Long Opportunity: The Calumet Specialty Products Stock Issuance

| About: Calumet Specialty (CLMT)

Calumet Specialty Products Partners (NASDAQ:CLMT) is a company that has some of the characteristics of the oil refiners, and is attractive because of its high dividend, which at the moment is over 9%.

CLMT derives 80% of its income from the sale of specialty lubricants. These are materials that include some medical grade waxes, oils and other high performance materials that are greatly more profitable than the fuel business. CLMT's refining margin, which is the amount over-and-above the crude oil price that they charge for their products, was $21.40 per barrel of crude oil input in the most recent quarter. Marathon Petroleum Corporation (NYSE:MPC) is a highly respected, well run, efficient refining company and in its most recent earnings announcement was proud that its refining margin for the same period was $8.36.

CLMT stock was doing well, but has had a hard time of it lately:

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The stock has been caught in the downdraft in general markets and energy prices. The stock has gone down 18% in the last ten days, which is greatly in excess of some of the general marketplace. MPC stock has also backed off in the same time period, but only about 12%.

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We're going to look at the recent announcement of an issuance of 6 million shares of new CLMT stock, which was made on May 7, and make the argument that the current reaction of the marketplace is giving us a buying opportunity for stock in this interesting company.

Here is a summary of the proceeds of the transaction:

Shares 6,000,000
Selling Price 25.5 21
Proceeds $ 153,000,000 $ 126,000,000

The announced issuance price for the new 6 million shares was $25.50, making the deal worth a bit more than $150M. At the current price of 21, the incremental shares are now worth $126M.

Depending on whether they were able to place all of the shares at the announced price, the company has options:

Pay Down Debt

CLMT is rather highly leveraged, with a debt/equity ratio of 1.06. MPC, which is conservatively run, has a ratio more like 0.30. Valero (NYSE:VLO) a company that is in about the middle of the range of the independent refiners, is leveraged at 0.47. So, it is plausible that the CLMT management would use the proceeds to pay down some debt:

Interest Expense (current) $18,000,000 per quarter
Current LTD $665,000,000
Interest Rate 2.71% per quarter
Interest Rate (annualized) 10.8%
New LTD $512,000,000
New Interest Expense 13,858,647 Per Quarter
Interest Savings 4,141,353 per quarter
Annualized 16,565,413.53 per year
Current Shares Outstanding 51,500,000
New Issuance 6,000,000
New Shares Outstanding 57,500,000
Additional Income/Share 0.29 Annualized
Current PE 11
Stock Price Benefit 3.17

CLMT's interest expense on the $665M in long term debt is $18M. Using the share issuance to reduce their long term debt to $512M would bring the quarterly interest expense down to $13.8M, a savings of more than $4M per quarter or $16.5M per year. This money would go straight to the bottom line, divided by the 57.5 million shares that are now outstanding would be an additional $0.29 per share. The company's PE ratio is about 11, which is much higher than the rest of the independent refiners (due in large part to their generous dividends) and at that rate, the debt retirement would turn itself into an additional $3 on the stock price.

This is an attractive option, because the chances of success are 100%, although the $3 stock price benefit could easily disappear in the short run because of a bad day in Greece or Spain.

Buy Another Refinery

A year ago CLMT issued shares, increased debt, and bought the Murphy Oil refinery in Superior WI. This refinery takes cheap Midwest crude oil, and produces mainly diesel fuel, which at the current time has a higher margin than gasoline.

So, conceptually, the company could do something similar with the proceeds from the current issuance.

Unleveraged Leveraged
Proceeds 153,000,000 153,000,000
New Debt 163,550,876
Total 153,000,000 316,550,876

I would just throw out for consideration that if the management chose to keep their debt/equity ratio at about where it is, they could raise an additional $163M in debt for a total of $316M for possible expansion on the high end, so it is possible that the deal could be anywhere between these extremes.

So, how much refining capacity can one get in the current era for $150M? Well, I have to say it depends on where the refinery is, and what kind of condition it is in.

We have done a lot of work on this, and I would refer you to the articles here and here for additional background into this important topic.

When CLMT bought the Superior refinery, the company paid $442M for a throughput of 45,000 BPD, a rate of just more than $9800 per BPD capacity.

