Is This Warren Buffett's Favorite Energy Stock?

posted on 06-07-2019

Warren Buffett needs no introduction. His stock-picking ability over the past several decades is without equal.

Many investors tend to focus on his mega-cap stocks, such as Coca-Cola (NYSE: KO), or one of his rare tech holdings, IBM (NYSE: IBM) -- but there are, of course, other great investments to be found in his portfolio.

One stock that he owns that doesn't get much attention is Phillips 66 (NYSE: PSX)Buffett's Berkshire Hathaway (NYSE: BRK-B) owns just under 5% of the company. (Last summer, my colleagues here at StreetAuthority found that PSX is a favorite of both Buffett and T. Boone Pickens.)

Spun off from ConocoPhillips (NYSE: COP) in 2012, Phillips 66 is one of the largest oil refiners and marketers in the U.S. It has a strong return on equity at 15%, its valuation is compelling, and it pays a solid dividend.

At the Ira Sohn Investment Conference this month, Zach Schreiber, CEO of hedge fund PointState Capital, made a case for taking a long position in refining companies. Schreiber expects the price of West Texas Intermediate (WTI) crude oil to fall in the next few years -- and fall hard.

That's because U.S. oil production is growing faster than demand. However, the U.S. can't export it, given the ban on crude oil exports. Thus, it'll have to be refined. That's a big win for Phillips 66. In addition, the U.S. government has no plans to reduce the amount of oil it imports from other countries.

Phillips is a fairly diversified downstream oil and gas company, with refining, marketing, chemicals and midstream businesses. All segments saw sequential earnings growth last quarter, except refining. Refining was weak due to lower volumes as a result of planned plant maintenance.

Going forward, Phillips 66's focus will be on higher-margin businesses, namely chemical and midstream operations. The greater shift toward chemicals and midstream should not only boost overall margins but also help reduce its exposure to the more volatile refining business. The ultimate goal is to lower its earnings from refining to about a third of total earnings from a current 50%.

The company plans to spend some $16 billion over the next few years on new projects, with 70% of that total going toward chemicals and midstream operations. It is looking to expand chemical capacity by 35% in that time.

Phillips 66 is also a dividend and buyback machine. Its current dividend yield is 2.4%, but that payout amounts to only 22% of earnings -- meaning that Phillips 66 has plenty of flexibility to boost its dividend. In comparison, both Valero Energy (NYSE: VLO) and Marathon Petroleum (NYSE: MPC) pay a dividend yield of only 1.8%.

Since being spun off from ConocoPhillips in 2012, Phillips 66 has reduced its shares outstanding by 10%. During the first quarter of 2014, the company bought back $1.6 billion in stock. It still has $1.8 billion available under its share buyback plan. That's good enough to reduce its shares outstanding by 4%.

PSX trades at a forward price-to-earnings (P/E) ratio of 10 based on next year's earnings estimates. That is a premium to its refining peers, including Valero Energy and Marathon Petroleum at 8.5 and 8.4, respectively. But this is easily justified given its diversified business model. And with its transition toward higher margin businesses, this premium valuation should persist.

Risks to Consider: Any unplanned downtime at its refining locations generally has a meaningful impact on earnings. As well, crude oil prices can have a big impact on Phillips 66's profitability. The other potential risk is that the U.S. could relax its export policy on crude oil exports, which would mean less oil for Phillips 66 to refine.

Action to Take --> Buy Phillips 66 for 20%-plus upside to $100, based on the assumption that Phillips 66 should trade at a P/E of 12.5 on expected 2015 earnings of $8.09 a share.