This year has been brutal for the refining industry. The COVID-19 outbreak has hammered demand for gasoline and jet fuel, taking refining margins and stock prices down with it. Giants Marathon Petroleum (MPC 1.33%) and Phillips 66 (PSX 0.28%) have both shed roughly 40% of their value this year.
On the bright side, as stock prices sell off, dividend yields rise, with Marathon's payout now up to 6.6%, while Phillips 66's is 5.3%. However, even though Marathon's higher yield might be tempting, Phillips 66 is the better income stock. Here's why.
Diversification pays dividends
While both Marathon and Phillips 66 make most of their money on refining, they also operate other related businesses that provide some diversification. For example, Marathon owns gas station operator Speedway and a large stake in midstream master limited partnership MPLX. Meanwhile, Phillips 66 has a large midstream business which includes interests in two MLPs, Phillips 66 Partners and DCP Midstream, as well as 50% of a chemicals joint venture with Chevron, and a marketing and specialties business. These other assets help provide some cushion against the volatility of the refining sector.
Overall, Phillips 66 has much broader diversification thanks to its chemical business and its minimal exposure to the hard-hit retail gasoline market. That provides a greater offset to its volatile refining segment, which was evident in the first quarter. The company was able to generate $450 million, or $1.02 per share, of adjusted earnings during the first quarter while Marathon Petroleum posted an adjusted loss of $106 million, or $0.16 per share.
Despite the benefits of diversification, Marathon Petroleum is working to narrow its focus on its core refining business. It's currently trying to sell or spin off Speedway and had explored the idea of jettisoning its midstream assets. Once the company does exit the gas station business, it will be even more reliant on its volatile refineries to support its dividend. On the other hand, Phillips 66 has been focusing most of its investments on expanding its non-refining businesses, including building out more midstream assets on its balance sheet as well as through its MLPs and growing its chemical joint venture with Chevron. These investments should help reduce the volatility of its earnings and cash flow over the long term.
Build on a bit firmer financial foundation
Another factor in Phillips 66's favor is the strength of its balance sheet. While both companies boast having an investment-grade credit profile, Phillip 66 has a higher rating (A3/BBB+ vs. Baa2/BBB). Furthermore, credit rating agencies are growing concerned about Marathon's credit. Both Moody's and Fitch recently revised their outlook to negative -- because Marathon issued new debt to shore up its liquidity -- which suggests a downgrade could be in its future. For comparison's sake, Phillips 66 also recently took on more debt to bolster its liquidity. However, Moody's left its outlook unchanged at stable, given its view that Phillips 66 will repay this debt as its earnings rebound over the next two years.
Credit rating agencies are starting to grow concerned with Marathon's balance sheet after its leverage ratio spiked during the first quarter. Its debt-to-capital rose from 23% at the end of last year to 34% at the end of the most recent period. While Phillips 66's leverage increased (from 25% to 31%), it's still much lower than its rival. Those credit concerns are why Marathon is considering selling Speedway so that it can use those proceeds to reduce debt, though it would also lose its income, which helps support the dividend.
A more sustainable dividend
While Marathon Petroleum currently offers a higher-yielding payout, Phillips 66's dividend is on a more durable foundation. That's because its broader diversification helps it generate a steadier cash flow stream while its stronger balance sheet provides a bit more cushion. This greater financial strength makes it a better option for dividend investors.