Via SeekingAlpha.com

About three months ago, I wrote an article in which I stated that Phillips 66 (NYSE:PSX) could double over the next 12 months. Since then, the stock has doubled. When a cyclical stock enjoys such a steep rally, it is usually time to take profits. However, in this article, I will discuss why Phillips 66 is not overvalued.

First of all, when I wrote the article, I did not expect the stock to double in less than three months. However, it is impossible to predict how long it will take to an investing thesis to materialize, no matter how strong the thesis is.

Business overview

Phillips 66 slumped 67% off its peak in late 2019 due to the collapse in the demand for refined products that resulted from coronavirus. The company was forced to reduce the throughput of its refineries to less than 70% in April. However, thanks to the reopening of the economy, Phillips 66 has now boosted the run rates of its refineries. For instance, its Bayway refinery is currently running at a 75%-80% rate.

Moreover, the improvement in the demand for refined products seems sustainable. In the short run, the pandemic may deteriorate and cause another plunge in the demand for oil products due to social distancing, but the pandemic is unlikely to cause a long-lasting effect. Numerous studies for a vaccine are currently underway, and hence, an effective vaccine is likely to come to the markets early next year. As soon as this takes place, the coronavirus crisis will attenuate, and people will return towards their normal lifestyle, and hence, the demand for refined products will recover. To cut a long story short, the coronavirus crisis is likely to have just a temporary effect on the business of Phillips 66.

Growth

When the spread of coronavirus attenuates, the market will shift its focus on the long-term growth prospects of Phillips 66. The company will greatly benefit from the new international marine standard, IMO 2020. According to this standard, all the vessels that sail in international waters are now forced to burn ultra-low sulfur fuel oil or diesel instead of heavy fuel oil. As the former are much more expensive than the latter, refiners will enjoy a strong tailwind in the upcoming years. Phillips 66 is ideally positioned to benefit from IMO 2020, as it is the refiner with the highest yield (38%) of distillates.

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In addition, Phillips 66 is well-known for the discipline of its management to invest only in high-return, quick payout growth projects. Most of these projects aim to enhance the yield of high-value products and increase the flexibility in crude processing so that the company takes advantage of the mispricing of some grades during some periods. Thanks to their high return and quick payout, these growth projects have minimum risk and generate strong free cash flows. This helps explain the healthy balance sheet of the company, which has earned an A3 credit rating from Moody’s, and its interest expense consumes only 11% of its operating income.

Competitive advantages

As mentioned above, the primary competitive advantage of Phillips 66 is the discipline of its management to invest only in high-return projects. Very few managements are so laser-focused on the expected return of an investment. Moreover, Phillips 66 is in the top quartile in non-energy operating expenses, and its maintenance and personnel costs have been trending to the top quartile as well. More importantly, this data comes from a strict, impartial research company, Solomon, and hence, they are much more reliable than other performance indicators, which are computed by managements. Overall, Phillips 66 is doing its best to improve its performance in the factors it can affect in the highly cyclical energy sector.

Dividend

Due to the high cyclicality of the energy sector, which results from the dramatic swings of the price of oil, very few energy companies have maintained multi-year dividend growth streaks. Phillips 66 was spun off from ConocoPhillips (COP) in 2012, and thus, it has a short history.

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Nevertheless, its management has repeatedly stated that one of its top priorities is to secure an attractive and growing dividend. Phillips 66 has certainly proved its shareholder-friendly character, as it has raised its dividend at a 22% average annual rate in the last eight years. It has also reduced its share count by 34% throughout this period, and hence, it has returned 124% of the initial market cap of the stock since its spin-off from ConocoPhillips.

Phillips 66 is currently offering a 4.3% dividend yield. Its annual dividend of $3.60 exceeds the expected earnings per share of $2.67 this year, but it is only 55% of next year’s expected earnings per share of $6.57. Therefore, as soon as Phillips 66 recovers from the ongoing downturn in its business, which has been caused by coronavirus, it will easily afford to resume growing its dividend.

Valuation

Thanks to the expected recovery in its business, Phillips 66 is expected by analysts to grow its earnings per share to $8.40 by 2022. Given that the company earned $8.05 per share last year and the expected boost in its earnings from IMO 2020 and the growth projects of the company, it is reasonable to expect Phillips 66 to at least meet the analysts’ consensus. This means that the stock is currently trading at 10.0 times its expected earnings in 2022.

Phillips 66 has traded at an average price-to-earnings ratio of 13.2 over the last eight years. As the recovery of the company unwinds in the next two years, it is reasonable to expect the stock to approach its historical valuation level. If this materializes, the stock will enjoy a 32% boost thanks to the expansion of its price-to-earnings ratio. Therefore, the stock still has room to reward investors, thanks to a reasonable expansion of its valuation level and its 4.3% dividend.

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Risks

Investors should always keep in mind that Phillips 66 is vulnerable to downturns in the energy sector. In the previous downturn, which was caused by the collapse of the oil price from $100 in mid-2014 to $26 in early 2016, Phillips 66 proved resilient, as the prices of refined products fell much less than the price of oil, and thus, the refining margins skyrocketed.

However, in the ongoing downturn, which has been caused by coronavirus, Phillips 66 is much more vulnerable. If the pandemic returns stronger and causes new lockdowns, the demand for refined products will collapse and the stock of Phillips 66 will slump once again. Therefore, only those who can tolerate temporary paper losses and maintain a long-term investing horizon should consider purchasing Phillips 66 at its current price. On the other hand, even if the pandemic causes another sell-off of Phillips 66, the sell-off is likely to be temporary, as the virus will almost certainly be held under control from next year thanks to a vaccine.

Final thoughts

Phillips 66 has doubled in less than three months and hence its rally is likely to take a breather in the short run. Moreover, if the coronavirus crisis causes new lockdowns, the stock of Phillips 66 will come under great pressure. However, such a headwind will prove short-lived, as it is unreasonable to expect the virus to condemn the economy to a permanent recession. Those who can maintain a long-term investing horizon and can tolerate temporary sell-offs should note that Phillips 66 is still reasonably valued.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.