Valero vs. Tesoro: Comparing Two Refiners 10 comments
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Refiner Valero (VLO) recently warned on a weak 2nd quarter, projecting a loss of (.50) and citing extended downtime at its Delaware City and McKee refineries and the continuation of weak sour crude oil discounts and lower diesel margins.
The stock tanked on the news, losing about 20%, and dragged fellow refiner Tesoro (TSO) down with it, about 15%. I wrote Tesoro up favorably in January on Seeking Alpha, when it traded around 14, so with the stock closing at 15.59 Friday, now would be a good time to compare the two companies in an effort to see how much VLO's bad news should influence my opinion of TSO.
Raising Capital - Valero took advantage of its low share price and bad news to price an offering of 40 million new shares, at 18 per share, raising 720 million by diluting existing shareholders by 8%. To place this move in the context of previous company actions, here is a quote from the 2008 10-K:
During the years ended December 31, 2008, 2007, and 2006, we purchased 23.0 million, 84.3 million, and 34.6 million shares of our common stock, respectively, at a cost of $955 million, $5.8 billion, and $2.0 billion, respectively.
Doing the math, they bought back 141.9 million shares for 8.755 billion, or an average cost of 61.69 per share. Now they are selling shares for 18. That would be buy high, sell low, at shareholder expense – sufficient reason to question management's ability to create long-term value.
Tesoro recently did a bond offering, raising 300 million, priced to yield 9.75%. Checking share repurchase activity, during the 4th quarter of 2008 they repurchased 182,250 shares at a cost of 8.44 per share. With the stock trading at 15 and above recently, they are buying low. Back in 2006, the company repurchased 4.8 million shares for 148 million, 30.83 per share. Activity since has been trivial, and over the intervening years the shares have traded as high as 68.98. Tesoro's buyback activity seems more restrained and apropriate than Valero's.
Not the Bobbsy Twins - sometimes two companies are sufficiently similar that the market seems to think of them together: the stocks trade more or less in tandem and bad news for one affects the share price of the other. However, as those who practice pair trading will tell you, frequently there are differences that over time will lead one company to clearly outperform. An example would be Linens 'N Things and Bed Bath and Beyond. The following table lists a selection of factors about the two refineries that will serve as a starting point for comparison:
Valero | Tesoro | |
Share Price (6/5/2009) | 18.21 | 15.56 |
Market Cap | 9.404 Billion | 2.153 Billion |
P/E TTM | -8.7 | 5.3 |
P/B | .6 | .7 |
P/S | .1 | .1 |
P/CF | 3.0 | 1.8 |
Total Refinery Capacity – barrels per day | 2,990,000 | 664,500 |
Regional Capacity - % to total | ||
East Coast (Northeast) | 21% | - |
Gulf Coast | 54% | - |
West Coast (California) | 10% | 40% |
Mid Continent | 15% | 17% |
Pacific Northwest | - | 29% |
Mid Pacific (Hawaii) | - | 14% |
Feedstocks - % to total | ||
Light/Sweet Crude | 26% | 62% |
Heavy/Sour Crude | 56% | 32% |
Other | 18% | 6% |
Outputs - % to total | ||
Gasoline | 45% | 44% |
Diesel – Distillates – Jet Fuel | 35% | 35% |
Other | 20% | 21% |
Valero is national in scope and focused on the ability to refine heavy/sour crudes. Tesoro is more regional, West Coast, and processes more light crude than heavy.
Book Values – both companies trade at prices that are well below the replacement cost of their assets. That provides margin of security, which made me bullish on both back in August last year. However, refinery utilization in the US has fallen steadily with decreasing demand, and many refiners have increased the throughput of existing refineries, resulting in utilization in the low 80's. Some marginal refineries will need to be shut down to rationalize capacity. Under the circumstances it makes sense to argue that the assets should be valued based on their ability to generate income.
Cash Flow – both companies are trading quite low compared to cash flow. This is justifiable, to a point, based on the observation that refining is capital intensive: there is always another turnaround, more maintenance, modifications and expansions to remain competitive. Refineries wear out and need to be constantly rebuilt: depreciation is not just an accounting formality. As excess capacity has become obvious, most refiners are cutting capex, which should result in increasing free cash flow over time. As a general rule, the market dislikes capex and rewards free cash flow.
