Western Refining's Bonds: Worth the Risk

| About: Western Refining, (WNR)
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I have a certain weakness in my heart for junk bonds. Junk bonds, of course, are bonds with a sub-investment grade credit rating, and they can range from just barely on the cusp of investment grade to the point where the purchaser would have to be crazy to consider them. As Ben Graham wrote, an ordinary bond investor should never buy them, and speculators normally prefer a more speculative medium, but there are millions (now hundreds of billions or trillions) of them out there and someone has to own them.

And in the case of Western Refining (NYSE:WNR)'s 2014 5.75% convertible bonds, perhaps that someone should be us. The bonds sell at about 74, representing a yield to maturity of about 14.8% and a current yield of about 7.8%. The conversion price is around $10.80 per share, more than twice the current share price, so profiting from conversion is an unlikely event. However, although the possibility is remote the conversion privilege may act as a sweetener; Western Refining traded well above $10.80 per share before February of 2008 and recovering ot that point is not outside the realm of possibility. The bonds' credit rating is CCC+, which is the best of the bottom tier.

These convertible bonds are designated the senior bonds, but the other classes of bonds at Western Refining have security and guaranty provisions, so in fact these bonds would be better identified as the junior debt. Western Refining's total interest requirement year to date has been $61 million. Operating earnings year to date are $37 million, plus $69 million in depreciation, and $37 million in capital expenditures, indicating that $69 million is a suitable rough measure of the firm's free cash flow.

Furthermore, the firm has listed $23 million in maintenance expenditures year to date. According to its financial statements, various classes of maintenance activities have a schedule of roughly 2-6 years between actions. Looking back at their history, we find that in the last five full years they have spent more than $23 million only once, and on average over that period maintenance expenditures were $16.5 million a year. If we assume that the company has spent an outsized amount on maintenance, and instead applied the average amount of maintenance expenditures over the years, we find that there is theoretically another $15 million in cash flows available to meet interest. This produces a theoretical operating cash flow of about $84 million to meet their interest requirements, producing an interest coverage ratio of 1.4, which is consistent with a CCC rating.

I should note that their working capital has expanded recently, resulting in a cash burn rate that would normally be disturbing for interest coverage issues. However, let us recall that Western Refining is an oil refinery, and the end of the last quarter coincided with the early phase of the summer driving season. Furthermore, the large amount of maintenance they did year to date has resulted in several weeks of a shutdown in production, which makes the year to date results unusually low.

Now, the fact that they are a refinery may also give investors some confidence; refining services will be in demand as long as oil is in use, and it may allow them to survive with lower interest coverage levels than a typical company that produces more discretionary products. However, refiners do not enjoy the advantage of a local monopoly the way utilities do, and because they are not so insulated from competition, they are in a more precarious situation. Western Refining also owns a chain of gas stations and a fleet of fuel distributors.

Western Refining's operating income has in fact been on the decline for the last few years, which the company attributes to narrowing spreads between light and heavy crude, and the continued economic slowdown. Although the United States hasn't built a new refinery in 30 years, Western Refining has in fact ceased operations at one of their unprofitable refineries, a move that the CEO claims will save them money. They have also raised the specter of asset impairments in their outlook, which is a noncash charge but makes the reported earnings drop dramatically for the quarter in which it happens.

Now, the possibility of default and bankruptcy cannot be ignored when examining high yield debt. After a rough analysis, I am not convinced that Western Refining's bonds would sail through a bankruptcy unharmed, as the convertible bonds are behind a number of secured and trade creditors in terms of priority. The firm has a total of about $2 billion in debt outstanding, and as I've calculated the firm has $85 million in free cash flow to the firm year to date. Doubling that to round out the year and capitalizing it at 10x creates a value of the firm of only $1.7 billion, although considering the difficulty of building new refineries in this country they may be entitled to a higher multiple.

Even so, the company has over $600 million available in borrowing capacity, a large figure considering the firm has $2.8 billion in assets and the market cap of the equity is only $400 million. Furthermore, apart from a nonrecurring writeoff of goodwill and other impairments they have operated at a profit for the last five years.

Accordingly, I have confidence that the interest on the convertible bonds is safe, at least as far as junk bonds go, and the likelihood of them being paid off at par is sufficient inducement to make these bonds attractive to any people interested in high yield debt.

Disclosure: No positions