Western Refining Mid-Cycle Valuation Offers 100% Upside

| About: Western Refining, (WNR)

Summary

Short-term upside is nearly 50% from current share price.

Shares offer +7% dividend yield while you wait.

WNR has an attractive asset base and above-average profitability.

This article will analyze Western Refining, Inc. (NYSE:WNR).

Key Statistics as of July 31, 2016

Closing Price:

$20.85

Desired Entry Point:

Wait for support to be established

Price Target: 1y/3y

$30/$39

Return to Target:

44%/87%

52-Week High:

$50.71

52 Week Low:

$18.14

Reporting Currency:

USD

Sales (prior year)

8,924 M

Market Cap

1,800 M

Shares Outstanding

94 M

Float

74 M

Cash

593 M

Total Debt

1,659 M

Equity

1,219 M

Debt/Equity

1.36x

ROA

5.77%

ROE

27.69%

Operating Margin

8.44%

Net Profit Margin

3.71%

DCF Intrinsic Value

$35

Cost of Equity

11%

Forward Div %

7.57%

Dividend Payout Ratio

41%

Trailing P/E

5.58x

Est. Fwd P/E

10.44x

Fiscal Year End

Dec 31

Click to enlarge

Company Description

Western Refining is a small-scale refiner with above average profitability for its industry and boasting an attractive asset base. The company only has three refining facilities which produce approximately 253,000 bbl/day after accounting for the acquisition of full control in NTI earlier in the year. Previously, the company owned a 38% interest in NTI and in the years prior to 2014 the company had only two refineries with production capacity of 152,000 barrels. Therefore, production capacity going forward will be 30% higher than the most recent operating history that included 38% ownership of NTI and approximately 60% higher than in the previous business cycle before WNR initiated its stake in NTI.

The NTI acquisition was paid for with $860M in cash and an offering of 17.1M shares dilutive to the share count. Our fair value calculations will have to account for the effect of the NTI acquisition on WNR's resulting capital structure.

The consensus opinion is that the best thing about WNR is the strategic positioning of their refineries. The three refineries are located in close proximity to the Bakken and the Permian Basin. Oil production in recent years has been highest in these regions, creating an oversupply of crude which allows WNR to purchase this crude at a discount, directly assisting gross margins. This is a direct cost saving compared to other refiners who don't exclusively operate in these two regions. The increased production in both the Bakken and Permian Basin regions during the most recent oil cycle resulted in significant discounts on the crude that WNR would purchase which led to improved gross margin profitability and cash flow yield in the past 5 years during the shale oil boom, compared to the previous business cycle that took place prior to 2009.

Given the oversupply of crude in the Bakken and Permian Basin regions, oil producers are disappointed that their product is receiving discounted prices when they sell to refiners. This has led to plans to build more pipelines to take crude out of the local Bakken and Permian Basin regions to areas where the price will not be so heavily discounted. Even still, those crude producers will have to pay to have their crude shipped. At the same time, crude staying local with WNR's refineries will not have to be shipped, saving the producers from paying these transport costs. WNR stands to capture some of these cost savings as they will be passed on from the producers and shared with WNR. Therefore, the advantageous location of the refineries is still relevant even after accounting for oncoming pipeline infrastructure.

Investment Thesis

Once again, we have another investment thesis primarily based off of an opportunity that the short term-ism of the market is providing us. This company's share price has been heavily discounted over the past 12 months as we reach what would seem to be a cycle trough for refineries. Research shows that there are 5 refinery stocks with at least 4 or 5 star ratings according to Morningstar. This tells me that the team at Morningstar believes the industry is currently undervalued and the long term outlook for this market is much better than what is currently being priced in.

This also happens to be what I believe to be the case given historical operating performance relative to today's conditions. What the market is failing to appreciate today is that market conditions for these refineries will eventually recover and return to some level of normalized operating conditions. For the purposes of long-term investing, mid-cycle earnings and valuations are how the company should be valued.

Industry

Some of the larger players in the refining industry include multinational integrated companies like Exxon Mobil, Chevron and BP. However, those companies are balanced between upstream and downstream operations so let's focus exclusively on companies whose primary business is refining, as is the case with WNR.

