The Bullish Case For Alon USA Energy

May.25.13 | About: Alon USA (ALJ)

Company overview

Ticker

ALJ

Exchange

NYSE

Country

U.S.A.

Sector

Basic Materials

Industry

Refining and marketing

Price

$17.60

Shares outstanding

62.7 million

Dividend yield

1.40%

Insider ownership

66%

52 week high/low

$21.24/$7.52

Market cap

$1.1 billion

Net debt

$333.5 million

Click to enlarge
2008 2009 2010 2011 2012
Net sales 5,156,706 3,915,732 4,030,743 7,186,257 8,017,741
Operating expense 5,258,153 3,994,977 4,192,469 7,005,465 7,745,957
Operating income 223,477 -80,836 -160,781 181,521 269,475
EBITDA 244,965 42,891 -44,475 263,977 394,291
Operating cash flow -812 283,145 21,330 69,560 387,810
Capex 434,492 153,128 59,838 122,359 105,361
FCF -435,304 130,017 -38,508 -52,799 282,449
Diluted EPS 1.72 -2.46 -2.27 0.69 1.24
Operating margin 4.3% -2.1% -4.0% 2.5% 3.4%
EBITDA margin 4.8% 1.1% -1.1% 3.7% 4.9%
Source: Company filings, in thousands of $
2008, 2009 capex higher to rebuild Big Springs refinery after fire
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Alon USA Energy is an independent refiner and marketer with three operating segments:

Alon USA Partners (NYSE:ALDW) is a variable rate MLP spun off from ALJ in November 2012 with assets including the 70,000 bpd Big Spring refinery, 840 miles of pipelines and six terminals. ALJ retained 81.6% ownership and transferred a $250 million term loan to ALDW. Competitive advantages include:

  • Low cost and modern refinery (rebuilt after February 2008 fire) uses cheaper West Texas Sour crude (76% in mrq) and benefits from growing production in Permian Basin and pipeline capacity constraints at Cushing.
  • Strategic location next to largest origination point of West Texas crude in Midland results in lower transportation costs.
  • Strategic location near customer base.
  • Ability to produce high-margin aromatics after refinery upgrade this summer results in value upgrade over gasoline of ~$14 million per year.

Krotz Springs refinery. One of lowest cost domestic refineries with 74,000 bpd throughput capacity, direct access to Colonial pipeline, recently able to use significant amount of cheaper WTI crude (via pipeline, truck and rail) and produce higher margin products. Management discussed placing Krotz Springs in a variable rate MLP like Big Springs on the most recent conference call as profitability improves over the long term.

California refineries. Three refineries (Paramount, Long Beach and Bakersfield) with throughput capacity of 70,000 bpd. Asphalt production (30% of capacity) currently suffering from seasonal weakness; however, demand should recover after passage of new federal highway spending bill, increased California highway budget and recovering housing market.

Refinery operations suspended in 4Q12 (startup expected in 3Q14) due to higher West Coast crude prices as increased mid-continent production was unable to be transported to California in large quantities. Crude mix reconfigured from heavy to light to utilize high distillate production capability and reduce lower value asphalt. Significantly lower operating costs offset mostly by use of logistical assets (unload and deliver oil for third parties) and trading.

Availability to source crude from mid-continent via rail (expect to receive permits and complete infrastructure build out during 4Q13) and increased production of light sweet Monterey shale oil expected to return refinery to profitability in mid to long term.

Asphalt. Second largest asphalt supplier in California and Texas (largest asphalt consuming states) and largest ground tire rubber asphalt marketer in U.S. Owns and operates 11 asphalt terminals in the Western U.S. with 50% ownership in Paramount Nevada Asphalt Company and 50% ownership in Wright Asphalt Products Company.

Retail. Largest 7-Eleven licensee in the U.S. with 298 retail gasoline and convenience stores in Central and West Texas and New Mexico (~50% fee owned). Markets fuel at ~635 sites under Alon brand, licenses use of Alon brand name and provides credit card processing services to ~103 licensed locations not under fuel supply agreements.

Investment thesis

Alon USA Energy is undervalued given the following:

Majority ownership of Alon USA Partners. The 81.6% stake in ALDW (retained after spin off) is worth $1.26 billion or ~12% more than the market cap of ALJ. This implies little to no value for the California/Krotz Spring refineries, asphalt or retail businesses.

