HollyFrontier Corporation (HFC) is an oil refiner that operates primarily in the Central, Southwest, and Rocky Mountains regions of the United States, as well as serving as general partner of a publicly traded pipeline partnership. HollyFrontier boasts a P/E ratio of 5.09 based on June 17, 2013, closing prices, and furthermore the firm has a substantial amount of excess cash on its balance sheet. As a result, based on 2012 results, HollyFrontier offers an unbelievable free cash flow yield on operating assets of over 26 percent.
Normally such an outsize free cash flow yield is worth buying with both hands, but the first question has to be what is the reason for the market's apparent pessimism about HollyFrontier and whether the same is justified. In the case of oil refiners, the main difficulty is that their profit margins are governed by the crack spread, i.e. the difference between the price of crude oil and refined petroleum products, is fairly volatile and not under the control of any refiner. Furthermore, the current refinery spread that has created this impressive free cash flow yield is very wide by historical standards, and apparently the market believes a pullback is not only inevitable, but imminent.
However, it seems to me that based on HollyFrontier's production volumes and current price, even if the crack spread makes an immediate and dramatic decline, it will be capable of producing an adequate cash flow return, and therefore the current generous crack spread is somewhat of a free roll.
HollyFrontier operates several refineries with a total capacity of 443,000 barrels per day and capable of using a wide range of crude quality at its various facilities. The company has one refinery in Kansas, one in Cheyenne, two facilities in Tulsa, that collectively form a full refinery, and a similar two in Artesia, and Lovington. The company also serves as the general partner and 44% owner of a pipeline partnership, HEP, which mainly services HollyFrontier itself but also has a long-term contract with Alon USA, Inc. Most of the company's sales are to the Midwest and Rocky Mountains regions of the nation, where the company believes that it can compete with the Gulf Coast refiners despite their greater economies of scale, because its product has less distance to travel.
Turning to the figures, I mentioned earlier that the company has a substantial amount of excess cash. Specifically, its latest balance sheet includes $1.872 billion in cash and $667 million in short-term debt instruments. The company's total current assets total $4.763 billion, with the excess consisting mainly of receivables and inventory, which of course consists of crude oil, petroleum products in various stages of refinement, and finished petroleum products and therefore are readily marketable. The firm's current liabilities total $1.767 billion. Since there is approximately a $3 billion net current asset position, it is fair to say that the company's entire cash and investment holdings of $2.54 billion can be considered excess and may be treated separately from the company's operating assets. Subtracting this amount from HollyFrontier's current market cap of $9.05 billion produces a market price of $6.51 billion for the company's operating assets.
In terms of earnings, in 2012 sales were $20.091 billion, cost of goods sold were $15.841 billion, with a gross margin of $24.89 per barrel. Operating income was $2.884 billion. Depreciation and amortization were $243 million, while capital expenditures were $335 million and the impact of derivative losses was $52 million, producing operating cash flow of $2.844 million. Interest expense was 104 million, producing pretax income of $2.74 billion. After estimated income taxes of 36.5%, this leaves us with $1.74 billion in free cash flow, of which $33 million goes to the other partners of HEP, which leaves $1.707 billion in free cash flow, which is a yield on operating assets of 26.2%.
HollyFrontier earnings & estimated free cash flows, 2010-2012 ($millions except for per barrel amounts)*
|Cogs of goods sold||(15841)||(12680)||(7367)|
|Gross margin per barrel||$24.89||$20.64||$8.79|
|Operating cash flow||2844||1518||168|
|Pretax free cash flow||2740||1440||94|
After-tax estimated free cash flow
(36.5% rate assumed)
|After-tax free cash flow to shareholders||1707||878||30|
*Holly and Frontier merged in July of 2011, hence the dramatic increase in sales.
I should point out that the above calculation makes no difference between maintenance and growth capital. The consensus among investors is that maintenance capital should be considered a genuine charge against free cash flow because it is necessary to allow the company to maintain its current earnings power, while growth capital may not need to be charged against free cash flow because the firm has the option of not spending it in order to preserve cash or if the business landscape changes. As a result, the calculation of free cash flow can perhaps be too conservative. In fact, the firm announced in its 2012 10-K that its 2013 capital budget was $400-450 million, but only half of it was for maintenance or compliance purposes, and the other half for expansion or operational improvements.
Based on the above figures, we assume that we would be satisfied with a free cash flow yield of 10%. Out of an ex-cash market cap of $6.51 billion, this is $651 million in free cash flow. If we assume that maintenance capital expenditures will equal depreciation, and that interest expenses and tax rates do not change from 2012, this works out to operating earnings of $1.075 billion per year ($651 million after tax is $1.025 billion before tax, plus $100 million in interest minus $50 million from its interest in HEP). If we further assume an average throughput of 400,000 barrels per day, which is 90% of HollyFrontier's capacity that works out to 146 million barrels of oil per year. Dividing $1.017 billion by 146 million barrels produces a required crack spread of $7.36 per barrel. HollyFrontier's overhead has recently hovered around $5.50 per barrel, for a total required spread of about $12.90.
According to HollyFrontier's latest conference calls, the average Mid-Continent crack spread the company's management has observed is $26, and has ranged from $7-27 over the last five years. Furthermore, because HollyFrontier is capable of handling heavy and/or sour crude at most of its refineries, its cost of crude oil is frequently several dollars per barrel lower than the West Texas Intermediate crude oil that forms the basis of the calculated crack spread. In fact, in the first quarter of 2013 the company reported that on average it sourced its oil for over $7 less than the West Texas Intermediate price.
The point is, though, that the current spread could decline by half without imperiling the adequacy of HollyFrontier's earnings relative to its price. Although such an outcome is entirely within the realm of possibility, until and unless it happens holders of HollyFrontier can reasonably expect the outsize earnings yield to continue, which is likely to be expressed ultimately in the share price. HollyFrontier's management is also committed to returning cash to shareholders, having increased the quarterly dividend to 30 cents and having declared an additional special dividend of 50 cents for the last five quarters. The combined regular and special dividend equates to a dividend yield of 7.2%.
As a result, I can confidently recommend HollyFrontier corporation as a candidate for portfolio inclusion.