dividend boost.  The company also received a very high profile stamp of approval after Berkshire Hathaway (NYSE: BRK-B) added to their position in the company above what they received in the spinoff.  Warren Buffett who’s known for wanting to own great businesses now holds a five percent stake in the company. 

Warren Buffett’s a big fan of investing in firms with high returns on invested capital, or compounding machines as he calls them.  All three of Phillips 66’s business segments are earning double digit returns on capital this year with both the chemical and midstream businesses generating a thirty percent return.  The refining and marketing segment is the outlier here generating a seventeen percent return, which is about average for their industry this year.

The portfolio is currently weighted well towards the R&M segment at 83% of their assets and another 13% is the chemicals business and the final 4% is midstream.  They have a plan to slowly shift to a more balanced mix of 50% R&M and 25% each for chemicals and midstream.  To do this they’ll sell off some non-core refining assets and drive some of that cash towards these higher return businesses.  A bulk of the capital shift is already taking place thanks to their heavy investments in both midstream and chemicals. 

Their midstream business, DCP Midstream, is fifty percent owned by Spectra (NYSE: SE) and they’re executing on $4 to $6 billion worth of growth projects that will come online by 2014.  They’re adding more than 400 MBD of NGL logistics capacity as well as increasing their gathering and processing capacity in the liquids rich basins of the Gulf Coast. With returns on capital employed of thirty percent, these assets will surely fuel the growth of the bottom line at both companies.  These high return projects are something that Spectra investors aren't used to as they've just averaged a 6.7% return on investment the past five years.  Meanwhile, the size of these growth projects is more than enough to make a difference for both as Spectra which has a $19.6 billion in market cap and Phillips 66 at $29.3 billion mean that the capital invested represents 15% of Spectra's market cap and up to 10% of Phillips.  As you can see these projects will matter.

In chemicals they own fifty percent of a joint venture with Chevron (NYSE: CVX) called CP Chem.  They’re investing heavily in the US Gulf Coast with an NGL fractionation expansion coming online next year, a 1-hexene plant in 2014 and an ethane cracker and ethylene derivative complex to be completed in 2017.  As these high return projects come online Phillips 66 will have more capital that can be reinvested in growth, used to reduce the debt or be returned to shareholders in the form of dividends and share buybacks.  All things that we shareholders like to see happen.  For Chevron, they're unlikely to matter that much for a $231 billion company that already sees 19% returns on their average investment.  Like the Conoco before the separation, their investment in CP Chem just doesn't move the needle like it will for Phillips 66 going forward.

The biggest benefit I see from separating these assets from Conoco's core E&P business is that it has freed them up from having to compete for capital with the much larger E&P business.  This has given management the opportunity to focus on high return projects that wouldn’t have been needle moving projects for a mammoth E&P company.  I continue to like what I see from Phillips 66 and plan on sticking around for the ride higher as these and other projects continue to deliver excellent returns.  It’s easy to understand why Berkshire has been buying as this compounding machine has just begun its journey.

latimerburned owns shares of Phillips 66 and ConocoPhillips and has an options position on Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway. Motley Fool newsletter services recommend Berkshire Hathaway, Chevron, and Spectra Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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