In our last article on HollyFrontier Corp. (HFC), we recommending buying on weakness. In light of the price action in the stock, and how wrong we have been since that recommendation, we thought it a good time to update our thoughts and thesis on HFC in this article.
Our investment thesis for HFC, at the time of the previous article, was: (1) relative to peers, HFC remained significantly undervalued, based upon most conventional metrics, (2) the company's strong balance sheet and cash position, combined with the considerable dividend payout and share repurchase activities over the past 18 months, supported ownership under the return of capital (and potential for more) banner, (3) the ownership interest in the GP and LP of Holly Energy Partners, L.P. (HEP) did not appear reflected in the stock price, as evidenced by the discounted multiple to the refining peer group and (4) the news around RIN (Renewable Identification Number) pricing was overblown, and would likely be priced into the pump over time. Since our March 13 article, there have been two notable developments around the refining industry that we believe have further adversely impacted the share price of HFC (as well as the refining sector).
First, the Environmental Protection Agency [EPA] is considering new rules (proposed by the White House) to reduce Gasoline sulfur levels which the refining industry has indicated will bear significant cost on upgrades. Public comments by Valero Energy Corp. (VLO), as an example, have indicated that the proposed rules would cost "hundreds of millions of dollars" in upgrades. It is currently unclear whether the new rules would be adopted (likely, but the rules are in the public comment phase) and what the cost would be to HFC.
However, the prospect of incremental capital expenditures related environmental compliance is not particularly good from an investment perspective, as the direction of cash away from Special Dividends and share repurchases is somewhat disappointing. The same is true of the RIN issue (and RIN pricing has moderated of late, but is still materially higher than in recent years). With the EPA uncertainty and RIN pricing, both seem to be emerging as headwinds for the refiners broadly, and specifically to HFC, the market is discounting the stock to reflect a premise that at least a portion of the considerable cash position might need to be directed to operations and not simply returned to shareholders at least until the price of the underlying products reflects these emerging costs. These issues have really taken hold since March, and we believe the uncertainty has weighed on shares significantly.
Second, the prospect of higher operating and capital costs would be less relevant if crack spreads were holding. However, they aren't. The following chart highlights crack spreads in the Mid-Continent since the beginning of the year. Based upon our math, the price of HFC common is moving with a 75% correlation since December 31 to this particular crack spread. More notably than this relationship is that with a tightening crack, the margin (and corresponding profitability) of HFC has come under some pressure. So, when it is pretty easy to understand why, when combining the uncertainty associated with the EPA and RIN prices with the prospect of lower margins, the market would discount HFC (and the broad refining sector).
The bull thesis around HFC is pretty simple: (1) the decline in cracks is seasonal, and will recover through the summer driving season, (2) RIN pricing will moderate and prove a one-off issue that ultimately is passed through the products, (3) the impact of the EPA rules will be managed with duration (multi-year capital spending) and passed through the products, (4) HFC will retain the strong cash position as cracks stabilize and the political issues are worked through, enabling the company to continue to aggressively return capital to shareholders, (5) HFC, on a relative basis, is discounted relative to most peers (trading at below 3.75x, versus the peer group trading in and above the 4.00x context) and has vastly underperformed in 2013 (up 2.86% as of this writing, versus industry leader VLO up 15.5% and most refiners up in the 10%-15% context), making the company attractive as compared to other refiners and (6) trading at 3.6x against the current year on an EV/EBITDA and 4.32x against the next year EV/EBITDA (using consensus metrics), the stock is pricing in considerable risk.
The outcome that would lead us to reassess our thesis: the cracks don't recover, and continue to rapidly deteriorate through the driving season (which is somewhat binary, in that either cracks recover or they don't, which is somewhat tough as binary calls are not fun, but we believe the earnings risk is more priced in than not). A break in cracks would lead to substantive earnings risk and makes the impact of the RIN and EPA issues more serious. For now, we remain holders and believe the upside to HFC at the current price relative to the valuation remains very attractive.