After startling runs driven by the US shale revolution in Texas and North Dakota, refining stocks have settled down in 2014. Over the past five years, the likes of HollyFrontier (NYSE:HFC), Phillips 66 (NYSE:PSX), and Valero (NYSE:VLO) have smoked the S&P 500, with each at least doubling. At the moment, several refiners trade at single-digit EV/EBITDA multiples in spite of an attractive medium-term fundamental outlook. Ultimately, the space will face pressure from evolutionary technology pushed forward by the likes of Tesla (NASDAQ:TSLA), but for the time being, I think refiners are set to enjoy cost advantages as shale production continues to soar.
In fact, crude oil production in North Dakota passed 1 million barrels per day of production in April and has grown in subsequent months. In my view, the refining space in general should perform well, though those with significant exposure to discounted Midland and Bakken crude likely have the most sustainable cost advantages. This leads me to HollyFrontier. I think management provided investors with plenty of hints to what lies ahead during the most recent earnings call, and I think it is one of the most attractive names in the space.
Catalyst #1: Cash Optionality
If you've followed the refining space at all, then you know that crack spreads (the price realized for refined product less the commodity cost) have been robust in the wake of increasing US crude production. Not long ago integrated oil companies like Marathon (NYSE:MRO) and ConocoPhillips (NYSE:COP) were pushed to divest of refining assets that required high capex spending and produced volatile returns. Booming US crude production created a glut of oil in the US without sufficient infrastructure to transport and store new resources. Thus, shale producers have been taking discounts versus WTI and Brent crude prices to dump product and continue growing production. Such has hurt the profitability of the likes of EOG (NYSE:EOG) and Continental Resources (NYSE:CLR), but it has been a boon to refiners that are now receiving discounted crude that they are able to sell at full price.
Over the past several years, HollyFrontier has built an impressive cash war chest, which now sits at $9/share or $1.7 billion-exceeding the debt balance. Holly rewarded shareholders after a strong Q2 by increasing the quarterly dividend 7% to $0.32/share and declaring a special dividend of $0.50-its 13th straight quarter of "special" dividends. The firm has also bought back over $20 million worth of stock year-to-date. Although this isn't an outrageous sum, I appreciate management's prudence as shares have traded at a premium to peers.
Investors may be frustrated by Holly's decision to build a sizeable cash war chest. In fact, with only $400 million (just $77 million in turnaround spending) in capex planned for 2014, the company will generate a considerable amount of free cash flow. The cash needs to be put to work. And Holly acknowledges as much.
Virtually every refiner was asked about Venezuela's possible sale of its US CITGO refining assets. Most refused to acknowledge that they might be for sale-let alone interested in acquiring these assets. However, CEO Mike Jennings did not shy away from the question when asked, saying:
"Incrementally, acquisitions, CITGO could fit very well, it's obviously a large buy if it's actually for sale. But we look hard at all these types of opportunities, particularly those with an Inland crude supply tributary, and so CITGO would obviously fit that. But with that said, we're really focused on returns at this company and to the extent that we feel like we can increase our share value by presenting such an acquisitions we'll do so, and if the price point or the opportunity doesn't fit us, we're very happy with the assets that we have."
I was even more pleased to hear CFO Doug Aron explain Holly's high hurdle rate and expectation for a large investment. He added:
"I would just add to that given no debt on our balance sheet and the extraordinarily low cost of debt today, as Mike said, you can make accretion look very appealing but if you look at our 20-year plus return on capital employed number of write out are just above 20%. That's a hurdle that we're proud of and one that as a management team we're compensated on one that will continue to look at as needing to be able to return a healthy risk return for our shareholders. So it's not just accretion, it's certainly return on capital as well."
A play for CITGO's refining assets could be a financial windfall for shareholders, particularly if Holly is able to acquire CITGO's Lemont, IL refinery that can run a light Bakken slate easily and diversify Holly's asset base a bit more.
As I mentioned earlier, Holly also has plenty of cash to return to shareholders via repurchases and more dividends. I think the firm's robust cash balance will create tremendous incremental value for shareholders.
Catalyst #2: Better Crude Discounts Drive Earnings
I think the other catalyst for Holly - the one that is more likely to occur short-term - is increased discounted Midland crude. While infrastructure investments into pipelines, rail, and gathering facilities remain robust; Cushing inventories have fallen substantially since January, leaving the region at a price disadvantage. Yet, management noted that 900,000 barrels per day of crude delivery capacity would come on-line in late 2014 and 2015. This will help Holly achieve deeper crude discounts at its Mid-Continental refining facility that accounts for over 60% of throughput capacity.
As a result, I think earnings estimates for the back half of 2014 and 2015 will prove to be a tad low. Shares currently trade at roughly 11.25x FY15 EPS, but I think the firm could earn closer to $4.50 than the $4.15 analysts currently expect.
Still, deeper crude discounts aren't paramount to my Holly thesis. The firm still earned an operating margin of $8.17/barrel in Q2, and it will generate plenty of cash in the event that crude prices remain flat or even rise slightly.
What Should Holly Trade At?
If we apply the current multiple to a more aggressive earnings forecast, we get a target price of roughly $50.63. This isn't a great return from current levels, but if we add in a dividend runrate of $3.28 per share, then we achieve a yield of 7% at current levels. Plus, when accounting for the optionality associated with its robust cash balance, I think shares should trade closer to $60. This implies a P/E of 13.33x FY15 earnings and a dividend yield (special + regular) of 5.5%. Due to its undervaluation, I think Holly provides income investors with a compelling margin of safety and an excellent total return vehicle.
Disclosure: The author is long CLR. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.