Heavy Crude Discounts - as oil soared to as high as 147 during 2008, heavy and sour crudes sold at attractive discounts, enabling refiners that were equipped to process the more difficult feed-stocks to make excellent profits. As prices declined and OPEC reduced output, the cuts were taken primarily in heavy or sour crudes, in order to maximize income from production. As a result, discounts have fallen, and a number of refiners have canceled or deferred plans to build or update cokers, which are necessary to process the heavy crudes. There is even discussion that some cokers may have to be shut down. In this environment, Valero's strength has become much less important, even a temporary handicap. Tesoro, which is less specialized to process heavy crudes, is less affected by this anomaly, which is expected to be temporary.
Distillates (Diesel) vs. Gasoline – US refining is biased toward the production of gasoline, which is in greater demand than diesel. European refineries produce more diesel, which is the fuel of choice in that area. It has been said that the Chinese economy runs on diesel, and during 2008 many US refiners did everything possible to produce more distillate rather than gasoline. There is about a 4% swing that can be handled without heavy investment in additional plant and equipment. This year, demand for diesel has been anemic, due to the global economic contraction, and the emphasis is back on producing gasoline. Infrastructure (roads) calls for asphalt, not something all refineries can produce. Both Valero and Tesoro have the ability to make asphalt.
Crack spreads in the various regions have not been uniformly affected by the change in the demand for diesel vs. gasoline. According to information provided by Tesoro on industry differentials, crack spreads in the East Coast, Gulf Coast and Mid Continent areas have suffered more than the West Coast and Pacific Northwest. So Tesoro should not be expected to experience the same degree of difficulty from this source as Valero.
Capex – Tesoro has scaled back capex fairly dramatically as the slowdown has unfolded, and is now concentrating on small projects, 2-5 million, with a two year payback. According to CEO Bruce Smith, they have about 300 million of such projects on the shelf, and plan to do them with capital generated by operations. However, the company recently completed a debt offering of 300 million. I think it was a safety play - any company that has debt maturing any time within the next few years would do well to roll it forward if that can be done at all realistically, to avoid getting caught in a renewed credit freeze.
Valero's approach doesn't make a lot of sense to me. Last year, they were doing strategic reviews and planning to sell off non-core refineries, basically those that are smaller and less complex. As the market for these properties has collapsed, they recently bought an ethanol producer and now on May 20th they announce that the company has entered into an agreement to acquire The Dow Chemical Company’s (NYSE: DOW) 45% interest in the Total Raffinaderij Nederland N.V. (TRN) for an enterprise value expected to be approximately $725 million, including working capital and inventories.This will be funded by the share offering discussed earlier in this article. The timing may be good.
But I would be far more comfortable if they had unloaded the non-core refineries while there was a market for them before getting involved in more acquisitions. Also, if the strategy was to grow by acquisition the capital should have been accumulated from operations. Again, that takes me back to the huge sums expended on share repurchases at premium prices. Whether any of those funds should have been deployed in keeping the Delaware City and McKee refineries up to snuff, preventing extended downtime, is another question worth asking.
Capture Rate – Tesoro has been able to beat the crack spread quite handily in recent quarters, based in large part on the size of the discount of heavy to light crudes, an advantage that has been reduced lately. In a recent presentation, the company says that in 2008, the average discount of Maya from WTI was 16, for 2009 year to date it was 9 in late May, and has been as low as 3.50 since then.
The discount of Maya from WTI is not directly relevant to Tesoro's operations. Their California and Pacific Northwest refineries process California or Ecuadorean heavy crudes and ANS (Alaska North Shore.) Tesoro includes Ken River at 57% in their index for the California refineries, which have a history of fairly generous margins. According to the IEA, West Coast refining margins for Kern (coking) were 14.41 at the end of April, compared to .94 for Maya (coking) on the Gulf Coast for the same month. Taking all of this together TSO is not under the same amount of margin pressure as VLO.
Earnings and Valuation - I spent quite a bit of time trying to project TSO's earnings for the 2nd quarter, and came up with .55. That would be on the high side of consensus. Projections are difficult because TSO's Golden Eagle coker came on line during a period when light/heavy spreads were widening, and it is difficult to separate the improved refinery capabilities from the spreads during the 3rd quarter last year. My track record on these projections is not good, first too low then too high.
Looking forward and assuming the global economy recovers, heavy crude discounts and diesel spreads should widen back out, so that TSO's earning capacity going forward would be similar to its last 5 years – about 3.50 per share. At a P/E of 12 on that average, my target would be 42 within 5 years, returning over 20% annualized.
Speculation vs. Demand in Oil Prices – Last year's run to 147 is still fresh in memory, as is the stunning collapse in prices that followed. This created a difficult environment for refiners, due to the uncertainty of supply and demand and the danger of inventory losses or being squeezed between expensive feed-stocks and consumer price resistance.
