Description

CVR Energy (ticker: CVI) is a compelling long (22% relative upside vs. group) with a few different ways to win:

·        Refining stocks are up massively 2018 YTD:  PSX +18%, MPC +27%, VLO +31%, HFC 44%, PBF +40%, DK +56%.  Even after this week’s move in CVI, the stock is up just 3% YTD.  And it is most comparable to HFC and DK given its leverage to Brent / WTI which are up the most.  As a result, CVI trades at 5.4x on 2019 EBITDA, a slight discount to peers    

·        I am still bullish refining.  Seasonally we are entering a period where summer demand begins to taper and refineries go into turnaround.  At the same time, inland crude growth continues to surge and Syncrude is coming back online after being out for a big part of the summer.  The confluence of these factors will likely lead to higher Brent / WTI spreads as Cushing will begin to build inventory

·        I think there is a material chance that Icahn sells CVR Energy between now and year end, and will offer my own mosaic theory on why now

Background

CVR Energy is majority owned by Carl Icahn (approximately 82%).  Carl has been in the stock since 2011, and took control of CVI back in May 2012.  So he has been in the stock for about 7 years.  CVR Energy is a publicly traded shell company that owns a majority of the units of CVR Refining (ticker: CVRR), approximately 80.6%) and 34% of the units of CVR Partners (ticker: UAN).  For the purpose of this discussion, I will not offer much commentary / analysis on UAN as it represents less than $150 million in value and is not central to my investment thesis.    CVRR is really where the value is here, owning two refineries in the Group 3 of PADD II: Coffeyville Refinery (132k bpd) and Wynnewood Refinery (74.5k bpd). 

There have been numerous write-ups on CVR Energy over the years at VIC (2007, 2010, 2011, 2012).  I am not looking to re-hash everything but would suggest reading the past write-ups for additional background info. 

Valuation thoughts on sector

Over the last 7 years a lot has happened to change the valuation framework for US refiners.  Simply stated, the emergence of structural crude differentials combined with capital discipline has served to re-rate refiners.  Here are some selected thoughts on each refiner:

Valero, the largest pure play refiner benchmark trades at 9.2x 2018 EBITDA and 7x 2019 EBITDA.  I would argue this is gold standard in pure play refiner valuation as VLO has a collection of top tier assets and under Joe Gorder, has been a best in class capital return machine.  So 7x I would say is the top of valuation range on 2019 refining EBITDA.

MPC and PSX – both of these guys are in perpetual empire building mode. PSX more organically, while MPC can’t stop the M&A binge (Hess, Mark West, Andeavor, etc.)  So looking at a blended EBITDA multiple for those two is less relevant and would suggest more a SOTP approach.  For the purpose of this CVI discussion, I am going to exclude MPC and PSX as relevant refining markers.

I would say the next real pure play refiner is HFC.  On consensus numbers HFC trades at 7.6x 2018 EBITDA and 6.4x 2019 EBITDA.  The discount vs. VLO makes sense to me as HFC under George Damiris has been executing a dubious M&A strategy.  HFC is also the most directly comparable refiner to CVR as they are both WTI-linked refiners.  While HFC has a larger refining asset footprint vs. CVI, HFC’s assets are not necessarily better.  A discount however is warranted, as CVI is less liquid with a small public float and under Icahn’s control.  That being said, Icahn has a documented history of running CVI for cash while HFC’s capital return strategy has been lacking under Damiris. 

So once we get past the large cap names, we are really only left with DK, PBF and CVR. 

Delek.  I would say this is the second best comp to CVI.  Problem is, they are more midland levered than WTI Cushing.  Midland diffs have blown out due to pipeline constraints so DK is going to really mint it over the next 18 months.  This is no secret to the market.  Just to give some context, when DK bought Alon and before midland diffs blew out, the super stretch EBITDA goal was $600 million with synergies.  And to be honest, very few people really believed Uzi (CEO of DK).  In 2018, DK is expected to print nearly $1bn of EBITDA and close to $1.3bn in 2019.  What a difference a >$10 midland differential makes.  So, headline valuation for DK is 5.9x 2018 and 4.5x 2019 EBITDA.  Valuation might look cheap, but DK is getting a big midland windfall in 2018/2019 that we should not be capitalizing that into the future. Uzi finally has the firepower to do a CVI size deal. 

