With Calumet Specialty Products Reaching A Yield Of 25%, Ignore The Units And Buy The Bonds

| About: Calumet Specialty (CLMT)
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Summary

Calumet Specialty Products has just completed a large suite of multi-year refinery expansion projects.

The 4th Quarter was terrible and the distribution level is now in doubt for the public units.

The bonds have been smashed along with the units, but the two are not the same thing.

The Calumet bond I own has a Yield to Maturity in excess of 14% at current pricing.

Please Note: Any bond yielding 14% to Maturity is a clear signal that the market believes it is in great distress.

Back in June of 2015, I wrote an article about buying units in Calumet Specialty Products Partners (NASDAQ:CLMT) that discussed it climbing a mountain and enjoying the view. I had been attracted to the company due to its high distribution and the very sizable percent of business done in niche refinery products like waxes, esters, and specialty solvents. In this article, however, I will not be pointing to the public units but rather my reasons for buying the

CALUMET SPECIALTY PRODUCTS PARTNERS, L.P 7.625% Coupon Senior Unsecured Bonds Maturing 1/2022 CUSIP: 131477AL5 B2/B (Moody/S&P)

(There are other bonds outstanding from this company, the logic of this article should apply equally to those)

Regarding the first article...by October things had gone in a way I wasn't comfortable with and you'll note the final comment in the article was one about me liquidating the position. Which was good because it turns out the view from the top of the Calumet mountain was brief and shortly thereafter the company lost its grip and fell screaming onto the rocks far below. From the point of my sale in October at over $26, the stock has fallen to under $10. That shattering drop is made all the more amazing because they have finally completed all of the refinery projects they had been working for many quarters as they related in the recent Fourth Quarter 2015 conference call.

After more than three years of heavy capital investment, our Montana refinery heavy crude oil expansion, our San Antonio refinery specialty solvents project and our Missouri specialty esters plant expansion project, have all reached completion. Our new crude unit in Montana is currently operating at 17,000 barrels per day, and is expected to reach 25,000 barrels per day by the end of March. San Antonio has started selling specialty solvents to customers, while our Missouri plant has started selling specialty esters post its expansion. On balance we anticipate all three projects will begin contributing material EBITDA beginning in the second quarter 2016. With the organic growth projects complete, our current focus remains on capital conservation, as our capital spending is poised to decline more than 60% in 2016 versus the 2015 period. Pat will speak to this in more detail in his remarks.

The question obviously given the horrifying performance of the units lately is what went so terribly wrong in the 4th Quarter? I think this quote from the CC by CFO Pat Murray sums up the situation rather succinctly:

As Tim mentioned clearly our fourth quarter results did not reflect the level of strength evidenced in our overall business during the first nine months of 2015. Although we achieved record fourth quarter throughput and record sales volume within our fuel product segment, fuels refining margins decrease materially between the third and fourth quarters, as reflected a by 45% quarter-over-quarter decline in the 2/1/1 Gulf Coast crack spread, along with a significant narrowing in select crude oil price differentials.

Even worse, one of the first of the 4 new projects (a brand new greenfield refinery in North Dakota) happened to come fully online in late 2015. A time that turned out to be the dead center of a massive decline in oil and gas drilling in that state. This massive headwind to the North Dakotan economy led to a parallel decline in fuel demands, particularly hurting the local crack spread for that operation. It hurt that location's profitability so bad that it is still running cashflow negative as of the time of the conference call (although numerous changes are apparently being made to fix that).

Now we all know (at least I hope everyone knows) that refining can be an extremely volatile business. One quarter its a question of how to count all the money and the next quarter the spread is compressed to trying to scrape pennies from the mud. So while the 4th Quarter of 2015 was a disaster (I don't think that's too strong a term) let's look at the distributable cash flow measure for not just the quarter but the whole year from Calumet's 4th Q Release:

The Non-Gaap Distributable Cash Flow measure shows what the company has left over for the distributions to be made to all of the partners of the MLP. It is important to note from the calculation above if there is even $1 of DCF in a given year, then that means all debt service costs have been covered. We can clearly see that in the 4th Quarter there was a disastrous shift down from positive to negative. Interestingly, for the whole year of 2014 to 2015 there was actually a slight uptick in total DCF, but given that the company had more shares outstanding year over year, the DCF available per share was not materially different.

