by Will Ashworth | June 7, 2012 7:30 am
It has been 25 trading days since ConocoPhillips (NYSE:COP) spun off Phillips 66 (NYSE:PSX) and its refining, marketing, chemicals and transportation businesses.
For every two shares of ConocoPhillips, shareholders received one new share in Phillips 66. In the days since, ConocoPhillips has mostly traded flat, while Phillips 66 has dropped several dollars. Many investors believe the refiner was overvalued by the parent. Keeping this in mind, I’ll decide which of these two stocks investors should own.
Morningstar stock analyst Allen Good does a great job dissecting the two businesses in a May 23 article. If you have a free moment, definitely have a read.
Good lays out the pros and cons of both stocks, and I’ll get to them shortly. However, I first want to discuss an appropriate comparison of Marathon Oil (NYSE:MRO) and Marathon Petroleum (NYSE:MPC), which separated on July 1, 2011.
As with ConocoPhillips, Marathon shareholders received one share in Marathon Petroleum for every two shares held in Marathon Oil. The value of two shares of Marathon Oil before the split was $105.36. As of June 5, the value of the two shares plus the one share of Marathon Petroleum is $83.18, a one-year decline of 21%.
Marathon Oil’s shares have lost 23.3%, versus 12.9% for Marathon Petroleum. At the time of the spin-off, I recall reading about overvalued refining assets, a subject that has been mentioned in the ConocoPhillips separation. Evidence suggests that most spin-offs are undervalued by the parent, and for this reason they generally outperform in their first 18 months of trading. Keep that in mind when deciding which is the better buy.
You don’t have to be a rocket scientist to see that the biggest positive with ConocoPhillips’ stock is its hefty annual dividend of $2.64 and a current yield above 5%. That’s heads above Chevron (NYSE:CVX), ExxonMobil (NYSE:XOM) and Marathon Oil. Essentially, you’re trading growth for income. Most of ConocoPhillips’ growth in production will come through domestic holdings in the Eagle Ford, Permian and Bakken regions. Internationally, its Canadian steam-assisted gravity-drainage operations, along with projects in the North Sea, Malaysia and Australia, will deliver increased revenues.
Unfortunately, this production will amount to only 3% to 5% growth annually, which is less than its smaller, less diversified peers. Even worse, future costs to extract its oil and gas reserves will rise, while margins will fall. In order to maintain that juicy dividend, then, the company might have to incur some additional debt to cover the shortfall in cash flow. That may be a risk you’re willing to take, but it’s important to be aware of it.
The elephant in the room for Phillips 66 is its legacy refining business. Currently, refining and marketing represent 84% of the spin-off’s capital employed and 64% of its adjusted earnings. However, return on capital employed is just 12%. As cars continue to get more efficient and the use of corn-based ethanol continues to rise, the value of refining assets diminishes.
That’s why the company is selling some of those assets. At the end of April, Phillips 66 announced the sale of its Trainer refinery for $180 million to a subsidiary of Delta Air Lines (NYSE:DAL). Several years ago, Virgin Atlantic toyed with the idea of buying a refinery to lower its fuel costs. So I don’t imagine this will be the last of such deals.
Moving forward, Phillips 66’s success as a company will come from its chemicals and midstream businesses.
Long term, it intends to allocate 50% of capital to these higher-margin businesses, up from 16% today. In 2011 its midstream and chemicals businesses earned returns on capital employed of 30% and 28%, respectively. If Phillips 66 continues to sell off its lower-performing refining assets while improving its margins on assets not being sold, its future looks secure. With approximately $1.5 billion in capital expenditures annually, it should generate significant free cash flow in the future, assuring investors that its $0.80 annual dividend will grow over time.
While it’s hard to ignore the dividend ConocoPhillips offers, I have to go with Phillips 66 as the stock to buy. Its dividend yield is currently 2.5%, which is decent. More importantly, its capital requirements aren’t nearly as great as those of its former parent. Although refining isn’t a glamorous business, the increase in onshore energy production in the U.S. will surely help. Lastly, remember the track record of companies spun off from their parents — in the first 18 months, there’s no comparison.
As of this writing, Will Ashworth did not own a position in any of the stocks named here.
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