Delek US IPO Analysis (DK)

On April 26th, Bill Simpson wrote an analysis of Delek US Holdings' (DK) IPO. DK shares priced at $16 a share on May 3rd. The text of Simpson's original writeup follows:

Delek US Holdings plans on offering 11.5 million shares (assuming over-allotment) at a range of at a range of $14- $16. Lehman Brothers and Citigroup are lead managing the deal. Post-offering DK will have approximately 50 million shares outstanding for a market cap mid-range of $750 million. 1/3 of the IPO proceeds will be going to repay debt, 2/3 set aside for future acquisitions and growth. Delek Group, an Israeli conglomerate will own all non-public shares in DK, 80% of the company post-offering. Delek is not selling any shares on this offering.

From the prospectus:

We are a diversified energy business focused on petroleum refining and supply and on retail marketing.

Much like recent IPO Alon USA (ALJ), DK's business has two segments refining and retailing. In 2005 DK received 54% of revenues from retailing 46% from refining.

The refining segment consists of an independent refinery in Tyler, TX which produces gasoline, diesel, jet fuels and petrochemical feedstock. 97% of output is gasoline, diesel and jet fuel. The refinery does not have the capability however to produce chemicals or petrochemicals. Crude capacity is 60,000 barrels per day and operated in 2005 at an average of 53,000 barrels per day, 88% capacity.

In comparison with recent IPOs, Western Refining (WNR) has a capacity of roughly 110,000 barrels per day, ALJ 80,000 and Calumet [CLMT] 65,000. 92% of output are light products less than 2% heavy. End customers of the refinery include ExxonMobil (XOM), Chevron (CVX), and Valero (VLO).

The refining space has been a very good place to be the past 1-2 years. All three above mentioned IPOs are well above pricing levels as refiners have benefited from record crack spreads for their products. Crack spreads are essentially the difference between the price they are able to sell the end product (gasoline, jet fuel etc....) minus the cost of inputs, mostly the price per barrel of oil. It is anticipated that crack spreads will contract at some point going forward and sector analysts estimate that 2005/ 2006 will be a peak earnings cycle for the sector. Note that for 2005, DK's average refining crack spread of $12.53 beat the Gulf Coast average refining crack spread of $10.58.

The retail segment consists of 349 company owned fuel and convenience stores located in Alabama, Arkansas, Georgia, Kentucky, Louisiana, Mississippi, Tennessee and Virginia. 93% of the stores are concentrated in Tennessee, Alabama and Virginia. The stores go by the name MAPCO Express, East Coast and Discount Food Mart and sell fuel under their own brand as well as most of the majors.

DK is in the process of converting many stores to the MAPCO Mart name, a name all new locations will possess. In addition DK wholesales fuel to 50 dealer owned locations. Fuel sales account for 70% of retail sales, tobacco products 14% and alcohol 12%. Note that the bulk of DK's stores are in the highest smoking areas of the country with the lowest tobacco tax rates.

DK plans to grow through acquisition. In fact they've only recently acquired the Tyler refinery, which closed in April 2005. DK will have $155 million in cash post offering and I fully expect them to put that money to use purchase more refining capacity and/ or more retail locations.

DK does experience seasonality as 1st quarter and 4th quarter are slower for the refining segment while 1'st quarter is slowest for retail segment.

Financials
DK will have debt post offering, due to the Tyler refinery purchase. $226 million in debt post-offering, while will not impede business could be a future earnings drag in a narrower crack spread environment. Normally in the current spread environment I would expect DK to pay down debt this year and next through cash flows. However DK has substantially increased capital spending budgets for 2006 and 2007, so I would imagine this debt will be sticking around for awhile.

As mentioned above DK will have $155 million in cash post-offering. They will not be utilizing this cash to pay down debt, rather it will be used to acquire refining capacity and/or increase number of retail fuel outlets.

At $15, DK will be trading 4 X's book value.

Revenues for 2005 are not comparable to prior years as the refining segment was purchased in 2005. While the buy closed in April, DK does breakout 2005 as if the Tyler refinery was theirs the entire year.

The retail segment has been steadily growing as DK has opened and acquired stores annually. Gross margins for the retail end have remained stable the past 4 years with 15-17% margins for fuel and 26%-30% for other merchandise. Margins for each were on the high end of those ranges in 2005.

Revenues in 2005 for the combined segments were $2.3 billion. Gross margins were 14% overall. Operating margins were in the 5.5% range. Net margins after tax/ debt servicing were 3%. Earnings per share in 2005 for DK were $1.43 per share. At a $15 pricing DK would be trading 10 X's trailing earnings.

Looking at full year 2006; DK had a strong first quarter in their seasonally weakest annually. Operating earnings declined from late 2005 levels as 1) crack spreads narrowed in q1 and 2) again it is seasonally their weakest quarter annually. In the 2nd quarter with rising gas prices I fully expect DK to have a blowout quarter as crack spreads recently have hit all-time highs. DK operated close to capacity in 2005, so they most likely will only be able to squeeze out slightly higher output from the Tyler refinery. I'd expect retail stores to increase in numbers for the 5th year in a row.

Overall I'd expect higher gas prices to contribute to roughly a 5%-10% revenue bump for DK in 2006. That number excludes any potential acquisitions, and DK will most likely acquire refining capacity and/or fuel convenience stores. I think DK could earn $1.75 - $2 a share in 2006 assuming the crack spread environment remains strong. At a $15 pricing, DK would be trading 8 X's 2006 estimates.

A look at recent IPOs WNR, ALJ as well as the largest US refiner VLO:

Valero (VLO): $39 billion cap, trading 3 X's book value and 0.5 X's trailing revenues. Currently trading 8 X's earnings with forecast 2007 revenue and earnings declines.

Alon (ALJ): $1.25 billion cap, trading 4 1/2 X's book value and 0.5 X's trailing revenues. Currently trading 12 X's 2006 estimates with forecast 2007 revenue/earnings declines.

Western Refining (WNR): $1.3 billion cap, trading 4 X's book value and 0.4 X's trailing revenue. Currently trading 11 X's 2006 estimates with flat 2007 forecasts.

Delek US (DK): $750 million cap at $15, 4 X's book value and 0.3 X's trailing revenue. At $15, $8's 2006 estimates, most like peak revenues/earnings as well excluding future acquisitions.

Risks:
Two major risks here and one tangential minor risk. The biggest risk here is the obvious, something occurring to DK's refining capacity. As they've just the one refinery, if something happened to cause a substantial shutdown to the refinery DK's business would be materially effected. The second is narrowing crack spreads. If the crack spreads narrow too much, refiners have trouble making money. It has happened numerous times over the past energy cycles and could very well happen again. It doesn't appear as if there is anything on the near horizon that would alter the current spread environment, but this is a cyclical industry and the possibility must be respected. The final risk would be an economic slowdown. DK's business is refining and retailing fuel as well as retailing tobacco/ alcohol. A slower economic climate would impact business.

US refiners have declined from 319 to 148 over the past 25 years, a period in which there have been no new refineries built. The lack of refining capacity in the US has helped to drive crack spreads to record highs following the Gulf Coast hurricanes of 2005. Currently they're still right near peak spread levels and there doesn't appear to be a near term driver for lower spreads. In this environment The 3 refining IPOs of the past 8 months have all done quite well. DK is another solid refiner, quite similar in scope and size to ALJ. It is not coming at a significant discount to the group, but I do expect DK to be fully committed to growing revenues through acquisition. They've a $155 million war chest from the IPO and they will put that to work.

I like this deal in range and $2 above -- these deals have been working and I think you go with them until something in the energy sector changes.