Activist investor Carl Icahn is on the verge of completing a hostile takeover of CVR Energy (CVI). Icahn has been quite vocal about his plans for the oil refinery company: having bought 80% of outstanding shares with a tender offer of about $30/share, Icahn plans to sell the company for $36 or $37 a share. While it seems like a lot of work and drama to win a 20% gain, ours is not to wonder why, but instead to figure out how to profit from the big-swinging investor's moves.
CVR Energy's business consists of two parts. The main part is the refinery business, as the company runs two refineries in the mid-continental region (one in Kansas, one in Oklahoma), where refineries famously benefited from an unusual gap between West Texas Intermediate (WTI) crude oil and Brent crude oil prices to make huge profits and generate large cash flows last year. CVR Energy is also the general partner of CVR Partners, LP (UAN), a nitrogen fertilizer business that trades independently.
While these two businesses are related, they are still separate entities, and many expect Icahn to break up the ownership stake of the fertilizer business from the refinery business before selling at least the latter. For analysis on the fertilizer business and Icahn's possible impact on UAN, Chris Damas is someone you should read, as he's done yeoman's work on the subject.
For the refinery business, the usual mid-continental refiners have been mentioned as likely buyers: Western Refining (WNR), Marathon Petroleum (MPC), Tesoro (TSO), and HollyFrontier (HFC). As a recently merged company and one with continually increasing shareholder payouts, HollyFrontier has often been mentioned as the most likely candidate to buy its rival. As an HFC shareholder, I thought it would be interesting to look into what CVR's refineries would be worth to an acquirer.
CVR Energy's refining business consists of the two refineries, some pipelines, and a crude oil gathering system to transport its oils. The bigger refinery is based in Coffeyville, Kansas, producing "clean transportation products such as gasoline, diesel fuels, and propane." The refinery is about 100 miles away from Cushing, Oklahoma, the center of the oil glut in the U.S. (a glut that may of course be decreasing with the reversal of the Seaway pipeline). This refinery has a capacity of 115,000 barrels of oil per day, though in the last two quarters it has averaged about 91K barrels throughput per day.
CVR Energy's second refinery is based in Wynnewood, Oklahoma. CVR bought the refinery from Gary-Williams Energy Corporation last winter, and has operated it for only one full quarter, this previous Q1. Per CVR's website, "The Wynnewood refinery produces gasoline, diesel fuel, military jet fuel, solvents and asphalt." Profitability again relies on, "access to a variety of cost advantaged WTI price-linked crudes." Capacity for the refinery is 70,000 barrels per day, though for Q1 CVR had an average of 58,255 barrels throughput.
Let's crack down on CVR's financial statements to get a sense of the company's strength and value. CVR Energy operated its refinery business at a 9.8% operating margin in 2011. This included 16 days of Wynnewood refinery operation at the end of the year. The Adjusted EBITDA earned from refining was $580.9M, leading to an adjusted EBITDA margin of 12.22%. In the first quarter of this year, the company ran Coffeyville at a 5.23% operating margin and Wynnewood at an 8.18% operating margin, a combined margin of 6.38%. Together, the refineries combined for $144.9M in Adjusted EBITDA, leading to an adjusted EBITDA margin of 6.83%. The last thing to consider on CVR's side is the cost of buying the company. Assuming Icahn gets 36/share for his 20% return, an optimistic but not unfeasible price, CVR's market capitalization would be $3.12B, and its enterprise value would be $3.62B.
From an acquirer's perspective, both the strategic and financial components of the deal have to make sense. HollyFrontier would presumably see CVR as a strategic fit if the company believes it can a) improve operations at the newly acquired refineries to unlock value, b) take advantage of the new refineries' locations to augment its current refineries, of which HFC owns 5, and c) continue to benefit from a long-term imbalance between cheap North American oils from the Bakken shale project or Canada, as compared with European prices.
With regards to improved operations, HollyFrontier is often considered the top U.S. mid-continental refiner. The company had throughput production of 448,460 barrels per day from five refineries. The company's operating margin for 2011 was 11.21%, and its non-adjusted EBITDA margin was 11.93%, both encouraging numbers compared to CVR's. For Q1 2012, those numbers drop to 8.51% operating margin and 9.55% EBITDA margin. These numbers are even better when stripping out HollyFrontier's non-refinery business, including its stake in Holly Energy Partners (HEP). HollyFrontier's mid-continent region refineries in Tulsa, OK, and El Dorado, KS, closest to the CVR refineries, had an operating margin of 12.17% last year. Overall, HollyFrontier's operating margin for its refinery business for 2011 was 12.86%, falling to 8.37% for the first quarter of 2012. HollyFrontier clearly has run its refineries more efficiently than CVR, though it's not clear how much of that is a result of the refineries themselves and how much of any proprietary knowledge HollyFrontier has.
