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Tesoro's (TSO) recent resumption of a dividend payout and the announcement of a share repurchase program have seen its stock price increase by 43% in the last three weeks (ever since the quarterly earnings announcement). We believe there is potential for the company to perform well in the future, and hence we have a positive stance on the stock.

Company Overview

Tesoro, headquartered in San Antonio, is an independent refining and marketing company with operations in the United States. It has two business segments, namely refining and retail. The refining segment owns seven refineries located in California, Washington, Hawaii, Alaska, North Dakota, and Utah. It has a production capacity of 675,000 barrels per day, and has a Nelson complexity index rating of 9.5.

The retail segment operates and sells petroleum products through 1,175 retail outlets in the western region of the U.S. The company also owns a stake in Tesoro Logistics LP (TLLP), which comes under the midstream segment, through its 2% general partnership interest and 100% of its common shareholding.

Earnings Review

The company reported revenues of $8.1 billion for the second quarter of 2012, showing an increase of 1.8% as compared to the revenue reported for the second quarter of 2011. The reported revenue for the second quarter of 2012 also beat mean revenue consensus expectations of $6.9 billion by 17.5%. The increase in the revenue was due to higher production, capacity utilization, higher product demand, and prices.

TSO reported EPS of $2.87 for Q2 2012, showing an increase of 74% compared to the reported EPS for Q2 2011. The reported EPS for the second quarter of 2012 also beat mean EPS consensus estimates of $2.30 by 25%. The increase in the earnings was due to the higher gross refining margins realized by the company in the outgoing quarter.

$ Million

% change

2Q2012

2Q2011

2Q2012E

Deviation

Revenues

2%

8,105

7,963

6,900

17.5%

EPS

74%

2.87

1.65

2.3

24.8%

Cash Flow From Operations and Capital Expenditure

The cash flow from operations at the end of the first half of 2012 reached $724 million, indicating a significant increase compared to the same period last year, due to better working capital management and improved revenues. The capital expenditure also witnessed a significant increase from the levels recorded in the same period last year. However, the improvement in the cash flow has a far more lasting impact.

$ Millions

1H2012

1H2011

% Change

Cash flow from operations

724

89

713%

Capital Expenditures

-243

-112

117%

Feedstock

The feedstock for Tesoro refineries as of the second quarter of 2012 is given below. Tesoro utilizes 30% heavy crude in its refining process, which gives it an opportunity to earn higher margins, since heavy crude oil trades at a discount to light crude oil.

Feedstock

2Q2012

Heavy Crude

30%

Light Crude

63%

Other feedstock

7%

Petroleum Products

From the table provided below, it can be seen that Tesoro has a higher production of high-margin petroleum products, such as gasoline, diesel, and jet fuel. This is another factor contributing to the high profitability of the company.

Products

2Q2012

Gasoline and gasoline blend stocks

48%

Diesel Fuel

21%

Jet Fuel

12%

Heavy oil/residue/other

19%

Dividend Resumption and Share Buyback

The company announced a $500 million share buyback program and a quarterly dividend of $0.12 per share. Tesoro has resumed its dividend payout, after suspending the same in early 2010. This was a significant development, and the share price has increased by 43% since the announcement on Aug. 1, 2012.

Acquisition of Refinery from BP

Tesoro announced its intention to purchase a fully integrated refining and marketing business in Southern California from British Petroleum (BP). The acquisition includes a high complexity refinery with a capacity of 266,000 barrels per day, an integrated retail marketing business with 800 dealer operated sites, brand ownership of ARCO, an ownership stake of 51% in a BP-operated generational plant, and ownership of the logistics business.

The said deal will expand the presence of Tesoro on the West Coast, and the company will enjoy synergies through lower costs and feedstock optimization.

Growth Opportunities

There are a number of growth opportunities for the company, including the increased production of crude oil from the Bakken Shale in North Dakota, where the company owns and operates the only refinery by the name of the Mandan refinery, with a capacity of 65,000 barrels per day. Tesoro recently expanded its refining capacity by 10,000 barrels for the above-mentioned refinery to take advantage of the increased production from the Bakken shale.

Tesoro intends to increase its supply of crude oil from the Bakken shale by constructing a rail facility to deliver 30,000 bpd of high margin crude oil to its Anacortes refinery in Washington State.

Threats

Tesoro's earnings are severely dependent on its refining business, as 92% of its earnings are contributed by the refining segment, and 7% by the retail segment. Therefore, any negative development such as reduced refining margins, decreased spread of the Western Texas Intermediate crude oil to the Brent crude oil, lower demand of petroleum products and decreased supply of high margin crude oil would adversely impact the company's earnings.

Outlook

Tesoro is in a strong position due to the locations of its refineries, which have made it primarily a player on the West Coast. We are of the opinion that the refining industry will continue to perform well in the U.S. due to the increased conventional and unconventional production of domestic crude oil. Tesoro was the only major independent refiner not paying a dividend among its peers, and a resumption of the dividend has been a major contributor to the increased investor interest in the company.

Tesoro is trading at forward P/E, P/B and P/S multiples of 8.2 times, 1.3 times, and 0.17 times and is offering a dividend yield of 1.4%. We believe the company will continue to perform well going forward, and thus adopt a positive stance on the stock.

P/E

P/B

P/s

Dividend yield

Tesoro Corp

8.19x

1.3x

0.17x

1.40%

Valero Corp (VLO)

6.62x

1.01x

0.12x

2.40%

HollyFrontier Corp (HFC)

8.38x

1.6x

0.42x

1.50%

Source: Tesoro's Dividend, Growth Opportunities, And Cheap Valuation Make It A Buy