by Robert Rapier
In a recent column, I highlighted a piece of investment advice from famed investor Warren Buffett. He advised investors to stick with the fundamentals. Invest in companies that boast strong cash flow, with products and services that won’t be obsolete in a few years.
That is certainly sound advice. If you look at the portfolio of Buffett’s holding company Berkshire Hathaway (NYSE: BRK.A, BRK.B), you’ll find a wide variety companies that all meet his criteria.
One of the companies in the Berkshire portfolio is the refiner Phillips 66 (NYSE: PSX). I frequently sing the praises of refiners as excellent choices for both growth and income, as long as you can get them at a reasonable price.
Let’s review the refiners, and compare some of their important financial metrics to three high profile technology companies. I know the general businesses are apples and oranges, but I want to compare the yields and cash-generating ability. Which companies come out on top?
Refining 101
First, a bit of background. Refiners make money by converting crude oil into finished products such as gasoline, diesel, and fuel oil. A refiner’s profit margin is the difference between the cost of crude oil and the price of finished products sold. This is what’s known in the industry as “the crack spread."
“Crack" refers to the fact that oil is being cracked, or split up, into the various refined products, and “spread" reflects the price spread between the raw material (crude) and the processed fuels.
Refiners were the only class of energy company that made money consistently throughout the collapse of oil prices that began in mid-2014. That’s because refiners can profit whether oil prices are high or low. However, historically the best conditions for refiners are when oil prices are falling. That’s because gasoline prices usually don’t fall as quickly, which leads to fatter margins.
Following several years of consolidation in the refining industry, there are now only three large publicly traded refiners in the U.S.: Phillips 66, Marathon Petroleum(NYSE: MPC), and Valero (NYSE: VLO). These companies have been cash-generating machines in recent years. They benefit from their ability to process lower grades of crude oil and increasingly export the finished products.
Apple or Valero?
Let’s look at how the refiners’ cash-generating abilities stack up against three of the best-known technology companies: Apple (NSDQ: AAPL), which is the top holding in the Berkshire portfolio, Microsoft (NSDQ: MSFT), and Intel (NSDQ: INTC):
EV - Enterprise value at the close on April 5, 2019
EBITDA - TTM earnings before interest, tax, depreciation, and amortization
TTM - Trailing 12 months
DPS Growth - five-year compound annual growth rate of dividend
FCF - Free cash flow
Debt - Net debt at the end of the previous fiscal quarter
Yield - Annualized distribution based on the most recent quarterly distribution
All of the refiners beat both Microsoft and Intel on the basis of free cash flow per share, while Phillips 66 wasn’t far behind Apple.
But where the refiners really stand out is in their ability to grow their dividends in recent years. The refiners beat these technology companies by a wide margin in this category, and Valero crushed all of the competitors. Since 2014, Valero’s quarterly dividend has risen from $0.25 a share to $0.90 a share.
The share performance hasn’t been too shabby either. Prior to a correction last summer, Valero’s total return had nearly tripled the five-year performance of the S&P 500.
It isn’t surprising that Warren Buffett would have a refiner in his portfolio. I would argue that he doesn’t have the biggest value among the refiners in his portfolio, but Phillips 66 has some synergies with Buffett’s BNSF Railroad.
When investing in refiners, timing is important. Margins ebb and flow, and share prices follow. Historically, though, the refiners haven’t stayed down long. In 2014, you could have bought Valero shares for $50. By the end of 2015, shares had topped $70. Shares pulled back to $50 again in 2016, but then went on the huge run that took them to $120 this past summer.
The other refiners had gotten expensive as well, but the group corrected last fall along with the rest of the market. That correction ultimately created the kind of value proposition that Buffett also espouses. Solid and growing free cash flow at fire sale prices. Sign me up for that.
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