After a tremendous 2012 in which they soared 70%, 80%, or even 100%, shares of oil refiners have struggled mightily in 2013. Following a decent first month of the year, many refining stocks have fallen between 10% and 20% since the start of February, while the S&P 500 has continued its upward rise. A few big factors have been in play. In March, reports surfaced of potential tougher fuel standards in the U.S., hitting refiners hard. Spreads between West Texas Intermediate crude and overseas Brent crude have narrowed considerably, meanwhile, eating away at the huge advantage U.S. refiners -- especially those in the middle of the country with easier access to WTI -- had last year. And now, lingering economic concerns exacerbated by the government shutdown have gas prices falling, which could further negatively impact refining margins.
All of that might make you want to dump shares of refiners as quickly as possible. But for my Guru Strategies, it's music to their ears. These models, each of which is based on the approach of a different investing great, tend to be contrarian in nature. And because investors have a tendency to overreact, they often will step in and snatch up shares of unloved, beaten-down stocks whose fundamentals indicate they've been hit too hard. That's the case right now with one major refiner, HollyFrontier Corp. (HFC), the Dallas-based firm that operates five complex refineries in the Midwest, Southwestern, and Rocky Mountain regions.
On September 23, my models triggered a Trade Alert on HollyFrontier ($8.6 billion market cap), which was formed in 2011 when Holly Corp. and Frontier Oil Corp. merged. These alerts are issued when a stock's fundamentals earn it certain level of interest from one or more of my models. With HFC, it was my Benjamin Graham-, Joel Greenblatt-, and Kenneth Fisher-based models that triggered the alert, which runs through Dec. 23. My back testing has shown that historically, stocks possessing similar fundamental characteristics have on average returned more than 7.4% over a three-month period, beating the S&P 500 more than 60% of the time.
The Bullish Case
To be sure, HollyFrontier has been hit hard by all the issues I mentioned above. After raking in $6.42 in earnings per share in 2011 and an even better $8.38 per share in 2012, the firm is on track to notch $4.37 in EPS this year, even though revenues are up close to 3% year-to-date. But there's a lot to like as well. For starters, HollyFrontier also has some competitive advantages, such as the complexity of its refineries and their proximity to cost-advantaged feedstock, as Morningstar analyst Allen Good recently noted. "Before merging, both companies invested to improve the complexity and heavy crude processing capabilities of their facilities," Good explained. "As a result, HollyFrontier [can] process heavy crude oil and produce comparable yields of refined product for less cost than refineries that only use the easier to refine, but more expensive, light crude."
Secondly, the firm is on good financial footing -- Moody's recently upgraded its credit rating to investment grade, citing the company's low leverage and history of conservative financial policies. "Even though HollyFrontier is smaller than almost all of its investment grade rated peers, we believe that the company will continue to be one of the industry leaders in through-the-cycle profitability given its crude procurement advantages emanating from the locations of its refineries near the major shale plays in the U.S.," the ratings agency said, adding that HollyFrontier is well-positioned to benefit from strong U.S. refining industry fundamentals over at least the intermediate term.
HFC's financials are one big reason my Graham-based model is high on the stock. The firm's current ratio is 2.37 (the model likes CRs over 2.0) and it has about three times as much in net current assets ($2.6 billion) as long-term debt ($990 million). My Fisher-based model, meanwhile, likes its very reasonable 16% debt/equity ratio, and its $3.25 in free cash flow per share.
The Price Is Right
Then there's the price. HollyFrontier trades for less than 6 times trailing 12-month EPS. But given the changed margin environment, that's probably misleading. When we look at projected EPS, which factor in significantly reduced margins, the stock is still dirt-cheap, however, with a forward P/E of just 9.
As for the top line, which, as I noted, has grown year-to-date, shares trade for only 0.42 times trailing sales. My Fisher-based model uses the price/sales ratio as its key valuation metric and for industrial firms like HFC, it considers PSRs below 0.75 extremely attractive. HFC easily passes that test.
My Graham-based model uses two valuation metrics: the P/E and price/book ratio. With the P/E, it looks at both the trailing 12-month P/E and the P/E using three-year average earnings, so that short-term anomalous earnings don't skew the ratio. For HFC, the three-year is higher, at 8.2, which comes in well below the model's 15 upper limit. The approach also likes HFC'S 1.38 price/book ratio
Finally, my Greenblatt-based model likes HollyFrontier's 37.4% earnings yield (Greenblatt and my model use earnings before interest and taxes, and divide by enterprise value to determine an earnings yield, thereby factoring in a company's debt), which ranks fourth in the entire market. It also likes that the firm has a stellar 44.3% return on capital.
Headwinds can be scary, and HollyFrontier certainly is facing some of them right now. But headwinds also signal opportunity, because many investors overreact to signs of trouble. Good investors are able to find situations where pessimism has gotten too extreme, and they pounce. My models think it's time to do just that with HFC.