Why The Analysts are Wrong on Alon and Delek

As part of my ongoing effort to understand the logic underpinning the activity of Wall Street analysts and commentators, I give you the example of crude oil. Energy Select Sector SPDR (NYSE:XLE) is an ETF representing 30 energy company listed in the Standard & Poor’s S&P 500. The energy companies’ weight in the index is heavy because of companies like Exxon Mobil Corp. (NYSE:XOM) and Chevron Corp. (NYSE:CVX), which have exceptionally high market caps.

The XLE ETF has fallen about 12% since the price of a barrel of oil began to drop by about the same amount. During this period, Alon USA Energy Inc. (NYSE:ALJ) has fallen 34% and Delek US Holdings Inc. (NYSE:DK) has fallen 24%. It’s not hard to explain why Alon USA has taken a harder fall than Delek US: Alon USA was a hot share over the past year, until oil prices began to go down. Even I said that the difference between Alon USA and Delek US was mostly in Wall Street’s perception of the two companies’ managements, and the two companies were actually very much alike. The difference was that analysts and investment institutions knew Alon USA’s managers better than they knew the managers of Delek US.

The questions I ask are: Why should recommendations for energy companies be downgraded in tandem with the fall in the price of oil, rather than upgraded? Why has the XLE fallen so far? What do companies like Alon USA and Delek US actually do, and how do they make their profits? Since both companies do almost the same thing to make sales and profits, let take a moment to look at Alon USA.

First of all, the company buys crude oil, refines it, and markets it entirely within the confines of the US Southwest and South-Central area. In addition to refining and marketing petroleum products, the company is also in the retail business. The company’s refineries produce gasoline, diesel, jet fuel, inputs for the petrochemical, food additives and asphalt industries, and other products. The gasoline and diesel are delivered to 1,250 fuel stations via an 800-km pipeline the company owns. In the retail sector, the company has 167 convenience stores in Texas and New Mexico, mostly directly owned, although some are franchised in long-term leases.

Alon USA posted $1.26 billion in sales in the first half of 2006, 49% more than in the first half of 2005. Its operating profit rose 77% to $166 million and its net profit rose 95% to $97.3 million. Quite impressive, really. Earnings per share rose 55%, which is also a rather impressive figure.

Delek US has an even more impressive first half. Sales totaled $1.48 billion, 115% more than in the first half of last year. Its operating profit rose over 300% to $92.3 million, and its net profit rose almost eight-fold to $55.8 million. Earnings per share rose seven-fold from $0.18 to $1.26.

Lehman Brothers downgraded its recommendation for both shares, so let’s examine why. Lehman Brothers analyst Paul Cheng explained that the investment bank lowered its assessment for the energy sector as a whole, mainly because of a drop in profit margins. He said Alon USA would be harder hit than Delek US because Alon USA had much higher profit margins. However, Delek US has nothing good to offer analysts either. They claim that, as volatility in the energy market intensifies, the switch from small and mid-sized energy stocks to large ones will grow; that’s how it’s always been. Cheng therefore slashed his target price for Alon USA from $36 to $28.

In contrast to Cheng, “Forbes” says in a survey of Wall Street gurus that Alon USA was a “guru buy” because “Gurus apparently decided that it was a good time to begin nibbling on refining assets again, despite oil's recent price declines.”

Why do gurus favor buying Alon USA but analysts recommend avoiding it? I’ll try to answer this question in a moment, but first let’s take a look at something else. It turns out that the analysts’ consensus about most energy stocks is that 2007 earnings per share will be lower than in 2006. They expect the earnings per share of Alon USA to fall 23% from $3.26 in 2006 to $2.51 in 2007, and the earnings per share of Delek US to fall 20.5% to $1.78 from $2.24.

I checked around, and discovered that the earnings per share for sector queen Chevron are expected to fall from $8.09 to $7.77, a much smaller drop, but still a drop. Why do analysts think that energy companies’ profits will fall? There are two main reasons. First are worries that the US is slipping into a recession. Second is that the companies’ costs are expected to rise. But the real reason for the current recommendation downgrades is the currently drop in oil prices.

Now let me look at the energy business on Main Street. One problem among analysts and gurus is that they never worked in the industry they’re covering. Production costs at refineries rise and fall in tandem with changes in the price for crude oil, because that’s the raw material. When the price of oil goes up, the first response of a company like Alon USA, Delek US, or Exxon Mobile is to absorb the cost, not to hurt customers. What happens when the price of oil falls? In this case too, the response takes time. A company doesn’t lower the price of gasoline on the same day, but later, and during the interim, its profits rise, because the cost of the raw material has fallen but sales have not.

Good things have happened to companies like Alon USA in the past two to three years. First, demand for its products from coffee and donuts at its convenience stores to petrol for cars has soared thanks to the booming US economy. The company’s sales have been steadily rising from one month to the next, and the higher sales have largely kept pace with the rise in costs. Let us assume that the price of crude oil continues to fall, the drop will outpace the market response, especially in the foreseeable future.

I therefore believe that the fall in the price of oil will actually improve companies’ profitability, and that what might harm profitability is a recession. In addition, energy companies are entering the recession (if one is actually approaching in the US) in far better shape and cash-rich than ever before. The companies can cover a drop in consumption and prices by boosting sales through discounts, which will be easier to offer because of their large cash reserves accumulated over the past couple of years.

Please note one other important point. If the pessimists are right about the economy, there’s nothing like a drop in oil prices to revive it, together with lower interest rates.

The problem with oil these days is that it’s very hard to guess where it’s going. It’s hard to predict the price of oil regardless of whether you believe a recession is coming or growth will continue, simply because of anxiety and the utter inability to guess the next moves by some of the insane producers, beginning with Iran and Venezuela. Buyers of oil are completely helpless in view of this uncertainty, and if they decide tomorrow, for whatever reason, that an oil shortage is in the offing, they’ll rush to replenish their inventories.

I therefore lean more towards the gurus than Lehman Brothers’ analysts, because if you weigh the logical pluses and minuses, the pluses win out. Yesterday, at least, the logic of Main Street overcame the logic of Wall Street, and both Alon USA and Delek US rose, despite the analysts.

ALJ, DK Last Three Months

Published originally by Globes [online], Israel business news - www.globes.co.il © Copyright of Globes Publisher Itonut (1983) Ltd. 2006. Republished on Seeking Alpha with full permission.

Comments

[The Kennel:]

LOL we are long both Alon and Delek (and Western Refining and Giant, soon to be one and the same)...we love the business model and expect them all to thrive short of a complete collapse of the USA economy...but having said that, the reality is that cheaper oil results in reduced refining profits simply because the total difference in dollars between what these companies pay for crude and what they charge for their refined products, assuming margins are proportinally constant, is arithmetically smaller. Meanwhile their fixed costs to run their refining operations are the same. Ergo profits decline.

If your theory that profits should increase while crude prices decline and vice versa is correct, then how do you explain the record 1H06 profits these companies posted as crude prices soared?


Brad Hessel, Manager
The Kennel

2006 Sep 18 09:00 AM