Shares of HollyFrontier Corp (NYSE:HFC) are up more than 4% after the company reported its results for the second quarter, and we don't understand why. Revenue did beat by $290 million, but it still fell 27% year-over-year, and while GAAP EPS did include goodwill and fixed asset impairment charges totaling $654.1 million, adjusted earnings still came up short of analyst expectations and declined 85% year-over-year. The fundamentals have gotten worse for HFC, and while we think the company remains of the best in the independent refining sector, investors should be cautious.
Production levels averaged 443,000 bpd, which was just a slight drop off from last year's 446,000, and management reiterated that demand was strong based on these figures. The problem is that the increase in production volumes doesn't necessarily reflect strong end-market fundamentals. Refiners have been taking advantage of cheaper crude inputs to produce refined products at lower cost, but this has resulted in record refined product inventories as supply has outpaced demand. HFC's ending inventory stood at $875 million (10% of assets) at the end of Q2, up from $713 million (8.5% of assets) at the end of FY15. Demand for refined products (gasoline, diesel fuel, and jet fuel) has been strong in recent years but there are signs that things are finally slowing down in the airline and auto sectors. We wouldn't be surprised to see some discounting and/or inventory write-downs in the next few quarters.
HollyFrontier's fundamentals have gotten much worse in the last year. The decline in net income not only reflected a steep drop in refining margins ($8.88 per barrel compared to $17.42 per barrel in Q215), a product of excess capacity, it also reflected higher operating costs. Average refining operating costs increased 7.2% year-over-year as a result of higher ethanol blending and RIN costs. In order to comply with the EPA's Renewable Fuel Standard Program, HFC spent $57 million on Renewable Identification Numbers, and we expect higher regulatory costs to continue to weigh on profitability over the next few quarters.
As much as we don't like the short-term outlook for HFC, if there is one company that can withstand the current operating environment it might be HollyFrontier Corp. The company has an important competitive advantage thanks to the proximity of its refineries to low cost feedstocks in the "midcontinent" region of North America. Light and heavyweight crude sourced from these areas is cheaper than WTI and Brent. According to Morningstar, HFC can process black wax crude (from Utah) at a 20% discount to WTI benchmark prices. Price is arguably the most important competitive factor in the refining business and HFC benefits materially from these crude differentials, although they have narrowed in recent quarters. HFC's refining complexity provides another advantage as it allows the company to produce comparable yields from heavy crude at lower cost than refineries that only use light crude as input, which is easier to process but more expensive as well. Thanks to its cost advantages, relatively strong balance sheet, and ample liquidity, we believe HFC is one of the best-of-breed in the refining space. However we don't think performance will improve meaningfully anytime soon and it seems like the rise in stock price after Q2 was unjustified.
HFC is an interesting contrarian pick. Even after the recent advance HFC's shares are attractively priced. The stock trades just above its 52-week low, at a forward P/E of 10.2 and a dividend yield 5%, and the company should be able to weather the storm. That being said, the only investors who should consider HFC, in our view, are those with a long-term investment horizon (2 years or more). We think end market demand will weaken in the next few quarters and that HFC could run into inventory issues.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.