October 22, 2020

Phillips 66 Looks Cheap Even If You Ignore Its Refining Segment (NYSE:PSX)

Phillips 66 (PSX) has plunged 40% since early June, primarily due to the indiscriminate sell-off of the entire energy sector, which has dramatically underperformed the broad market over this period. This sell-off has affected, not only the weak energy stocks, but also the resilient ones, such as Phillips 66, which is likely to recover strongly from the pandemic from next year. In this article, I will take a deep look in the valuation of Phillips 66 and will thus demonstrate how cheap this high-quality stock is.

The effect of the pandemic

The pandemic has caused an unprecedented downturn in the energy sector this year. The global demand for refined products is expected to slump by approximately 8.1 million barrels per day on average this year (~8%) before it rebounds by 7.0 million barrels per day next year. This will be the steepest decline in at least three decades. In August, the global oil consumption averaged 94.3 million barrels per day, down 8.2 million b/d from August 2019, but up from an average of 85.1 million b/d during the second quarter of 2020 and 93.3 million b/d in July. The plunge in the demand for oil products caused by the lockdowns in April led Phillips 66 to reduce the utilization of its refineries to less than 70% back then.

However, thanks to the reopening of the economy, the demand for refined products has recovered strongly in the last few months. In July, the demand for gasoline and distillates returned to 80%-90% of normal levels and thus Phillips 66 boosted its refinery utilization to more than 80%. The only problem is the jet fuel, whose demand remains suppressed due to the slump in global air traffic. Leisure travel has recovered to 48% of normal level but business travel remains 88% below its normal level. On the bright side, jet fuel comprises only 10% of the production of a normal refinery and can be blended into diesel if it is not sold.

Moreover, the economy and the energy market are likely to enjoy a steep recovery beginning next year thanks to the development of a vaccine against the coronavirus. There are numerous ongoing studies for a vaccine, with some of them about to enter the last phase of clinical trials. The studies of AstraZeneca (AZN), Johnson & Johnson (JNJ), Pfizer (PFE) and Moderna (MRNA) have exhibited promising results so far and thus a vaccine is likely to become available early next year. When that happens, the demand for refined products should return close to last year’s levels. The U.S. Energy Information Administration seems to agree on this view, as it expects the global demand for refined products to retrieve 7.0 million barrels per day next year out of the 8.1 million barrels per day lost this year.

Valuation

Thanks to the expected recovery of the global economy and the energy market, analysts expect Phillips 66 to earn $5.23 per share next year and $8.12 per share in 2022. In essence, analysts expect the company to return to its pre-COVID profitability by 2022. Given these estimates, Phillips 66 is currently trading at 10.5 times its 2021 earnings and only 6.8 times its 2022 earnings. As the stock has traded at an average price-to-earnings ratio of 13.2 over the last eight years, it is evident that the stock is exceptionally cheap right now.

Data by YCharts

Even if the stock does not revert to its average valuation level and reaches an earnings multiple of only 11.0 by 2022, it will offer a 62% return (=11*8.12/55 – 1) over the next two years, without including the dividends. If the 6.5% dividend is included, the stock will offer an approximate 68% total return over the next two years. Overall, if Phillips 66 comes close to meet or exceed the analysts’ consensus, it is likely to offer outsized returns over the next two years. Notably, Phillips 66 has exceeded the analysts’ consensus in 13 of the last 14 quarters. Therefore, there is a good chance that the company meets or exceeds the aforementioned expectations of analysts.

A deep look in valuation

Conservative investors should always examine what will happen to a stock in a worst-case scenario. There is no doubt that the second quarter of this year was the worst quarter for all the refiners due to the unprecedented lockdown of the economy. In that quarter, Phillips 66 posted a loss of -$0.74 per share.

However, a deep look in the earnings report reveals that the performance of the company was not as poor as it seemed on the surface. The losses of Phillips 66 resulted from a single segment, namely refining, which was severely hurt by the lockdown of the economy. In fact, the refining segment incurred a double hit in the second quarter: much thinner margins and lower volumes. It is worth noting that the refining segment is the most important of the four segments of Phillips 66. To provide a perspective, it generated 48% of the total earnings of the company in 2019.

It is absolutely unrealistic to expect the refining segment to remain unprofitable for years. Refining is a highly cyclical business, which forces some refineries to go out of business during rough periods but offers great profits during boom periods. In the previous downturn of refining, during 2011-2013, about 20% of the refineries went out of business worldwide but the U.S. refiners were well protected from that downturn thanks to the ban on oil exports that prevailed back then. Now that the ban has been lifted, U.S. refiners are somewhat more vulnerable but they are still the most resilient in the world thanks to the material discount of WTI to Brent and their great complexity, which enables them to optimize their crude oil and product blends and thus earn greater profits than their international counterparts.

It is evident that the refining business recorded its bottom in April due to the lockdown of the economy, with a recovery widely expected in the upcoming years. Nevertheless, it is useful to examine a worst-case scenario, in which the refining business would remain unprofitable for many years. This has never occurred in the past and is not likely to happen but it is useful for evaluating the stock of Phillips 66.

In such a scenario, Phillips 66 would be forced to shut down all its refineries and rely on its other three segments, namely the midstream, the chemical and the marketing segment. In the worst quarter (Q2), these three segments saw their earnings plunge by approximately 50% each but they still generated a pre-tax profit of $627 million. Assuming that the extremely adverse business conditions of the second quarter remain in place for a full year, Phillips 66 would generate pre-tax annual income of $2.5 billion. As Phillips 66 had a tax rate very close to 20% in each of the last two years, the company would post earnings of $2.0 billion or $4.54 per share in the (unrealistic) worst-case scenario.

In other words, Phillips 66 is currently trading at 12.1 times the earnings it would post if it shut down all its refineries and its other three segments faced the fierce conditions witnessed in the second quarter all year long. It is thus evident that the stock is trading at an exceptionally cheap valuation level right now.

Of course, if Phillips 66 shut down all its refineries, it would adversely affect its other segments, as it would have to purchase the products it sells from other refineries. However, it is unrealistic to expect the unprecedented downturn in the second quarter to become the new norm. It is also unrealistic to expect Phillips 66 to shut down all its 13 refineries, which process 2.2 million barrels per day in total. Moreover, as refining is a highly cyclical business, it will certainly become profitable again at some point in the future, the latest next year.

Final thoughts

The pandemic has caused an unprecedented downturn in the energy sector this year. As usual in such cases, the market punishes the solid stocks along with the vulnerable ones. This is certainly the case for Phillips 66, which has become deeply undervalued. As demonstrated above, even in an unrealistic worst-case scenario, in which the pandemic would condemn the energy market to a prolonged depression, the stock of Phillips 66 would be attractively valued.

Disclosure: I am/we are long PSX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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