Phillips 66

Moat: 2/5

Understandability: 3/5

Balance Sheet Health: 4/5

Phillips 66 is a diversified energy manufacturing and logistics company, primarily engaged in the business of refining petroleum, as well as in chemicals and midstream operations.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Phillips 66 operates in the Midstream, Chemicals, Refining and Marketing & Specialities business segments.

Business Overview

  • Midstream: This segment is primarily engaged in gathering, processing, transporting and storing natural gas, crude oil, and natural gas liquids (NGLs) through pipelines, terminals, and processing plants in the US. Its goal is to optimize logistics and product flows from wellhead to end-users, while focusing on delivering to energy markets on the Gulf Coast.
    • It’s worth noting that the company’s largest investments are typically in this segment, with significant ongoing and planned capital projects.
    • A portion of their operations is driven by long-term contracts or fee-based activities, while others are impacted by commodity prices.
  • Chemicals: This is a 50/50 joint venture with Chevron (CPChem) which produces and markets petrochemicals and plastics worldwide. This joint venture generates recurring revenue for Philips.
    • A key activity for CPChem is a new plant in Baytown for higher-margin polyethylene product.
  • Refining: This segment transforms crude oil and other feedstocks into petroleum products such as gasoline, diesel, and jet fuel.
    • Refined products are primarily marketed in the United States and Europe.
    • The refining segment is highly sensitive to crack spreads (the difference between oil purchase prices and refined product sales prices).
  • Marketing and Specialties (M&S): This segment purchases, sells, and transports gasoline, diesel, and other refined petroleum products to both retail and business customers. As part of its marketing efforts, it sells its wares through a network of 7,000 branded retail sites, and directly to business customers.
    • The key drivers of profitability in the M&S segment are brand recognition and loyalty, as well as the ability to generate volume sales.
    • It also includes sales of specialty products (such as lubricants, greases, and waxes.)

Phillips 66’s business spans a broad range of activities in the energy sector, from oil and natural gas production to the sale of refined products and speciality chemicals. This diversification makes it a somewhat complex business.

Moat Analysis: 2 / 5

  • Network Effect - The size of the transportation and logistics network has positive feedback. The larger the network, the easier it is for Phillips 66 to transport fuel. This creates a barrier for competitors, as it would be difficult for a new entrant to duplicate Phillips 66’s network of terminals and pipelines. However, many other companies, like Enterprise Products Partners (EPD) and Kinder Morgan (KMI) also have extensive networks, which reduces the moat of Phillips 66.

  • Cost Advantages - Phillips 66 has some cost advantages due to scale and operational efficiency. However, these are not unique and easily replicable.

  • Switching Costs - Petroleum refining and transportation is a somewhat sticky market, and it might be harder for customers to switch. However, there are many other refining companies that offer similar services.

  • Brand Intangibles - Philips 66 doesn’t really have a large brand recognition. It is mostly a commodity seller.

  • Overall Assessment While Phillips 66 has some minor structural advantages and benefits from scale in the midstream segment, it faces significant competition in a highly regulated and cyclical industry, thus the moat is rather weak. Overall, the moat is very thin, hence its rating of 2/5.

Risks to the Moat and Business Resilience

Phillips 66 is susceptible to commodity price fluctuations, regulations, and shifts in global demand, all of which pose threats to its moat and its business resilience.

  • Commodity Price Volatility: The company’s financials are highly sensitive to changes in oil, natural gas, and refined product prices. Prices may fluctuate depending on supply-demand imbalances and global events. The company has very little control over commodity prices, and therefore cannot accurately estimate its future profitability.
  • Technological Disruption: The long-term trend of less oil usage poses a threat to a traditional refinery business. The market for biofuels is also quickly developing, threatening to reduce demand for traditionally refined petroleum products. It is unclear how the company will adapt to this shift. * In particular, while the company is investing in renewable energy, there is still no clarity how the company’s profits will be affected if a larger part of energy demand is satisfied through renewables instead of traditional gasoline and petrochemicals.
  • Regulatory and Environmental Risks: Stricter environmental regulations and policies aimed at reducing carbon emissions will likely increase compliance costs, and also potentially reduce demand for some of the company’s key products. The political and social climate surrounding climate change could create both new regulations and higher taxes, reducing the company’s profitability.
    • The Inflation Reduction Act created a minimum tax on the largest corporations in the US, which would cut in on the returns of many big energy corporations like Phillips 66.
  • Operational Risks: Plant shutdowns due to unforeseen circumstances, such as extreme weather events and equipment failures, could halt operations. These incidents may lead to considerable losses and reputational damage, that might take years to repair.
  • Integration Risks: The company had been undertaking several large acquisitions in the previous years. If the integration of these companies does not go as planned, the company could fail to achieve predicted synergies, lower its profitability.
  • Competitive Landscape: Phillips 66 competes in a very competitive industry, and other competitors may try to expand their market share. This may result in lower margins and sales volume for Phillips 66.

