CVI, like many other oil and gas refiners, has struggled in the credit and equity markets over the last several years, as collapsing energy prices and subsequent tightening of crack spreads drove both the top and bottom-line lower. Continued headwinds to profitability led to material compression in equity market valuations, with credit markets following suit and bond yields reaching 10%+ in early 2016. This circular effect of weakening equity markets driving poorer credit pricing and perceived increases in credit risk driving lower equity prices has led to market expectations that are significantly too bearish at current valuations. Moreover, even if markets are slow to recognize this fact, cash flows and liquidity significantly in excess of obligations imply the firm's 8% dividend is safe, offering return while you wait.
Performance and Valuation Prime™ Chart
Prior to the firm's acquisition of Gary-Williams in 2011, CVI saw volatile profitability, with UAFRS-based ROA (ROA') ranging from -4% to 29% from 2005-2010. However, as they integrated Gary-Williams, and benefited from stable, strong spreads, the firm improved ROA' to 19% in 2011 and saw it stabilize at 19-22% levels through 2013. In 2014, as crack spreads tightened, they saw profitability fall, with ROA' fading to 11-12% levels where they remained in 2015. Meanwhile, the firm has seen Adjusted Asset (Asset') growth fade steadily, notwithstanding 50% growth in 2011 related to the aforementioned acquisition, from 10%+ levels pre 2009 to -4% levels in 2015.
For context, the PVP chart below reflects the real, economic performance and valuation measures of CVR Energy (NYSE:CVI) after making many major adjustments to the as-reported financials. This chart, along with all of the charts included in this article, as well as the detail behind the graphics, can be found here.
The four panels above explain the company's historical corporate performance and valuation levels plus consensus estimates for forecast years as well as what the market is currently pricing in, in terms of expectations for profitability and growth.
This analysis uses Uniform Adjusted Financial Reporting Standards (UAFRS) metrics, or adjusted metrics, which remove accounting distortions found in GAAP and IFRS to reveal the true economic profitability of a firm. This allows us to better understand the real historic economic profitability of a firm as well as allows for better comparability between peers. To better understand UAFRS, please refer to our explanation here.
Embedded Expectations Analysis
In addition to understanding the true profitability of the firm, understanding what the market is embedding in the stock price in terms of expectations is paramount to making good decisions. Without understanding what the market is pricing in, it is impossible to claim that the market is wrong. We derive market expectations for the firm from valuations and historical performance trends, to give a clearer picture into what the market is projecting for the firm.
CVI is currently trading at a 1.4x UAFRS-based P/B (V/A'), which is at its lowest point since 2011. At these levels, the market is pricing in expectations for declining ROA', from 11% in 2015 to just 8% by 2020, accompanied by 3% Asset' growth. With these expectations, it appears equity markets are expecting the firm to struggle to maintain profitability levels that it has sustained since 2011, and instead to seen ROA' decline to levels analysts project in 2016, and remain there for the foreseeable future.
In addition to being able to understand market expectations for a firm, a major benefit of adjusting as-reported financial statements is to clear away accounting distortions, to allow for more accurate peer-to- peer comparisons. To this end, we have included a scatter chart below plotting CVI against peers with similar businesses.
Generally, when looking across industries, markets, and time, there is a very strong relationship between a company's ROA' relative to the corporate average (6%) ROA', and the multiple the market will pay above the company's book Asset' base, in terms of V/A'.
Relative to its peers, CVI appears undervalued with its 1.4x V/A' and projected 8% ROA'. Not only is the firm trading in line or at a discount to firms with lower profitability, such as PSX, MPC and TSO, but it also has greater or similar expected Asset' growth, which would generally warrant an even higher multiple. Furthermore, the firm pays an 8% dividend, significantly higher than any of the peers above, and unless investors believe this is likely to be cut soon, one would expect valuations to regress upwards. However, absent a material unforeseen worsening in the firm's fundamentals, its current dividend should be safe from further cuts.
