HollyFrontier Corporation (HFC) has offered investors a wild ride since the closing of the merger in early 2011, moving up 81% from deal close to its peak in late summer, then back down 42% to a low of $21.74 in November. Since November, the HFC rollercoaster has risen about 56% since to close at $33.89 last week. With earnings reported on Tuesday, what is the current consensus long-term outlook for the refining industry, and HFC in particular?
What are some potential catalysts that might drive the stock? We will add some color to the current market view on HFC and explain why the risk-reward at this level should be compelling to investors.
First, a good overview of the merger of equals of Frontier and Holly Energy is provided by David White in an early February SA article. White does an excellent job of highlighting some of the operational advantages of HFC, including its high-complexity refineries (highest in industry based on Nelson rating), the efficiency with which the company operates (consistently has the highest Net Income/Barrel of capacity in industry), and HFC's strong advantage in ROIC generation. We will expand on some of the operational points White discussed and provide what we think he doesn't offer: a disagreement with the consensus view on HFC.
First, it is difficult to understate how efficient HFC is operationally. Some of this efficiency is derived by management's experience and skill, but even more is derived from the geographical advantages of HFC's operations. For example, the El Dorado refinery in El Dorado, KS has dual geographic advantages of low transport costs to a major end market (Kansas City) and easy access to a cheap feedstock in the form of heavy crude from Canada.
El Dorado's complexity (11.8 on the Nelson scale) allows it to process the ever-cheapening heavy crude from oil sands into high value light refined products. El Dorado's access to Mid-Continental high-margin markets is mirrored by HFC's refinery operations at Cheyenne, WY, Artesia, NM, and Woods Cross, UT. The Woods Cross facility also has the unique advantage of processing lower-cost black wax crude and easy distribution to the Salt Lake City area. Further, HFC's combination of its two Tulsa, OK refineries into a single operation able to process 10,000 bpd of heavy crude and a Nelson complexity rating of 14.0 will boost operating margins going forward. While several of HFC's refineries serve isolated markets where pipeline bottlenecks restrict peer competition, many also have access to major markets at very low transportation costs.
As the US becomes increasingly reliant on low-cost, heavy Canadian crudes, HFC will be the leader with expertise and geographical positioning. If unconventional Canadian crude is the future of American energy, HFC is the future of American refining. HFC's advantages become apparent when observing the company's ROIC and Net Income/Barrel comparisons. The perpetuation of cheap Mid-Continental supply will continue to help HFC's margins going forward. Coupled with its extremely flexible balance sheet, we think that HFC merits a meaningful premium over its refining peers. (All information from above paragraph can be found in the Q3 Investor Presentation.)
Nevertheless, all of this information is relatively well known. Even if we view HFC as a top player in the independent refiner sector, the industry remains subdued on a valuation basis. Morningstar suggests HFC is fairly valued at $33, based on a 4.7x multiple of 2012 EBITDA estimates of $1.5b (Morningstar Research's Feb '12 report - Thomson One Subscription). Ignoring the fact that a 4.7x multiple is at the historic bottom of HFC's trading range (pre-merger Holly traded around 8.0x EV/EBITDA), we believe that a variety of factors will contribute to boost refiner margins and the demand for refined products.
First, the clearing of the macroeconomic horizon in the US over the past few weeks has made upside surprises in refiners' capacity utilization rates more likely, in our view. Second, there are some reasons to suggest that variables such as the crack spread and the WTI-Brent price differential may conspire to boost refinery margins higher, and for a longer period, than currently expected.
First, despite the imminent reversal of the Seaway pipeline, the Brent-WTI spread closed at $16.60 last week (Bloomberg data). We believe this is indicative of two major issues. First, and most basically, the amount of oil flowing south from Cushing will be insufficient to lower the spread even with Seaway open. This will continue to boost refiners' margins over the next few years as transport infrastructure continues to play catch-up with demand.
Second, political instability in North Africa and the Middle East will continue to boost Brent prices. The downside risk inherent in an extremely volatile Egyptian political environment, open civil war in Syria, an evolving situation in Yemen, and the constant threat of an Israel-Iran confrontation is larger than the market currently appreciates. These factors may mean a Brent-WTI spread averaging close to $10 during 2012 and 2013 (average of close to $17 in 2011), meaningfully above consensus estimates.
Second, the differential between Light and Heavy crude feedstocks, shown in the spread between the prices of WTI and Canadian Heavy crude, will continue to remain elevated. As demand growth picks up, so will production in Canada's unconventional oil resources. While the differential averaged a little over $8 during 2009-2011, that figure should increase to an average close to $20. Oppenheimer currently projects that the WTI-Canadian differential will be around $17 during 2012 and 2013, though that number appears low when you consider that the spread averaged above $20 in 2007 and 2008, before the current Canadian production glut (Oppenheimer Report, February 3, 2012 - Thomson One Subscription).
Given our projections of the upside risk in both of the above spreads, we believe there is a substantial probability that the multi-year uptrend (Bloomberg Data) in 3-2-1 crack spreads continues and delivers several very profitable years to domestic refineries. Currently, it appears that the analyst community remains fairly restrained in their projections of future crack spreads. Despite our estimates of stronger-than-expected crack spreads, it is difficult to extrapolate this idea into estimates of HFC's operating margins and FCF because of the lack of granularity in the company's public filings.
Using a favored metric in the industry, we would revise Morningstar's 4.7x 2012 EBITDA of $1.5b valuation towards 5.0-5.5x 2012 EBITDA of $1.75-2.0b. This would offer substantial returns to HFC's investors beyond the meaningful dividend income the company generates. Given that HFC trades at a P/E multiple of 6.4x, even the Morningstar consensus estimates of 17% growth (Morningstar) make the stock look ridiculously cheap. With HFC offering a 28.3% ROE (BI Peer Average of 11.02%), a ROA of 12.24% (BI Peer Average of 5.16%), and the lowest Net Debt ratio in the industry, the company should not be trading perfectly in-line with its peers (Bloomberg Data). We believe HollyFrontier operates a best-in-breed company in the midst of an industry beginning to see strong improvement in its economic characteristics.
HollyFrontier's Q4 earnings release yesterday morning offers little evidence that our thesis should shift (Company Release and Press Analysis). The company reported strong performance with sales of $4,972m handily beating expectations of Bloomberg consensus expectations of $4,290m. The company flexed its operational muscle to meet growing economic demand for refined product by increasing its capacity utilization rate from 86.6% in Q4 '10 to 91.8% last quarter. Somewhat disappointingly, margins fell, casuing EPS to miss expectations.
CEO Mike Jennings attributed some of the margin blame to tightened WTI crude differentials and slightly narrowed crack spreads, but did mention that they expect the inland-coastal price differentials to continue going forward. Jennings suggested that inland margin strength would be a long-term feature of the industry given the proximity of such refiners to Canadian crude, regardless of the slow buildout of Mid-Con to Gulf Coast pipeline infrastructure. While the market gradually reassesses its long-term view of refining margins, HollyFrontier should continue to out-operate its industry peers.