Refiner HollyFrontier Corp. (HFC) represents a meaningful value opportunity, as the company's core operations are discounted improperly. Recent noise about Renewable Identification Number (RIN) prices spiking should not materially impact the long-term thesis around HFC. Let's walk through the "pieces" here, and discuss why HFC should be added now.
First, What Is HFC?
HFC is a Dallas-based refining company, with ownership of 5 refiners that have 443,000 bpd of capacity. The company's refineries are located in Kansas, New Mexico, Oklahoma, Utah and Wyoming, and pull crude from the Rocky Mountains, Southwest and Mid-Continent. The following picture (taken from the February investor presentation) highlights the details of the company's refining operations.
In addition to the company's refining operations, HFC owns 24 mm units and the General Partner (GP) of Holly Energy Partners, L.P. (HEP), a refined products pipeline and distribution system. HEP is publicly traded, and closed at $43.92/unit on March 12, 2013.
Let's start with the balance sheet:
As you can see from the attached table, you need to separate the HFC and HEP debt and cash to get a real snapshot of the balance sheet (as HEP is consolidated up, but is a separate entity, not guaranteed by HFC, and thus, should be viewed differently). What is clear: HFC has an exceptional balance sheet, with $2.4 billion of cash and equivalents and a very manageable $471.6 mm of debt (of which one, the 9.875% due June 2017, is callable this June at a 104.938, which should be expected considering the extraordinarily high coupon that will lead to interest savings going forward).
Using the latest share count (203.5 mm), HFC is sitting on $11.71/share of cash that should be expected to be returned to shareholders (why am I concluding this, we'll get to later).
HFC also owns 24 mm units of HEP, which, using the March 12 closing price, are worth $1.1 billion to the shareholders of HFC. The company also offers some guidance around valuing the GP of HEP. Using the backward looking $21.2 mm of cash generated by the GP, at a reasonable mid-point (versus peers) multiple, the GP is worth $318.0 mm. I could argue the GP is worth more (a higher multiple, or against some expectation of forward cash) but for the purposes of this analysis, let's keep it simple. In total, the HEP ownership interest is worth $6.79/share of value to HFC.
In total, HFC has $18.50/share of non-refining operations value, between the cash and HEP. Taking out the $18.50/share from the $54.94 closing price on March 12, and the HFC refining operations are currently valued at $36.44/share, or $7.4 billion, before adding the debt of $471.6 mm ($2.32/share).
Compared To Peers, HFC Is Heavily Discounted…
Using Valero Energy Corp. (VLO) as the benchmark, the historical, average multiple (including the depressed 2008-2009 cycle) is 7.25x for a refiner. Currently, VLO is trading at around 8.0x forward earnings (2013), so for the sake of trying to be reflective of the current market versus the historical average, let's value HFC at 7.50x.
Valuing refining earnings are complicated. The business has little control over the prices of the input (the cost of crude) or output (price of products). Refineries break down, are in constant need of repair and downtime and, at times, environmental uplifts. Basically, the earnings are volatile. This is why refiners trade at such a discount to the broad market (for example, a 7.50x multiple against forward earnings is substantial discount to the 12.5x 2013 market multiple).
The way I look at the refiners is to attempt to approximate a mid-cycle earnings while also adjusting for the down-cycle to know where my baseline is. In the case of HFC, the consensus calls for $1.5 billion of earnings in 2013, and a drop to $1.1 billion in 2014 (which feels punitive relative to other refiners that do not reflect a 1/3 drop in earnings power, but 2014 is way off, and estimates will move around a lot). For my assumptions, as highlighted in the following table, I am (which is truly a coincidence) at $1.0 billion for the low-cycle, $1.5 billion for the mid-cycle and $2.0 billion for the high-cycle of earnings power.
As you can see from the table, HFC (adjusted for the cash, HEP and debt) is trading at 6.18x versus the low-cycle, 4.64x versus the mid-cycle and 3.71x versus the high cycle, all below the 7.50x multiple. When you look at the next table and apply a 7.50x multiple and add back the value of the cash, HEP and subtract the debt, you see that the company is trading now (roughly) to the low-cycle (which is punitive and unlike any other refiner), with upside of over 25% to just the mid-cycle.
The bottom line is that the stock is trading to the low cycle, and even with the recent RIN noise (which I don't think is worth getting into, as the market has digested the higher RIN prices adequately considering the ultimate consequence is a pass-through) refining margins should be expected to hold higher than the low-cycle for the foreseeable future (Mid-Con cracks are still holding the high-end of the 5-year range, and motor gasoline stocks are approaching lower levels relative to the 5-year average headed into the driving season). Right now, as an entry point, it represents a reasonable up/down opportunity.
Oh, Yeah, The Cash…
HFC has already paid one $0.50/share special dividend and a $0.30/share regular dividend in 2013. In 2012, the company returned $3.10/share in dividends and repurchased $209.6 mm of common stock, and still ended the year with a record cash balance. I believe the average industry multiple I am assigning to HFC is somewhat punitive, in that HFC has done more to return cash to shareholders than any other peer in the refining segment while maintaining considerable financial integrity. The company is well positioned to continue to return capital to shareholders, and should refining margins hold within the current context over the next 12-18 months, should (1) build more cash and (2) justify at least a mid-cycle valuation.
Within the context of a parabolic market, HFC remains a real value play. For my last article on HFC (when the stock was a lot lower), please click here.