Credit Cash Flow Prime™ Chart
As oil prices reached trough levels in early 2016, and refining spreads tightened to levels not seen in years, credit spreads in the energy sector reached higher levels than during any point in the financial crisis. While perceived credit risk has stabilized significantly in the last year, CVI's credit risk is still being overstated. Valens' credit analysis shows that the firm has strong cash flows relative to its operating obligations, a significant expected cash build, a robust recovery rate, and a lengthy runway prior to their 2022 debt headwall. Moreover, not only should the firm have significant liquidity relative to maintenance capex, and interest expense owed, but also relative to its current dividend payments, indicating that even should cash flows dip somewhat, the firm should have no issue servicing this obligation as well.
Below, we've included our Credit Cash Flow Prime chart for CVI. The chart provides a far more comprehensive view of credit fundamentals than traditional ratio-based analyses. It shows the cash flow generation and cash obligations related to the credit of the firm, adjusted for non-cash financial statement reporting distortions from GAAP. The blue line indicates the gross cash earnings (Valens' scrubbed cash flow number) expected to be generated based on consensus analyst estimates and Valens Research's own in-house research team. The blue dots above that line include the cash available at that time while the blue triangles indicate that same amount plus any existing, available lines of credit.
The colored, stacked bars show the cash obligations of the firm in each year forecast. The most difficult obligations to avoid are at the bottom of each stack, such as interest expense. The obligations with more flexibility to defer year to year, such as pension contributions and maintenance capital expenditures, are at the top of the stacked bars. All of the calculations are adjusted for non-cash distortions that are inherent in GAAP accounting, including the highly problematic and often misused statement of cash flows.
Credit markets appear to be overstating the firm's risk, with a 6.496% YTW on their 2022 notes, relative to Valens' Intrinsic YTW of 4.996%, and Moody's Ba3 rating relative to Valens' IG4 (Baa2) rating. This exaggerated credit risk may be part of the reason equity markets do not appear to be respecting the sustainability of the firm's current dividend. The market appears focused on CVI's debt headwall in 2022, during which the firm has to repay $500m of notes. However, the firm's cash flows are expected to exceed its operating obligations in every year (except 2017, in which it is expected to fall short by ~$23m), allowing the firm to build a significant cash reserve, which would be more than sufficient to service this obligation. Additionally, given CVI's large working capital and strong asset base, they have a robust 160%+ recovery rate, and the firm should have no problem refinancing if they desire.
Valuation Matrix - Adjusted ROA and Adjusted Asset Growth as Drivers of Valuation
When valuing a company, it is important to consider more than a singular target price, and instead the potential value of a firm at various levels of performance. The below matrix highlights potential prices for CVI at various levels of profitability (in terms of ROA') and growth (Asset' growth). Prices that are in excess of 10% equity upside are highlighted in black, and prices representing an excess of 10% equity downside are highlighted in red.
To justify current prices, CVI would have to see ROA' fall below cost of capital levels to roughly 5%, while only growing its Asset' base by 1-4% annually. Given the fact that the firm has seen ROA' remain well in excess of 10% since the firm's acquisition of Gary-Williams in 2011, expectations for ROA' to remain below trend forever appear significantly too bearish. Moreover, considering the fact that the firm's overall credit risk is safer than credit markets are pricing, any equity market discount due to perceived credit risk is also unwarranted. Lastly, given the firm's safer-than-expected credit positioning, it is likely that the firm will also be able to sustain its current $2 per share dividend, which represents an 8% yield, offering significant returns while investors wait for the market to realize this mispricing.
To find out more about CVR Energy, Inc and how their performance and market expectations compare to peers, click here to access the open beta of the Valens Research database.
Our Chief Investment Strategist, Joel Litman, chairs the Valens Equities and Credit Research Committees, which are responsible for this article. Professor Litman is regarded around the world for his expertise in forensic accounting and "forensic fundamental" analysis, particularly in corporate performance and valuation.
Disclosure: I am/we are long CVI.
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.