CEO Bruce Smith responded to a question on this area during Tesoro's last presentation. His point was that speculators were running with the tide in 2008 – there was strong demand and they were pushing prices in the direction they were going anyway. In 2009, speculators do not have demand on their side: it is more about the value of the dollar and the fear of inflation. It seems unlikely they can achieve the same results. I personally advocate that Obama release supply from the Strategic Petroleum Reserve before anything gets out of hand.
As an individual investor my preferred approach, when the speculators and manipulators get going, is to vacate the affected area. However, it is sometimes difficult to locate any part of the market that is not subject to these concerns. In Tesoro's case I look to management to minimize the damage of operating in the environment that we have.
Implications for Investment – While Tesoro is by no means immune from the reductions in heavy crude discounts and diesel crack spreads that have hit Valero, the company has been less affected. I would not let Valero's troubles lead me to sell Tesoro at the wrong time. I like the company's approach to managing the deployment of cash flow, and regard them as a capable competitor.
Always tempted by value, I would nevertheless back away from any involvement in Valero, for the fact that I dislike the acquisitions and capital raise combined with an earnings warning, in the wake of massive waste of capital on repurchases at premium prices. I held a starter position briefly last year, closing it – I don't know why – with a small profit. Shorting doesn't seem like a good idea, based on the low valuation multiples.
Strategy for Tesoro - I originally played Tesoro by means of a covered combination, long shares at 27.xx and short straddles at 22.50. I was attracted by the combination of volatility and value, and guessed that the stock would trade in a range. Instead, it tanked and I wound up being assigned on the puts, owning the shares at an average cost of 19.xx. I traded around the position pretty heavily during March and April, working my average cost down to 16.52 per share.
The summer driving season and the demand for gasoline will drive results for 2009. Last year there was no driving season: what will happen this year will not be known with certainty until we get 3rd quarter results.
I plan to hold the position through the 3rd quarter earnings, adding at prices under 15 and reducing when recent buys show LIFO profits. The thinking is, the shares are already priced for a mediocre result, or worse, so any surprise will be to the upside. Meanwhile, the company provides a lot of relevant information on their website, and I can monitor and adjust accordingly.
Disclosure: Long TSO, no position in VLO
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This article has 10 comments:
seekingalpha.com/artic...
And my comment.
As a thought, I've often wondered if this practice of "buy high and sell low" is *designed* to benefit management, who are often paid with shares as a large part of their compensation package.
Once the shares are vested, they can have the buy-back program working and sell their shares. Knowing that the cycle will be repeated, they can either then buy low upon the new issuance or just get more shares through their compensation package.
Considering the environment we've recently lived through, may not be too far-fetched?
HTL
"Raising Capital - Valero took advantage of its low share price and bad news to price an offering of 40 million new shares, at 18 per share, raising 720 million by diluting existing shareholders by 8%. To place this move in the context of previous company actions, here is a quote from the 2008 10-K:
During the years ended December 31, 2008, 2007, and 2006, we purchased 23.0 million, 84.3 million, and 34.6 million shares of our common stock, respectively, at a cost of $955 million, $5.8 billion, and $2.0 billion, respectively.
Doing the math, they bought back 141.9 million shares for 8.755 billion, or an average cost of 61.69 per share. Now they are selling shares for 18. That would be buy high, sell low, at shareholder expense – sufficient reason to question management's ability to create long-term value."
Ponderous vs Nimble
Too slow to react and when they do, they make the wrong decision.
Even though VLO has strong market share and strong value with hight future demand of less desirable stock, management is inept at best and ... at worst.
Jared.
HTL, I am pretty well convinced that some managements get into the buybacks just to support their own compensation, in the cases where there is a track record of overpaying. I don't think they deliberately work the cycle, although from where it lies they would do well to take more of their compensation in the form of stock right now.
searcher and jmann83, looks like you both picked up on the pair trading idea. I was tempted to call for long TSO.short VLO but VLO just seems to be well positioned long term based on their ability to refine heavy/sour crudes.
pone, thanks for mentioning HOC. I haven't been following them but went to their website and browsed the presentation on the refinery they just bought from Sunoco. I liked what I saw and will probably take up a starter position.
> pone, thanks for mentioning HOC. I haven't been following them but
> went to their website and browsed the presentation on the refinery
> they just bought from Sunoco. I liked what I saw and will probably
> take up a starter position.
I should mention that HOC has a bit of a headwind. They had a supply constrained situation in the Phoenix metro area, but a new very large pipeline will be come in there soon, which will hit their margins. Personally I am still hoping for a refiner sector selloff and I would be a buyer of HOC around $10/share.
Then again, this market is getting a bit frantic and nothing seems to want to sell off.