Crack spreads in refining are notoriously volatile quarter to quarter, which is why a full year view is probably the better way to look at it for any purpose. Historically, there are numerous and varied periods of high and low profit margins in the refining business as the sector's huge number of unpredictable variables come into play. For example, one element that hurt the fourth quarter for almost all US refiners was the outrageously warm December in the region of the US that uses the most heating oil. It was the warmest December in the US in modern times. Such weather effects are hard to plan for, but they tend to smooth out over longer periods of time.

The most critical point to make is that in neither the year 2014 or 2015 did the distributable cash flow come close to covering the distributions made to the unitholders. The DCF was certainly positive, but in both years, the distribution coverage was approximately 70% of the totals paid out.

Now, of course, with the public units yielding well in excess of 20%, the game of "Will they cut the distribution and how much" has begun. Analysts are guessing at various percentages, and nobody seems to have a solid answer. When you couple this unexpectedly bad quarter with the general damage that the entire MLP sector has sustained in recent months in the energy sector meltdown, I find myself unwilling to make a call on the distribution levels of the public units. But I do feel more confident predicting the company will be able to service its debt. Let's go through the three reasons as I see them...

First reason: it is, of course, nearly impossible to predict on a month-to-month basis the crack spreads for Calumet. But this company differentiates itself from many other refiners by the large percentage of business they do in stable profit niche products. Even in their worst quarter in years, the specialty businesses - waxes, esters, specialty solvents - did hold up well as evidenced by this chart from the 4th Quarter presentation:

You can see the blue line of the specialty products is nothing like the highly volatile regular fuel profit margins. Therefore, it's fair to conclude that some of the new projects that specialize in these types of products are going to be profitable in almost any environment.

Second Reason: The CEO clearly noted in the first quote I pulled from the conference call that the other three projects recently completed are in the process of beginning operations/sales and should improve the company's financial flexibility:

On balance we anticipate all three projects will begin contributing material EBITDA beginning in the second quarter 2016

So while the new refinery in North Dakota is having problems with its profitability, on the whole, it's quite probable that all four projects together will have a positive EBITDA contribution. I say that because while the company was originally estimating the total EBIDTA contribution from all four projects to be roughly 135 million dollars a year, it estimated that only 30 to 35 of that would come from the (for now ill-fated) Dakota Prairie Refinery. This means that even if the DPR continues to run at negative EBIDTA, with all four projects online, it seems unlikely to me that the EBITDA will be collectively negative.

Third and Final Reason: As seen in the exhibits above, the company has been failing to cover its very high unit distribution yield. But it has had materially positive DCF for all of its recent history. Even if the public unit distribution must be cut down to a far lower level than the current 68 cents per unit, any cuts are actually positive for the bond holders. It is improbable in my view that the brand new CEO (this was his first quarter) will choose to over distribute knowing he will eventually default on the bonds leading to the company's bankruptcy (and his removal most likely). Indeed, one could argue the best thing for the debt holders would be an extremely tough cut based on the new manager's "cleaning house" down to a level in the 20 cent per unit level which would free up cash flow over the year to reduce leverage (good for bond holders) or even expand/upgrade various facilities (also positive for bond holders).

It is my outlook that the company knows the need to dramatically cut the distribution (indeed, given the market action, I am not alone in this view). A reduction in the distribution combined with a simultaneous increase in the company's EBITDA from the full operational capacity of the three latest projects will be a major difference from the awful end of the past quarter. The company is also working on reducing losses at the Dakota Prairie Refinery, which is a new operation and still has kinks to work out.

All in all, these items should lead to the bond holders to eventually see the company as a less of a risk than they currently do. While I have no idea what size unit distribution will be chosen over the 2016 fiscal year, there is no evidence from the past years and cycles that the company will be unable to support at least a small distribution. This has led me to buy the bonds at very high yields which normally signal serious distress. I think the overall market hatred for Energy and MLPs, plus the specific fears created by the fourth-quarter failure have caused the market to ignore the coming increases in EBITDA and the anticipated (sizable) decrease in distribution. By the end of this year, I think the market will have become more constructive on these bonds' future and the price will improve, while the interest will continue to get paid.

Disclosure: I am/we are long CLMT BONDS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have no plans to transact on any other security mentioned in this article over the next 72 hours. This article is not a solicitation to participate in any of Volte-Face's strategies or funds. All the information included in this article was believed by the author to be accurate at the time of publication, but is not guaranteed. This is not investment advice, but is a description of the author's thoughts or an explanation of his actions.