Strategically, the two CVR refineries are located close to HollyFrontier's Oklahoma and Kansas refineries. El Dorado and Coffeyville are about 120 miles apart; Tulsa and Wynnewood are about 170 miles apart. Each of these refineries is close to the Cushing hub from which oil is shipped out to the Gulf Coast and other regions. While there would be obvious overlap for HollyFrontier in buying these refineries, the possible synergies and the concentrated position that HollyFrontier would have in the region could help HollyFrontier increase its advantage in the sector.
That advantage is only worthwhile under the thesis that the crack spread won't disappear. Much has been made of the Seaway pipeline reversal, but the crack spread remains elevated, and still well above last year's Q4 levels for sure. The reversal will have an impact, but the continued boom in cheap oil in the middle of America and the ongoing possibility of turmoil involving Iran (despite any possible deal the country might claim) offer reasons to believe Brent-WTI spreads might remain high. On the other hand, a European recession and/or a comprehensive Iran deal that would bring their oil back to the market would presumably dent Brent oil prices much more than WTI oil prices. I view the situation as very uncertain, but I imagine HollyFrontier's management has a better feel on where the spread will go, and if management feels bullish about the company's prospects as a whole, an acquisition would be a strong signal of intent.
In terms of cost, HFC is in good position to afford an acquisition. The company has $1.9B in cash and cash equivalents as of March 31, 2012. It has $1.3B in debt, a debt to equity ratio of 22.66%, and a debt to market capitalization ratio of 20.8%. The company's cash flows are especially impressive. For the trailing twelve months, the company's free cash flow less the payment of its ever-increasing dividends has been $730M (4.59 per share). Even if those twelve months included the peak of the oil spread boom, HollyFrontier seems poised to continue generating solid free cash flow for the coming years.
Given HFC's position, it would not be hard to envision a deal for CVR Energy's refineries at the asking price of 36 a share, i.e. $3.62B in Enterprise Value. HollyFrontier could make that deal paying a large portion of its current cash load, say a third of the total figure, and then pay the rest with debt, which the company could service with free cash flows that would presumably increase with the addition of two new refineries that operate at a decent profit margin, a margin that could grow with HFC's expert handling. Credit Suisse refinery analyst Edward Westlake has pointed out in a February 17, report titled "Merger Mania" that any acquirer can make the deal accretive to earnings in the current low-interest environment, making the taking on of debt more attractive.
The deal may be easy to see, but does that make it a good one for HollyFrontier and, more importantly for our purposes, for shareholders of the stock? HollyFrontier is already the primary pure play on mid-continental oil, and with the Seaway pipeline reversal, the potential of a future Keystone pipeline, and other moves to reduce the spread between WTI and Brent, that play feels riskier now than it did last summer. While HollyFrontier has paid out great dividends since becoming a merged company - just shy of 8% yield in the past year, and 8.52% if annualizing the Q2 payouts to come, and those yields after the stock has run up two dollars a share since Friday's close - the share price has not broken out and remains well below the highs the company saw last summer. Further, the company has expressed skepticism over whether anybody can fairly assess value of refineries with current high margins.
I see a move by HollyFrontier, or any other refiner for that matter, to acquire CVR's refining business as a magnifier move. It would magnify the volatility inherent in refiner stocks in today's market. It would magnify the risk that the Cushing glut seeps away, with refining margins leaking along with it. It would also magnify the potential profit if the good times keep rolling, or if refiners prove they don't need the highest of up-cycles to succeed. Beyond the special and increased regular dividends, beyond positive conference calls, a buy like this would be the ultimate bullish signal for a refiner.
Icahn has all but won the first stage of his battle, achieving control of CVR Energy. For him to win the war, he's going to need to pass the company off to an eager buyer at a premium. Some think he has the deal lined up already, but if he doesn't, it's going to take Icahn some time. The situation on (or under) the ground may change by then.
But if I see a market current telling me that HollyFrontier has agreed to buy what Icahn's selling, I'll first feel nervous about the added risk to an already volatile stock. Then I'll think that HollyFrontier management must feel even better about the company's prospects. And I'll probably remember that the management knows much more about the company than I do.