A Quality Dividend Stock Yielding 7% in the Energy Space

Oil stocks are not for the faint of heart. The oil industry has been under intense pressure from multiple headwinds, including a global supply glut and falling demand due to the coronavirus. These forces have combined to pummel oil prices, now trading at around $40 per barrel in the United States. Not surprisingly, this has weighed on oil stocks. The main ETF that tracks energy stocks, the Energy Select Sector SPDR Fund , has declined nearly 50% year to date. Meanwhile, the broader S&P 500 Index has increased 7% so far in 2020. The massive underperformance of the energy sector could present some bargains, however. Investors need to be more selective, but many high-quality stocks are now undervalued, with elevated dividend yields. For example, Phillips 66 has lost more than half of its value this year, but the stock is cheap and pays a high dividend yield above 7%. The dividend appears to be safe, making Phillips 66 an attractive stock for income investors. Business Overview Phillips 66 was spun off from ConocoPhillips in 2012. Phillips 66 has a market capitalization of $22 billion and operates in four segments: refining, midstream, chemicals, and marketing. It is a diversified downstream company with each of its segments behaving differently under various oil prices, in the absence of a severe recession. When oil prices collapsed in 2014, the refining segment became by far the most profitable segment, as low oil prices improved demand for oil products and boosted refining margins. In 2019, the refining segment generated 48% of the total earnings of Phillips 66. In late July, Phillips 66 reported financial results for the second quarter of fiscal 2020. The company was severely affected by the pandemic, which caused a collapse in the demand for refined products and in the margins of all the segments of Phillips 66. The midstream, chemical and marketing segments saw their adjusted profits fall roughly 50% sequentially while the refining segment saw its loss more than double, from -$401 million to -$867 million. As a result, Phillips 66 switched from adjusted earnings per share of $1.02 in the first quarter to an adjusted loss per share of $0.74. On the bright side, the company has somewhat increased its refinery utilization in the running quarter, from 75% in the second quarter to the low 80s. Growth Catalysts The current environment is extremely challenging for oil stocks, including Phillips 66, but better days could be on the horizon for the company. There are a number of potential catalysts that could fuel a return to growth in 2021 and beyond. Growth projects in the oil industry take many years to start bearing fruit and hence there is a great lag between capital expenses and their resultant cash flows. Fortunately for Phillips 66, the company is currently in the positive phase of its cycle. While it has greatly reduced its capital expenses in recent years, it has begun to reap the benefits from its huge investments in 2014 and 2015, when it invested a total of $9.5 billion. In addition, management is well known for its discipline to invest only in high-return projects. The pandemic will greatly affect the results of Phillips 66 this year but we expect the company to recover from next year, along with the energy market. As soon as the pandemic subsides, Phillips 66 will greatly benefit from the new international marine standard (IMO 2020), which has forced vessels sailing in international waters to burn low-sulfur diesel instead of heavy fuel oil since Jan. 1, 2020. Diesel is much more expensive than fuel oil and hence refiners will enjoy a boost in their earnings. Phillips 66 also has many ongoing growth projects in its midstream segment. For example, in the 2020 second quarter, Phillips 66 started full operations at the Gray Oak Pipeline, which has capacity of 900,000 barrels per day. Separately, Phillips 66 is expanding its Sweeny Hub with the addition of two 150,000 barrels-per-day fractionators that are supported by long-term customer commitments. Moreover, while Phillips 66 has suspended share repurchases due to the pandemic, it will resume them when the economy recovers. Overall, we expect Phillips 66 to grow its EPS by 4.0% per year on average over the next five years. Valuation & Expected Returns We expect the company to return to growth; in the meantime, the stock is cheap, trading for less than 12 times next year's consensus EPS estimate of $4.30. Based on 2022 EPS estimates of $7.05, the stock trades for just 7 times. While investors will need to have patience to ride out the coronavirus pandemic, there appears to be considerable value in PSX stock. An expanding multiple would generate significant returns for shareholders, through a rising share price. In addition, returns will be boosted meaningfully by dividends. Phillips 66 pays a quarterly dividend of $0.90, which represents an annual payout of $3.60 for a current yield of 7.2%. This is a very high yield, especially in an environment of near-zero interest rates. The S&P 500 Index, on average, yields less than 2%. Importantly, Phillips 66 should be able to maintain the dividend. Although the company could report a significant decrease in EPS in 2020 due to the coronavirus pandemic, the dividend will once again be fully covered if Phillips 66 returns to higher profitability in 2021 and 2022. Phillips 66 has a significant competitive advantage, namely the discipline of its management to invest only in high-return projects. However, despite its diversified business, the company is cyclical, just like most oil companies. In the recent downturn of the oil sector, between mid-2014 and 2017, low oil prices resulted in high refining margins thanks to healthy underlying economic growth. If the broader economy can recover next year and beyond, Phillips 66 should return to growth as well. Final Thoughts Oil stocks have struggled across the board, as the economy is in recession and oil prices are taking. But for investors looking for value, multiple bargains exist in the oil patch. Investors need to be more selective, and focus on quality companies such as Phillips 66. While 2020 will be a weak year, investors looking forward could be getting a high-quality business at a bargain price. With a high dividend yield above 7%, Phillips 66 is a buy for income investors not afraid to take risks.

A Quality Dividend Stock Yielding 7% in the Energy Space

Forward-looking income investors could be getting a high-quality business at a bargain price.

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