EV 1,500
EBITDA 524
EV/EBITDA 2.9
EV 1,500
Revenue 7,877
EV/Revenue 0.19
FCF 415
FCF yield 37.66%
EBITDA 524
Multiple 3.75
EV 1,965
- net debt 334
- Preferred stock 36
- Minority interest 49
+ equity method investments 21
Equity total 1,568
Shares outstanding 63
Equity per share 25.01
All values in millions of $ except per share data
Based on ttm
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Company Ticker EV/EBITDA ttm
CVR Refining CVRR 3.9
Delek US Holdings DK 3.2
HollyFrontier HFC 2.7
Tesoro TSO 3.9
Valero VLO 4.0
Western Refining WNR 3.0
PBF Energy PBF 0.8
Alon USA Energy ALJ 2.9
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Possibility of retail business spin off. ALJ should finally spin off its retail business just like Valero (NYSE:VLO) spun off CST Brands (NYSE:CST) in order to take advantage of favorable market conditions (read: high valuation) and focus solely on refining. Factors supporting a high valuation:

  • Stable cash flows, strong sales and margin growth
  • Continued improvements over past several years (rebranding from FINA to ALON, interior and exterior remodeling including "Clean Team" image program, higher store count (almost doubled since 2006) in concentrated target markets, increased sales of higher margin food and beverage products, higher inventory turns.
  • Operating income rose from -$1.2 million in 2008 to $21.9 million last year.

ALJ withdrew its IPO registration of Alon Brands last year due to unfavorable market conditions (courtesy of Greece). The initial registration in 2008 did not proceed due to the financial crisis. Last year Alon Brands president and CEO Kyle McKeen reaffirmed his intention to go public and said he would "continue to assess the market for the right opportunity". The right opportunity is now. An IPO would provide additional capital to be used for store upgrades and extract value currently unrealized by the market.

Despite claims by management that "diversified operations provide stability", the trend of integrated oil companies and refiners spinning off non-core assets (mostly due to pressure from activist investors) in order to maximize shareholder value will continue. Investors can diversify more efficiently and effectively (by owning several different stocks) than management can (by owning several different businesses).

Company Ticker Revenue EBITA EBITDA margin EV/EBITDA
CST Brands (CST) 11,150 430 3.86% 7.5
Casey's General Stores (NASDAQ:CASY) 6,670 319 4.78% 9.6
Alimentation Couche-Tard (OTCPK:ANCUF) 32,960 1,230 3.73% 11.7
Susser Holdings (NYSE:SUSS) 5,890 187 3.18% 7.5
The Pantry (NASDAQ:PTRY) 7,210 216 3.00% 5.8
Alon Brands 915 33 3.63%
All values in millions of $
SUSS is closet peer in size and location of stores
Based on ttm
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2008 2009 2010 2011 2012
Net sales 1,227,319 808,221 666,398 833,470 907,918
EBIT -1,239 7,832 11,768 19,762 21,918
D&A 13,674 13,464 11,794 14,728 10,298
EBITDA 12,435 21,296 23,562 34,490 32,216
EBIT Margin -0.10% 0.97% 1.77% 2.37% 2.41%
EBITDA Margin 1.01% 2.63% 3.54% 4.14% 3.55%
Source: Company filings, in thousands of $
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An activist investor (preferably one with experience in the energy sector like Paul Singer, Carl Icahn or T. Boone Pickens) may be required in order to force a spin-off of the retail business if management does not do so soon. High insider ownership does not give ALJ immunity to pressure from activist investors. Below are two examples:

First, historically uninvestable companies, industries and countries have now become "fair game". Japan used to be dead to activist investors as many tried to force management to maximize shareholder value only to meet resistance by a corporate culture more concerned with everyone except shareholders. The most significant sign of a change is the success of Daniel Loeb in pressing Sony (NYSE:SNE) to spin off its entertainment division. SNE initially said the entertainment division was not for sale then said it would consider Loeb's proposals. The mere presence of an activist investor (much less actions taken as a result) can result in significant price gains.