A peer review analysis of refiners yields the following results:

Market Cap (m)

P/S

P/B

P/E

Dividend Yield %

5-Year Rev. Growth %

Operating Profit %

D/E

Western Refining

1,903

0.2

1.6

6.0

7.3

4.2

7.2

1.4

Valero

24,561

0.3

1.2

7.3

4.0

1.3

3.6

0.3

Marathon Petroleum

20,870

0.3

1.6

10.8

3.2

2.9

4.8

0.9

Tesoro

9,136

0.3

1.7

6.5

2.6

6.9

5.4

0.8

Holly Frontier

4,487

0.4

0.9

8.9

5.2

9.7

9.4

0.3

Click to enlarge

Source: Morningstar.com

Among these companies, WNR has the lowest P/S and P/E ratios. This is despite having the second highest level of profitability among the group. This appears as an obvious anomaly because it should be that companies with higher levels of profitability would enjoy higher multiples on both sales and profits.

Also, WNR has the highest dividend yield and highest debt/equity ratio. This tells me that perhaps the market is pricing WNR at a discount because of fears that they may have difficulty financing their dividend during this downturn and/or be forced to add to already high debt balances to finance a potential cash flow deficit. Whether the market is correct in their concern about cash flow issues remains to be seen. All we can do for the time being is examine what we know today.

Prior to the NTI acquisition, the company had cash balances of around 600M and debt of around 1,650M. The acquisition will cost 860M in cash so we know the company will be forced to finance at least some of that purchase with debt. For the sake of our analysis, let's assume the purchase is financed exclusively via debt issuance. This will leave the company with debt of approximately 2,510M. 2015 interest pre-tax interest cost was approximately 6.5%. Even though interest rates continue to move lower, let's assume that the company's cost of debt will increase due to higher debt levels post-acquisition. A 7% pre-tax interest expense would yield interest expense of 175M. Add this to approximately 140M of annual dividend payments and the company has ongoing annual financing obligations of approximately 315M.

If we look at the most recent two quarters during this downturn, WNR is has been Free Cash Flow to the Firm neutral meaning that it hasn't generated any free cash flow to service either the company's debt nor equity holders. However given 600M in existing cash balances and after accounting for interest costs, it will be almost two years before WNR's cash is depleted if it continues to pay the existing dividend. Not to mention that along with the NTI acquisition the company's revolving line of credit increased from 350M to 500M. This gives me enough reason to believe that WNR will be able to weather the current storm, but I still leave in the possibility that the company may reduce, or suspend its dividend.

There are two possible scenarios that the market could be worrying about which would be the cause for the currently discounted share price. One is that the market might be concerned that shares could fall further if the company were forced to cut its dividend which is currently yielding in excess of 7% today. A yield of 7%, if it is viewed as sustainable, would provide a floor on the share price however if the dividend were cut this floor would no longer be in place and shares may fall. The second scenario is that the market feels shares are worth less than today's price if WNR were to continue paying the dividend and erode its balance sheet in the process.

There is no question that WNR is high risk/reward trade given the looming dividend cut and/or cash burn scenario. But I actually like this, because it tells me that the share price could appreciate significantly, and quickly, if the market believes the risk of a potential cash flow deficit has been mitigated by improved operating conditions (in my view, a matter of when, not if) or even a responsible dividend suspension or reduction. It's important to note that shares may also react favorably if a dividend cut or suspension was announced -- if the market believes that suspending or reducing the dividend is a more responsible use of capital rather than paying a yield to current shareholders.

So, really, there are two potentially favorable outcomes on the near horizon. But, it is also worth noting that this type of high risk/reward trade means that we have to be very careful about managing the position once it is initiated in order to avoid any outsized losses.

Valuation

EV/EBITDA:

My preferred metric to value WNR is EV/EBITDA because EBTIDA is a decent proxy for cash flow which is why most investors would buy this company (for the current dividend yield rather than future growth prospects) and EV because the company employs a fairly high level of debt in its capital structure.

Our research suggests an EV/EBITDA multiple of around 4x. This is approximately the mid-point of WNR's average over the past 5 years.

Normalized EBITDA of the past 5 years was approximately 980M. Multiply this by 30% to account for the increased stake in NTI gives us normalized EBITDA of 1275M.

EBITDA 1275 x 4.0 = Equity share price of $30

Or, we can look at three other scenarios:

With the acquisition of NTI, WNR becomes a more well-rounded, diversified company having added control of a third refining operation. The company may have been penalized in the past with a lower EV/EBITDA multiple because it was a bit on the small side with just two refineries and relatively higher operating risk.

Maybe after the acquisition, the company could get a 6x EV/EBITDA multiple. Based on my experience I would not consider this out of line at all.

EBITDA 1275 x 6.0 = Equity share price of $52

However, maybe our operating assumptions are too optimistic and our EBITDA forecast is too high. If we take the last operating cycle, normalized revenue is about 10B. Multiply this by 30% as a result of the increased stake in NTI to get 13B. EBITDA margins historically have been 8-10% of sales. Apply an 8% EBITDA margin to our estimate of sales to get 1,040M.

