Western Refining: A Lesson in Corporate Finance

Includes: FTO, MRO, TSO, VLO, WNR, XOM
by: James Shell

As an old process guy, I never really appreciated the extent to which the way a business is financed makes such a difference in the company story until the recent downturn, which exposed a lot of situations that were not readily evident during the good times.

One need look no farther than Western Refining (NYSE:WNR) as an example of a company that is good at what it does, turning crude oil into finished products, but because of its financing, has a bit of a struggle in the current environment, despite the improving refining margins.

We had constructed a little model by which we could measure the refiners against one another as to sensitivity to a weighted-average refining margin, and WNR actually compares favorably to its competitors Frontier (NYSE:FTO) and Tesoro (NYSE:TSO), and with an R-squared of 0.66 is comparable to the largest company in this little group, Valero (NYSE:VLO). The lower this number, the less sensitive the operating income is to the refining margins, 1.0 is perfectly sensitive, and 0 is perfectly insensitive (click to enlarge).

Click to enlarge

In fact, these guys are high achievers. With a couple of exceptions, they outperform where they should be, given the little model we developed which includes a weighted average crack spread, the industry refining utilization, and some seasonality.

Here's their performance compared to Valero (click to enlarge):
Click to enlarge

Now obviously Valero is a much bigger company and the graph above has the two company results on different scales, but you can see that when times were good, WNR was able to perform relatively equally to VLO and from an operating income standpoint they even managed to avoid the catastrophic Q42008 that really pounded their competitors.

The reason for this is that 2/3 of their capacity is located out in the far Southwest, they are isolated from their big competitors for the Phoenix and Tucson markets, which have west-coast type finished products pricing, but their feedstock comes from either the Gulf or the Permian Basin, which has Gulf-coast type costs, so they have some extra gross margin relative to the rest of the industry.

So given this, the company should be a no-brainer as an investment since refinery margins are picking up.... right? Wrong.

In mid-2007 these guys borrowed a lot of money to purchase a refinery in Virginia, a move which made some sense at the time to get the 70,000 bpd of heavy-crude refining capacity. However, we all know what happened since then, to the refining margins, the heavy/light differential, and the financial markets in general. I have posted some additional analysis of this deal on my blog but to make a long story short, because this deal was debt financed, the company needs to come up with on the order of $115M per year in interest on the long term debt.

With their current refining capacity of 220,000 bpd, that equates to approximately $1.45 per barrel refining margin at 100% utilization just to service the debt, not including their conversion cost, or any profitability for the shareholders. Add another $7 for conversion costs, and another $5-6 or so for overhead and/or the shareholders and you get something like $13-14 per barrel of capacity for this outfit to break even in an environment where the actual margin is only about $11 at the present time.

This company also has a new CEO, whose job it is to figure a way out of this. There are some alternatives, none of them beautiful, With the credit markets fractured, the refining business is at such low utilization so that the mortgage on the Virginia plant is underwater, relative to its current probable selling price. They're borrowing money short-term to keep things moving for the moment. They might get lucky and have margins get to the point where they can pay down the debt a little.

Still there is some value at which this stock makes some sense as a speculation. At $5.30 per share, the company's market valuation is about the same as the value of its inventory of crude oil and finished products, in other words, a potential buyer could get the company (and the debt) for free, just by buying the stock and selling what is in the tank farm. At some level of recovery in this business, it might make sense to do this, namely the point at which incurring the debt is worth buying the 220kbd refining capacity, but that date is a way off unless you have deep pockets, which right now, nobody does.

So the lesson to be learned is: Even if you are good at what you do, you are still vulnerable to business decisions that are made with good intentions, and a lot of analysis, and a big factor is the method of financing, in this case that method was debt, which had ramifications later on when the economy went south. Had it been by some other method, the current cash flow situation would be completely different and the stock would have some value. They might be pretty close to break-even, everything else being equal, without the ongoing debt problem.

Your guess is as good as mine as to what might happen from here on. At the moment this stock is speculative, probably priced above its actual value as a business.

Disclosure: none