Second, increased activist activity in general (especially in companies with high insider ownership such as Commonwealth) along with institutional shareholders now taking an active role in corporate governance (BlackRock - 2% holder, DFA) prove that no company can ignore its primary and fiduciary duty to maximize shareholder value.

Strong operating results in mrq. Improving crude slate resulted in record adjusted EBITDA of $157 million (vs. $13 million in year-ago period), operating income of $126 million (vs. loss of $10 million in year-ago period) and record adjusted net income of $0.86 per share (vs. $0.15 in year-ago period) despite lower throughput rates due to maintenance at Big Spring and Krotz Springs.

Source: Company presentation

Retail fuel sales volume increased 7.5% to 44.4 million gallons and operating income rose 36% to $4.5 million due to higher fuel sales volumes and margins.

Source: Company presentation

Low cost, high margin, geographically diverse refineries. Able to process cheaper sour crude (~76% of feedstock) and produce high margin distillates (distillate yield of 40% vs. 35% for peer group). Furthermore, secular growth in domestic energy production (natural gas, crude) should lower feedstock costs for mid-continent refiners such as ALJ.

Source: Company presentation

Improving asphalt business. The asphalt business is valued under the assumption current low seasonal demand will persist indefinitely and that the California refineries (which produce a significant amount of asphalt) will never come back online. Encouraging signs include the following:

  • High margins (~$62 per ton compared to ~$55 per ton in year ago period) due to lower crude oil costs and higher non-blended asphalt sales prices.
  • Purchased winter fill inventories at attractive prices.
  • Future sales commitments at higher pace than last year.
  • Reformulating some asphalt blends to take advantage of less expensive blending oils.
  • Additional operating expense savings at terminals.

Improving financial strength. Reduced net debt by $137 million to $334 million from 4Q12. In 4Q12 reduced net debt by $282 million using $171 million from ALDW IPO proceeds and operating cash flow. Total net debt reduction over ttm of $530 million. Net debt to total capitalization of 32% (vs. 70% in year ago period) and net debt to adjusted ttm EBITDA of 0.6x (vs. 3.7x for year ago period).

Higher dividends. The board approved a special dividend of $0.16 per share (due to fall in debt and desire to reward shareholders directly as opposed to buyback) and a 50% regular dividend increase to $0.06 per share (in order for yield to be competitive with peers).

Risks

  • Gasoline demand dependent on U.S. economic growth. The risk is mitigated by numerous signs of strong economic growth as well as an accommodative fed.
  • Narrowing of crack spread/crude differentials. Spreads remain at high levels despite recently narrowing. Furthermore, a significant portion of 2013 distillate production is hedged.
  • Refinery shut down for maintenance, fire, etc. There is no way to avoid this. This is an inherent risk in the refining industry.
  • Current weak demand for asphalt. Risk mitigated by factors mentioned above.
  • California refineries currently suspended operations due to high crude prices. Risk mitigated by factors mentioned above.
  • Recently proposed EPA pollution standards aimed at reducing sulfur content in gasoline created fears of massive costs. This created an opportunity for value investors to accumulate shares due to the overreaction. The effect on ALJ will be less than initially expected (less than $30 million) and is "not expected to be material to the company's performance." The California refineries already meet the new proposed standard. Furthermore, as with most government regulations, the consumer will bear the ultimate cost as any costs will simply be passed on.
  • Fear of rapid increases in ethanol credits is overblown for two reasons. First, management said on the most recent conference call that Big Spring currently covers 80% of ethanol RIN obligation internally. They are investigating several options for Krotz Springs to generate additional credits. Second, Congress may act to reduce this mandate, which would reduce the price at the pump for their constituents.

Conclusion

The asymmetric risk/reward profile is not dependent on an activist investor pressing the board to spin off the retail business. The downside risk is limited given the low valuation, lower leverage, high insider ownership (unlikely to sell if for no other reason than to prevent a takeover) and multiple high quality assets. The upside is significant with a price target of $25 (using an EV/EBITDA multiple of 3.75x) vs. the current price of $17.60. A low float (due to high insider ownership) and moderately high short ratio (11% of float) should further enhance price gains. The time frame is intermediate (six months to a year) as the market will begin to price in the spin-off of the retail business and the improving asphalt business faster than their actualization.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.