Let's use this new EBITDA estimate with our 4x and 6x EV multiples.

4 x 1,040 = Equity share price of $21

6 x 1,040 = Equity share price of $40

So we have a range of values between $21 at the low end and $52 at the high end. This would be approximately my expected trading range for this stock. This also happens to be approximately the range of prices over the past 52 weeks as sentiment has ranged from prior optimism when oil prices were elevated, to the current view which is a bit on the cynical side. It would seem sentiment has gone from being overly optimistic too overly pessimistic in a hurry.

Discounted Cash Flow Analysis - Free Cash Flow to Equity

The bedrock of any good fundamental analysis is an evaluation of the cash flows that are available to return to equity holders. After all, cash flow distributions are the only reason we would consider a purchase of WNR shares in the first place not to mention the fact that FCFE valuation is the single valuation theory most closely linked to stock market returns. Here, we use a FCFE model to evaluate the quality of WNR's cash flows under normal operating conditions.

Revenue of 13,000M x 3.7% profit margin = 480M Net Income

Add: 220M NCC + 30 WC = 730M Operating Cash Flow

Less: 260M Capex (2% of sales)

FCFE = 470M

Growth = 3%, Cost of Equity = 11%

Equity share price = $54

In my view, this would represent a full valuation of the company under normal operating conditions. We should also consider that the company may in fact use some of its available cash flow to repay the debt it took on as part of the NTI investment, so perhaps the actual value of cash flow available to shareholders is less than our assumptions and the value of $54 falls a bit on the high side.

Valuation Multiples - Price-to-Earnings

The most widely used metric to value a publicly traded company is the ratio of the price investors would be willing to pay for a dollar of earnings generated by an investment. This is called the price-to-earnings ratio.

Here we use my estimate of mid-cycle earnings from our previous example and a mid-point PE estimate. Historically, WNR's PE multiple has ranged from 6x to as high as 12x so we use 9x as the mid-point.

480M Net Income / (94 + 17) = $4.33 eps x 9 = $39

Recall that the NTI investment diluted the share count by 17M so we need to add these to the current share count of 94M.

Downside Scenario:

We've established that a "normal" mid-cycle for WNR is likely somewhere between $30 and $40 depending on your outlook and time horizon. However, we should also review a more "bearish" scenario to estimate how much further shares could fall if the current environment were to continue to deteriorate.

Estimated earnings for 2016 according to Yahoo Finance are approximately $1.50. Measured against current book value per share of $13.36 this would result in ROE of about 11% which is roughly equal to my estimate of the company's cost of equity. According to the justified price-to-book approach this means that shares could trade equal to book value if the market believed the currently forecast level of earnings were going to persist for an extended period. Note that the resulting $13.36 share price would yield a dividend of 8.8% so this scenario is likely only to happen if the board of directors decided to cut or suspend the dividend.

Still, with upside of 50% to 100% and downside in a worse case scenario of -33%, this is a winning scenario even if we assume the simple heuristic that every investment decision is a coin flip.

Conclusion

For me, the shares of WNR present an attractive trading opportunity. I see easy upside to $30 in the near term, offering a 50% return from the current share price. The $30 near-term price target is slightly below the midpoint of my estimate of the acceptable trading range for this company which accounts for the negative sentiment the company is experiencing at the present time. Over a longer period, I would expect shares to drift higher towards $40 in line with a mid-cycle P/E valuation and beyond that potentially higher to the $50 range once they have become fully valued.

Before initiating a trade what I would want to see is a certain level of support in the stock chart in order to give me comfort with the timing of the trade. I would also advocate for the use of a tight stop loss here, in the event that the chart unexpectedly broke down after making my purchase.

As part of my research Holly Frontier also caught my attention as another refiner that appears to be both oversold and undervalued. I will add this company to my list of companies to research as from my preliminary analysis; it would seem that while WNR may be the better high risk trade, Holly Frontier may be in fact a better company, with better operating performance, less debt and better growth potential.

Other Factors

The chairman of the board currently owns 21.2% of the outstanding common stock and has been adding to his position since May of this year. This is the cause of the discrepancy between outstanding shares and float. Not only does the chairman's ownership stake give me a certain level of comfort that the board of directors and management will keep shareholders interests front of mind as they navigate the decision of whether to protect the balance sheet by cutting the dividend or to continue to pay out cash flow to shareholders, but recent buying also tells me he too feels shares are undervalued at current levels.

Disclosure: I am/we are long WNR.

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.