Western Refining: Can It Get Any Better Than This?

| About: Western Refining, (WNR)

For investors such as myself who bought Western Refining (NYSE:WNR) nearly two years ago, it's been an incredible run. From a low of $4, the stock has quintupled to more than $21, setting another fresh new 52-week high today. The stock has been climbing the so-called wall of worry for several quarters now, and skeptics continue to say that the end of the rally is near. With the stock up 400% since last autumn's all-time low, investors are rightfully asking if things can get any better than this.

The bears have a decent case. For one, Western Refining has among the worst liquidity positions in the entire refining industry. The company carries more than a billion dollars of debt and only, according to Yahoo Finance's numbers, $12 million of cash as of the most recent quarter. Due to the company's very small profit margin (the company generates roughly $8 billion a year in revenue but can convert only a few percentage points of that into profit), the company faces crippling danger if industry profit margins contract even slightly.

Given its higher interest burden, versus competitors, Western is greatly levered to the crack spread (the difference between the selling price of finished oil products such as gasoline and the input cost, crude oil). This is a double-edged sword. During good times for the refining industry, Western can post remarkable quarters. For example, in the third quarter of 2008, Western posted $1.61/share earnings versus $0.66 estimates. That's a 95 cent a share beat! And one-time items weren't responsible; the beat was driven by a huge swing in refining margins due to weather-related events.

Of course, the flipside of this is that a negative move in refining margins could cripple Western Refining. Due to a combination of a bad acquisition and severe margin compression, Western saw its shares fall from $60 in the summer of 2007 to $5 in the fall of 2008. A similar fall is possible, with Western's liquidity situation still perilous, a sharp reversal in the recent refining boom could leave shares vulnerable to huge downside.

Western's bears also point to the hyper-cyclical nature of the refining industry. Profitable periods tend to come and go very quickly, as supply can generally be quickly increased or decreased according to demand. Unlike many other industries, there is little lag time between higher margins and when refiners subsequently increase production. So with crack spreads, which directly drive refining margins, at record highs, shouldn't investors be taking their gains and moving on?

Not necessarily. While I've been cautious about how far the refining rally could run and urged taking some gains back in February, the situation remains guardedly optimistic for refiners in general and Western in particular. Western benefit especially strongly from leverage. Analysts are still, in my opinion, underestimating the strength of the upcoming quarter for Western, just as they did back in 2008.

Since earnings have been negative or only faintly positive for almost three years now, it is hard to fully appreciate just how good things are for Western now. While analysts are expecting $1.15 a share for the upcoming quarter, something in the range of $1.50/share is not unreasonable if management fully took advantage of the rising crack spread. Remember, the company made $1.61/share in one quarter on a significantly lower crack spread in 2008 (though the company has since shuttered a refinery and diluted its shares, reducing the value of this direct comparison somewhat). Western's Price/sales ratio is still a very low 0.24, meaning that the company can produce a great deal of earnings on incremental increases in margins.

With short positions constituting 38% of Western's float, the stock can still run significantly higher if Western puts up a blowout second quarter. And while the crack spread will inevitably return to more normal levels, there is no sign of the reversion to the mean coming yet. The unprecedented glut of oil in the Cushing storage facility (which could last nearly two more years) continues to keep mid-continent oil refiners in the sweet spot, as their crude costs up to $20/barrel less than foreign crude. And while oil prices remain high, consumer gasoline demand has remained unexpectedly strong.

The conditions are in place for Western to continue to post greater than $1/share profit earnings each quarter for at least several quarters to come. Western could, if the crack spread stabilizes or falls only moderately, produce $4/share in earnings for the full year. With the gigantic short interest in the stock and with analysts' estimates still on the low side, Western still has substantial upside; though if the crack spread starts to fall, the music could stop suddenly. But for now, Western's investors can expect more upside heading into next quarter's earning announcement, which will be released August 4.

Disclosure: I am long WNR.