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Week 55 Update: Phillips 66

I have actually owned Phillips 66 (PSX) for a while now, just not in the account I track online. Phillips 66 is a spin-off from Conoco Phillips.  The company has 3 lines of business:

  1. Refining
  2. Midstream
  3. Chemicals

I originally came across the idea of Phillips 66 after reading a Barrons article that was posted on the Investorvillage.com BRY board.  Phillips was a recommended pick of Meryl Witmer.  The thesis outlined by Witmer was as follows:

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 at $35 you get the refining business for free.

My original purchase a few weeks ago was somewhat vindicated after Warren Buffett noted in a Bloomberg interview that his company had bought a large position recently.

The interesting thing about Phillips is that they stand to benefit from the increased liquids production in North America.  Below is an excerpt from the company’s CEO at the Citigroup Global Energy Conference:

If you think about natural gas at kind of $2 a day and ethane that was 30 cents and going down I think the last time I looked at it. But ethane at 30 cents is about $5 a million BTUs. So we capture the upgrade from the wellhead at $2 to 5 bucks through the midstream business and then the petchems really pick up at $5 and go to essentially the crude level, which is what the rest of the world competes on when they’re buying naphtha. Think about that at $17 to $18. And while we don’t know exactly where that rent is going to get captured through that chain, by the ownership in DCP and CPChem, we benefit all the way through that chain in the ownership in capturing that margin upgrade. So we really like that position that we have there.

The thing that makes Phillips interesting is that, as was implied by the Meryl Witmer analysis in Barrons, based on the valuation of the company, investors seem to be treating the company as a refiner, when really only a third of the company’s business is refining.   Moreover, as the company pointed out at another conference recently, this time put on by UBS, the other two-thirds of the business, midstream and chemicals, have return on capital metric north of 20%.

My only problem with Phillips is finding a price to buy in at.  I bought into it in other accounts at under $32.  It pains me now to buy at $35-$36.  Perhaps we will get a further pullback, though after the Buffett endorsement I kind of doubt it.

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