Attractive Valuations On Large U.S. Refiners

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 |  Includes: MPC, PSX, TSO, VLO, XOM
by: Junius

In my previous article on the U.S. refinery industry, I explained that the outlook for the industry remains bullish. Higher U.S. oil production, increasing exports of refined products and an expected widening of refinery margins are likely to increase profitability for U.S. refiners in the medium term. With strong free cash flow at many refiners, many have been rapidly reducing debt and increasing returns to shareholders through increased dividends and share buybacks. Despite this, the market values for many independent refiners have remained low since the selloff in June this year.

The selloff in refiners in June was the result of the release of disappointing quarterly results for the second quarter of 2013. Refining margins had declined substantially, as new pipelines became operation earlier in the year and the increasing use of road and rail to transport oil had eased the price dislocations in the crude market. Nevertheless, the longer term fundamentals for the oil refining industry remain strong; and the valuations of many refiners are particularly attractive.

This article will focus on the valuations and the recent financial performance of the large independent refiners.

Valero Energy (NYSE:VLO) is the largest independent refiner in the U.S., with a refining capacity of 2.8 million barrels per day (bpd). The escalation of the price of RINs in the first half of this year, increasing natural gas prices, and the decline in refinery margins had led Valero to report significantly lower earnings for the second quarter of 2013. Refiners like Valero are required to purchase RINs, ethanol credits required to comply with the Renewable Fuel Standard. For the second quarter of 2013, the company spent $125 million on purchasing RINs from the market, $67 million more than the prior year period.

2013 Q2

2013 Q1

2012 Q2

Revenue ($m)

34,034

33,474

34,662

Net income ($m)

466

654

831

Earnings per share ($)

0.86

1.18

1.50

Refining gross margin ($ per barrel)

9.26

10.59

10.63

Click to enlarge

Phillips 66 (NYSE:PSX) was created to hold the downstream assets of ConocoPhillips (NYSE:COP), when the company was spun off in May 2012. Currently, Phillips 66 is the second largest domestic refiner, with 11 refineries in the U.S., which have a combined capacity of 1.8 million bpd. The company also operates a sizeable midstream and chemicals business.

2013 Q2

2013 Q1

2012 Q2

Revenue ($m)

43,948

42,326

47,827

Net income ($m)

958

1,407

1,181

Earnings per share ($)

1.55

2.25

1.88

Refining gross margin ($ per barrel)

9.88

13.94

12.85

Click to enlarge

Marathon Petroleum (NYSE:MPC) operates seven refineries with a combined refining capacity of 1.7 million barrels per day. The company completed its $2.4 billion acquisition of BP's (NYSE:BP) Texas City refinery in February 2013. The base purchase price for the 451,000 bpd refinery is just $598 million; as infrastructure and inventories are valued $1.1 billion, and $700 million are to be paid over the next six years, subject to profitability conditions. This seems to have been an attractive acquisition, as the refinery is expected to add between $700 - $1,200 million in EBITDA to Marathon.

2013 Q2

2013 Q1

2012 Q2

Revenue ($m)

25,703

23,345

20,257

Net income ($m)

593

725

814

Earnings per share ($)

1.84

2.19

2.39

Refining & Marketing gross margin ($ per barrel)

6.18

7.92

11.13

Click to enlarge

Tesoro (NYSE:TSO) now operates seven refineries following the completion of the acquisition of BP's Carson, California refinery for $2.4 billion in June 2013. The refining, marketing, logistics and complementary assets are priced at an attractive cost of $1.075 billion, whilst inventories are valued at $1.3 billion. BP's assets are expected to add roughly $500 million in EBITDA, or $245 million to net income; and so the acquisition is likely to be highly accretive to earnings. Tesoro already operates an adjacent refinery in Wilmington, California; and expects to benefit from annual synergies of $250 million by 2017, through feedstock optimization, operating process synergies and lower product distribution costs.

2013 Q2

2013 Q1

2012 Q2

Revenue ($m)

8.897

8,156

8,105

Net income ($m)

227

93

387

Earnings per share ($)

1.67

0.68

2.77

Refining gross margin ($ per barrel)

15.42

13.68

20.96

Click to enlarge

EV / EBITDA Analysis

VLO EV / EBITDA TTM Chart

VLO EV / EBITDA TTM data by YCharts

Three out of four of the independent refiners are trading at very low multiple on EBITDA; and at a significant discount to integrated oil majors, such as Exxon Mobil (NYSE:XOM). Tesoro is showing a higher multiple on EBITDA primarily because of higher debt in relation to its acquisition of BP's Carson refinery; whilst higher EBITDA from the transaction has yet to be realized. So, when we take this into account, all four refiners are trading at very low multiples on operating income before depreciation and amortization.

P/E Analysis

VLO PE Ratio TTM Chart

VLO PE Ratio TTM data by YCharts

Valero

Phillips 66

Marathon Petroleum

Tesoro

P/E (TTM)

7.20

7.90

7.40

10.39

Forward P/E (2013)

8.62

8.58

9.30

9.48

Forward P/E (2014)

7.44

8.59

8.16

6.92

Forward P/E (2015)

7.83

8.82

8.02

6.28

Click to enlarge

Valuations for the large refiners are also attractive on both; current and forward price-to-earnings ratios. Combined with declining capital expenditure per dollar of revenue, oil refiners have recently been able to return much more capital to shareholders. This trend is expected to continue, as strong free cash flow should persist given strong profitability.

Marathon Petroleum and Tesoro may be particularly attractive because of their acquisitions of BP's former refining and marketing assets, which are likely to be highly accretive to EBITDA, and there is significant potential for further gains from operational synergies and greater export potential.

A major downside risk for independent refiners in the short term could come from disappointment in the announcement of the EPA's proposed 2014 target for biofuel production, which is due in September. The EPA has announced that it would cut the 2014 target, but a great deal of uncertainty still surrounds the industry: and although the price of RINs have eased since the announcement, they remain significantly more expensive than in 2012. The escalation in the price of RINs had been a significant contributing factor to last quarter's disappointing earnings at many independent refiners. With declining domestic gasoline consumption, even a modest rise in the biofuel target would only delay the 'blend wall' dilemma. Nevertheless, much of this uncertainty, or perhaps too much, appear to have been already priced into the valuation of these refining stocks.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in MPC, TSO over 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.