Recently, Delta Air Lines purchased a refinery in Trainer PA, with a throughput of 185,000 BPD for a bargain price of $150M, which is just more than $800 per BPD capacity. If you refer to the second article above we outlined a couple of years worth of these transactions and the average price of a lot of the refinery projects at the time I wrote that article was around $3000 per BPD.

The low price for the East Coast refinery is an artifact of the current situation in the Brent/WTI markets, where imported Brent crude oil is much more expensive than Midwest WTI. As a side point, the weekly EIA refinery utilization data reflects this. As of a couple of weeks ago, before the refiners started to scale up for summer, capacity utilization in the U.S. East Coast was only about 55%, compared to 90% in the middle of the country. Last week, according to this report, it had improved a bit to 84% compared to 94% in the Midwest.

So, the two options are: buy another refinery in the Midwest, and get a similar deal to the Superior deal last year, or get a bargain basement price on the East Coast, knowing that you are going to be a swing producer, and go through periods of lower utilization because of the Brent/WTI issues.

Refinery Assets Midwest East Coast
Cost per MBPD Capacity 9822 2000
Funds Available 153,000,000 153,000,000
Incremental Capacity (BPD) 15,577.28 76,500.00
Utilization 90% 60%
Quarterly Throughput (BBL) 1,261,759 4,131,000
Refining Margin ($/bbl) 21.4 10
Possible quarterly NOI Improvement 27,001,649 41,310,000
Annualized 108,006,597 165,240,000
Net of Taxes 66,964,090 102,448,800
Shares Outstanding 57,500,000 57,500,000
EPS Improvement 1.16 1.78
PE 11 11
Share Price Improvement 12.81 19.60

So here are the alternatives, using the following assumptions: The Midwest refinery would be purchased at the same effective price as Superior, the refinery utilization would be 90%, and the deal would be cash only, and not include any additional debt. It is quite true that per the above some additional debt could be issued, and there could be some retrofitting expense to allow the conversion of the refinery to CLMT's high margin product lines.

In the second case, the assumption is a much lower entry price for the East Coast refinery, and a much lower capacity utilization. Also, because of the additional cost of Brent, the refining margin for the products is also going to be much lower. Still, despite all of these assumptions, the deal actually looks better than the Midwest refinery from the standpoint of the benefit to the stock price.

So, if the East Coast refinery is such a good deal, why doesn't everyone want to do it? It's because of the higher margins for CLMT's products. A company like MPC with a $9 refining margin would actually lose money on exactly the same deal, so it would all depend on CLMT's ability to convert the capacity to the higher value-added product lines, rather than try to compete with ExxonMobil (NYSE:XOM) in unleaded gasoline.

So would CLMT actually do the East Coast deal? I am sure the management is tempted. But, all of their current system including their distribution network is within a couple hundred miles of the Mississippi River. They might rather walk away from the deal because there are many unknowns, including the long term state of the Brent/WTI spread, and most of all, the ability to convert the equipment to the CLMT product line.

Another Strategic Acquisition

Over the past five months, the company has made a couple of other strategic acquisitions, in complimentary product lines. This included TruSouth Oil, a blender and distributor of specialty lubricants, and the Hercules Chemical Synlube business, both of which are in similar high-value markets.

So, it is likely with at least another $150M in capital the company will continue this type of activity.

The Risks

The headwinds in this business: At the moment, the stock prices in this industry are all vulnerable to general economic weakness, and the price of CLMT stock will rise and fall with the overall market.

The company also participates in a lot of hedging activities: I did some analysis awhile back to the effect that over time, the CLMT hedging tends to add about $1 per barrel to the feedstock price. This protects the company in case of a big increase in feedstock costs. However, in the event of big decrease in feedstock costs, such as we saw in 2011, there is what appears to be a bad quarter as some of these hedging positions unwind, so we stockholders should be prepared for something similar this year.

Thirdly, as in all investing, timing is really important. When the company made a very similar issuance in 2011, it made a big difference as to when you made the investment. I will have more to say about this later.

But here is the upside: a very minimum $3 per share increase and potentially anywhere from $12 to $19 per share increase as this company gets bigger. While we patient investors are waiting for the rest of the events to unfold, we will be getting a nice dividend over 9% to reward us for deferred consumption.

The world is full of chaos, and there are no guarantees on anything. But, the current pullback and probable oversold position represents an opportunity. Do with this information what you will.

Disclosure: I am long CLMT. I was long CLMT just before the share issuance a year ago, and have been patiently collecting my dividend every quarter.

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