A Value Play in Oil and Gas

Piyush is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Oil-and-gas refiners benefit not only from high crude oil prices, but also from higher demand for refined petroleum products. Since Brent crude has been hovering at around the $110 mark, and US industrial production is rising, almost all major refiners in the US have had a profitable ride over the last year. This makes value picking in the industry difficult, but not impossible.

Since last year's initial public offering, shares of Phillips 66 (NYSE: PSX) have appreciated nearly 90% and I believe that significant upside is still in store.

Investors' delight

Phillips 66 has a share buyback program worth $2 billion underway, and the company repurchased $245 million worth of shares in the most recent quarter. Management expects to repurchase $1 billion worth of share in FY13, which should reduce the dividend burden by nearly 2.4%. Moreover, the company boosted its annual dividend by 25% and at the CMP, its share yield is 1.85% with a modest 9.86% payout ratio.

During the quarter, Phillips 66 returned $400 million to its shareholders through repurchase programs and dividends. Such activities not only bolster EPS performance, but also highlight the faith and confidence of the board in its company’s future.

Improving balance sheet

Last year, Phillips 66 repaid $1 billion in debt, reducing its overall leverage to $7 billion. Its debt-to-cap has slid to 25% while its debt/equity ratio is down to just 34% from 42% last year.

Further, its cash balance stands at a hefty $3.5 billion, and its net debt-to-cap ratio is just 14%. With $1.7 billion in quarterly operating cash flows, Phillips 66 is an absolute cash cow. I don’t think that it will have any debt related worries to slow down its growth.

For FY12, the company reported an impressive 22% return on capital employed, up from 14% in 2011. Its ROE of 18.75% is almost equally impressive, and analysts expect its annual EPS to grow by 10.8% for the next 5 years. That means an investment made this year could yield around 85% returns over the 5-year period.

Structural changes

Phillips 66 is aiming for an MLP structure in 2013, a design under which its investors would become unit holders. Many energy companies with stable cash flows opt for MLP status, which allows tax savings in the form of capital gains. These tax savings effectively lower the cost of funds for the company, savings that can be used for acquisition or expansive activities. This also means that its quarterly dividend distributions could create an annual yield of between 4% and 7%. 

Other MLPs, including Energy Transfer Partners (NYSE: ETP) and Enterprise Products Partners (NYSE: EPD), are dependent on oil and gas demand, as well. At current prices, their shares yield 7.25% and 4.5%, respectively, with payout ratios of 73.5% and 94.3%, respectively.

But at current market prices, shares of Energy Transfer Partners and Enterprise Products Partners trade at high forward earnings multiples of 22x and 21x, respectively, indicating that both stocks are currently overvalued.

Since Phillips 66 has a low payout ratio with abundant cash on its books, I think Phillips 66 can sustain high dividend payouts without any problems whatsoever.

Future plans

During the recent quarter, Phillips 66 produced 135,000 barrels of shale crude per day, which was almost double when compared with last year’s performance in the same period. For FY13, management expects to produce 200,000 barrels of shale crude per day, which is a massive 78.5% increase over its FY12 average production. Naturally, this would hugely improve its FY13 revenues, but management is not stopping here.

Its CPChem utilization rate was 90%, which was slightly lower than the previous quarter due to unplanned down times. For the coming year, management is aiming for a full utilization rate without any operational hassles.

A quick wrap up

It's not hard to conclude that Phillips 66 is a value play here. Its solid financials and operational efficiency are already spectacular, and if the MLP structure is approved, it could sport a hefty yield. Its board has begun share repurchases within a year of its IPO, which highlights the board members' faith and confidence in the company’s future. To wrap up, I believe that Phillips 66 could be one of the few out-performers this year.

Piyush Arora has no position in any stocks mentioned. The Motley Fool recommends Enterprise Products Partners L.P. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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