Calumet Specialty Products: No Fuel For Growth

| About: Calumet Specialty (CLMT)

Calumet Specialty Products Partners (NASDAQ:CLMT) suffered the same result of most refiners this past quarter with a loss of 54c per share while posting a negative distributable cash flow of -16mn. Sales were up on larger volumes but their margins suffered greatly. The spread between their sales and cost, per boe, dropped 38% sequentially (not including RIN cost) which is a reflection of fuel crack spreads having declined in Q3. In the meantime, distributions of $52mn were paid out, including $4.5mn to the partnership's GP where incentive distribution rights are paid. Needless to say, paying on IDRs when distributable cash flow is negative is never a good thing for common units and the negative cash flow is reflected in the $78mn decline in partnership capital over the quarter.

So looking through the rear-view mirror does not look very pleasing. The question is what happens going forward. First, it appears crack spreads have improved of late and are targeting for a rebound to 1H13 levels. If that is the case, we could see CLMT's gross margin move back to around 7.5% from a low of 4% this quarter. Distributable cash flow would turn back into positive territory but DCF coverage would still be low at 60-70% and close to zero on a TTM basis. We assume RIN cost to drop back down to $7.5mn/quarter starting in Q4. CLMT's target for DCF coverage is ~1.2 or better. Leverage remains a concern as net debt to EBITDA will be close to 4 by the end of Q4 with debt/capital in the high 40s. Fixed charge coverage will remain healthy, above 2, leading to no concerns around debt covenants. That said, healthy capital spending leads us to believe that CLMT will come to the capital markets to issue more debt and equity in the near future, certainly by 1Q14 the latest.

CLMT is forecasted to spend $525mn in organic growth investments over the next few years ('13 included). In 2014, alone, 50% is to be spent, or approximately $270mn. The bulk of this is for an expansion of their Montana refinery whose total price tag just went up from $275 mn to $400 mn and whose start date was pushed back to early 2016. In Q4, CLMT is likely to spend $57mn, up slightly from Q3. Coupled with the sub 100% DCF coverage, CLMT will require additional funding. In Q3, CLMT avoided a large decline in cash balance as working capital declined with, for example, accounts payable increasing $38mn. Whether further reductions in working capital are possible is unknown, we project that CLMT will need to raise $50-100mn in 4Q13 as well as an additional $300mn or so in 2014 to fund the company's distribution and capital spending plans. We look for a mixture of debt and equity with a lean towards equity to reduce leverage slightly.

While raising capital does not imply that a stock is overvalued, investors do have to consider it in terms of income expectations. CLMT is an MLP and a high yielding stock with a yield close to 10%. However, if the distribution is not covered, and equity is needed for growth, then investors will need to reinvest capital to avoid dilution. Over the course of the next 9 quarters, CLMT will issue $300mn in debt and about $12mn new shares if our model is correct. This will allow CLMT to get back to their growth trajectory in 2016 and beyond, where DCF is likely to be back to their target range of ~1.3 with increased cash flow from their organic projects. That said, shares outstanding will increase about 18%. This implies, for example, that an investor with 100 shares would need to purchase 18 additional shares to retain ownership and avoid dilution. At say $28 per share, that would cost 7.5 quarter's worth of distributions, or 80% of distributions will require reinvestment.

To make a long story short, we see little in the way of distribution growth until 2016 at best. Further, with planned issuance, investors will need to reinvest back into new shares. Thus, we do not view CLMT as an income or growth stock and suspect a higher yield is required. Prior to the dramatic widening of fuel crack spreads, in 2011-12, CLMT had minimal distribution growth and yielded between 11 and 12%, with robust distribution coverage. The company's low yield earlier this year was a reflection of expectations of further distribution growth. When that dissipated, the share price decline. We see limited upside in shares from current levels and would not be surprised to see the share price pull back into the low 20s before investor appetite returns.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in CLMT 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.