Personal Finance

Better Buy: Phillips 66 vs. Valero Energy Corporation

Oil pipeline in industrial district with factories at dusk.

Phillips 66 (NYSE: PSX) and Valero Energy (NYSE: VLO) are two of the largest independent refiners in the world. That's both a benefit and a drawback for investors because the refining industry can be quite volatile. That was certainly the case last year when refining margins declined sharply due to oversupply and higher costs to comply with the EPA's renewable fuel standards, which cut deeply into earnings.

That said, despite a rough year in 2016, both companies generated billions of dollars in cash flow. That gave them plenty of money to invest in growth projects with ample left over for shareholder distributions. However, while both are excellent companies, one does have several advantages over its rival, which in my opinion makes it the better buy for long-term investors.

Oil pipeline in industrial district with factories at dusk.

Image source: Getty Images.

Battle of the balance sheets

Because of how volatile the refining sector can be, it's imperative that a refiner has a balance sheet that can weather tough times. Here's a look under the hood at how these two compare:

Company Credit Rating Enterprise Value Total Debt Cash on Hand Debt as a percentage of enterprise value Net debt-to-capital ratio
Phillips 66 A3/BBB+ $48.8 billion $10.1 billion $2.7 billion 15% 24%
Valero Energy Baa2/BBB $33.3 billion $8 billion $4.8 billion 9% 23%

Data source: Valero Energy, Phillips 66, Moody's, Fitch, and S&P Global.

As that chart shows, both have solid balance sheets, backed by large cash positions and low levels of net debt and each sports very similar net debt-to-capital ratios. However, the one metric that stands out is Phillips 66's higher credit rating, which gives it a slight edge over Valero because it can borrow at a cheaper rate.

Comparing the portfolios

One area where these companies do differ significantly is in their portfolios. While at their core both are refiners, Phillips 66's is more than just a refining company. That's why it has a larger enterprise value than Valero even though Valero is the world's largest independent refining company. Overall, the company operates four separate business segments:

Chart comparing Phillips 66's earnings by segment in 2016 and 2015.

Data source: Phillips 66. Chart by author. In millions of dollars.

As that chart shows, while Phillips 66's refining business was by far its largest source of income in 2015, it was under tremendous pressure last year. That's when the strength of its diversified business model paid off as the company was able to mute some of that pressure thanks to the steadier earnings from its midstream, chemicals, and marketing and specialties segments.

Valero Energy, on the other hand, only has two operating segments: Refining and ethanol. Though, as the following chart shows, it makes the bulk of its money from refining:

Chart comparing Valero's earnings by segment in 2015 and 2016.

Data source: Valero Energy. Chart by author. NOTE: In millions of dollars.

While earnings in Valero Energy's refining segment didn't drop quite as significantly as Phillips 66's did last year, the concern here is they could dive deeper in the future because it doesn't have anything to help soften the blow. While the company is building a midstream business thanks to the recent creation of its MLP Valero Energy Partners (NYSE: VLP) , it doesn't yet break those results out because they're such a small portion of its overall results.

Because Phillips 66's diversified business model helps insulate it from the volatility of the refining segment, it wins this round in my opinion.

A look at the upside

The other main benefit of Phillips 66's diversification is that it provides the company with more ways to grow. In 2017 the company anticipates investing $2.3 billion in growth projects across its various entities. The bulk of that spending will be in the company's midstream segment where Phillips 66 plans to spend $942 million in growth capital to continue the expansion of its Beaumont terminal as well as other projects. In addition to that, its MLP Phillips 66 Partners (NYSE: PSXP) intends to invest $381 million in growth projects such as the Bayou Bridge Pipeline. Finally, the company's other MLP investment, DCP Midstream (NYSE: DCP) , will invest $175 million in several growth projects.

Meanwhile, Phillips 66's chemical's joint venture CPChem plans to spend $450 million to complete its share of a major Gulf Coast petrochemical expansion phase. Once complete later this year, it will increase CPChem's capacity by a third, and start generating free cash flow for Phillips 66. Finally, the company plans to invest $317 million in growth projects in its refinery segment "toward small, high-return, quick pay-out projects, primarily to reduce feedstock costs and improve clean product yields," according to the company. Overall, the bulk of Phillips 66's investments will pay off later this year because 2017 marks the end of a major expansion phase.

Contrast these investments with Valero, which only plans to spend $1.1 billion on growth projects this year. While it has several large projects under construction, just one will enter service later this year. Meanwhile, the bulk of Valero's other major projects are longer term in nature and will not add incremental earnings until 2018 and 2019.

Again, Phillips 66 wins this head-to-head match because it has a more diverse set of growth projects under way, most of which will deliver a near-term boost to earnings and cash flow.

Investor takeaway

While Valero Energy is a top-notch refining company, Phillips 66 stands out as the better investment in my opinion. It has a slightly stronger balance sheet, a more diversified portfolio to soften the blow of the volatile refining market, and visible growth on the near horizon. The incremental income from those growth projects should act as a catalyst for the stock in 2017, which is what makes it the better buy right now in my opinion.

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Matt DiLallo owns shares of Phillips 66. The Motley Fool recommends DCP Midstream. The Motley Fool has a disclosure policy .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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