While these risks are noteworthy, the company’s large scale, diverse operations, and high level of operational and financial integration, it helps in protecting its financial performance even when things go wrong, giving it some resilience to overcome such challenges.

Financial Analysis

  • Revenues: The majority of Phillips 66’s revenue comes from the sale of refined products in their refining segment. The company has also other streams of revenue, including those from chemicals, midstream, and marketing & specialities. However, most revenues depend on commodity prices. So, large increases or decreases in commodity prices impact revenues more than volumes sold.
    • A big part of revenue generation is reliant on the price of oil, and its byproducts, which is a volatile input.
  • Profitability: Phillips 66 is able to generate profits, primarily by refining petroleum. Historically, the company has generated great profits, with gross margins around 20 percent, however in recent times, margins have suffered due to weaker demand, increased input costs, and higher energy prices. It’s also worth noting that different segments have varying levels of profitability.
    • Refining operations margins are highly cyclical depending on the spread between crude oil and refined products. So, in times of lower oil spreads, refining profitability takes a big hit.
    • The most stable margins come from chemical operations, because of the long-term contracts with clients.
  • Cash Flows: Phillips 66 typically generates strong operating cash flows. However, these flows are also volatile, depending heavily on the performance of its refining and marketing activities. The company has been using the cash to fund capital expenditures, acquisitions, shareholder dividends, and share repurchases.
  • Capital Structure: Phillips 66 has a good capital structure, with a reasonable debt-to-equity ratio, that gives the company flexibility in times of economic volatility.

Phillips 66’s financials are very sensitive to commodity prices. When prices increase, the company can make more profits. But when prices decrease, the company’s profitability will sharply drop.

Understandability: 3 / 5

The business is relatively complex, spanning multiple segments in the energy sector, including crude oil, transportation, refining, chemicals, and marketing. This requires investors to understand the intricacies of each segment and how they operate and interact. In terms of financial performance, there are many inputs that influence its earnings, including commodity prices, spreads, global economic conditions, which all make accurate forecasting difficult. However, each segment of the business is somewhat simple to understand.

Balance Sheet Health: 4 / 5

Phillips 66 has a strong balance sheet with enough cash to operate its business, and to take care of future investment and debt repayments. The company has an acceptable debt-to-equity ratio and its debt is typically at good interest rates, helping it weather economic volatility. Overall, the balance sheet seems relatively healthy.

Management Commentary from Earnings Calls & Reports

The most recent earnings call for the third quarter of 2023 was on October 27, 2023. Based on the call and the released reports, these are the main things of note:

  • Third Quarter 2023 Results The company recorded adjusted earnings of $2.8 billion, or $6.97 per share. They also generated $3.5 billion in cash from operating activities, and returned $2.2 billion to shareholders.
    • The Midstream segment had a record quarter in terms of volumes.
    • The Chemicals segment was impacted by lower demand and lower sales volumes due to destocking.
  • Refining: While product demand was strong during the quarter, refining margins were relatively lower. There was a large planned turnaround in the company’s largest refinery, which has impacted results. However, the company expects refining margins to increase after the end of turnaround.
  • Midstream & Chemicals: These businesses have been more resilient, with record volumes being transported and processed through the midstream operations.
  • Future Strategy: Company plans to cut capital investments to improve returns, and will return more profits to shareholders through share buybacks and dividends.
  • Financial Stability Debt has been reduced to make the company more financially resilient.

Phillips 66 is focusing on using its strong cash flow and financial flexibility to improve returns and to navigate a volatile economic environment.

Conclusion

Phillips 66 is a somewhat complex business in a volatile sector, but has a good capital structure and decent competitive advantages. However, its moat is not that strong, hence its moat rating of 2/5. Despite volatility, the company has proven to be resilient, and its management is striving to streamline the business to maintain profitability. Even with the challenges faced by the business, the long-term returns seem to be promising.