PBF, which I am not really a fan of, trades at 7.6x 2018 and 6.1x 2019 EBITDA.  PBF appears to be on a mission to own a refinery in nearly every PADD in the US, and has done a good job in accumulating a portfolio of refineries that nobody else wanted.  And what I think is most egregious, PBF recently issued equity during a time when refineries are minting FCF… yet PBF doesn’t seem to be generating enough cash flow to self-fund its organic IMO 2020 projects.  Or perhaps it is to bolster its M&A war chest.  Or maybe it’s as simple as let’s sell stock to delever because we think our stock is overvalued?  But I digress.  Bottom-line, PBF’s asset profile is a collection of marginal refineries.  I can’t explain PBF’s valuation – perhaps people want to own the crappiest set of refineries for IMO 2020 leverage.  Or maybe someone thinks Motiva will show up one day and take PBF out. 

Finally onto CVR Energy.  So I am going to keep this simple.  CVR has two refineries, some midstream assets and an interest in UAN.  I think the two refineries can earn over $800 million in EBITDA in 2019. 

My assumptions as follows:

·        Coffeyville runs 70k WTI, 25k WCS and 20k midland

·        Wynnewood runs 50k WTI and 20k midland

·        Diffs: Brent / WTI = $8, Brent / WCS = $22, Mid-Cush = $3

·        Cracks: Gas = $9, Distillate = $20, Fuel Oil = ($25) and 6321 crack = $7

·        95% Capture and $4.0 / bbl opex

·        Yields refining EBITDA of around $828mm. Sanity Check – six analysts on street cover CVRR, range of 2019 estimates $609-851 million, consensus of $717 million

·        There is also around $75 million of midstream EBITDA which I assume will offset by RINS.   If I wanted to play for some extra valuation juice, I would capitalize midstream at 8-10x and value cost of RINS at refining multiple of 5-7x. 

·        Also important to note that I have given them no credit for the WTI barrels they are running through their own gathering system. Those barrels are actually gathered barrels from Scoop/Stack/PRB etc and they get 0.50cents discount on WTI on those bbls.

·        CVR Energy also has 40 mbpd of access to WCS bbls and is currently working on projects to increase ability to run 40 mbpd of WCS instead of current WCS of 25 mppd. As WCS widens out it is actually more profitable for them to sell WCS at Cushing which prices off Maya and make as much as $10.0/bbl sold.  This represents an annual benefit of $100 million for which I am giving them no benefit. 

My math is as follows:

CVI Market Cap = $3,870 million

CVI Debt = $1,167 million

CVI Cash = $534 million

CVI TEV = $4,503

However, CVI TEV includes UAN debt and ownership of UAN units.  So we need to adjust CVI TEV by reducing debt $599 (UAN’s net debt) and increasing by CVR’s ownership of UAN, or $143 million.  We also need to add approximately 15.5% equity value in CVRR to reflect minorities owned by public ($427 million).  In this way we can look at refining EBITDA vs. refining TEV. 

Adj. CVI TEV = $4,473

My 2019E EBITDA = $828 million

 ð  5.4x 2019 EBITDA. 

At 6.0x multiple = CVI stock worth ~$44.00 (+14% upside) – parity with PBF, discount to HFC

At 6.4x multiple = CVI stock worth ~$47.00 (+22% upside) – parity to HFC

At 7.0x multiple = CVI stock worth ~$52.00 (+35% upside) – take-out scenario

I would argue CVI should trade at parity to HFC, offering 22% upside with a $47 price target. While this might appear aggressive, I think HFC’s multiple is depressed due to the current CEO’s capital return policies.  Also post NTI, WNR, ANDV, ALJ, there is a scarcity of US refining assets for sale which should be reflected in CVI’s valuation.   In a take-out scenario I see 35% upside in CVI.    

Bullish Refining: A seasonal call on Cushing

 I am bullish refining for a few reasons:

1)      Seasonally we are about to come off peak summer demand and refiners have been running harder than a pack of scalded dogs.  Latest DOE weekly figure showed refiners ran at 98.1% capacity utilization.  You would have to go back to 1997 to see this level of utilization.  Despite this level of utilization, cracks are holding up and crude diffs remain wide for various inland crudes (e.g., WTI Cushing, Midland, WCS).  As refiners go into fall turnaround, I expect crude diffs to widen further as the onslaught of US supply continues.

2)      I expect Cushing to sustainably build from here.  Simply stated there are more pipes going into Cushing than coming out (near term).  The last several months, Syncrude has been down and that is coming back.  Continued growth from the Bakken, DJ, Scoop / Stack will begin to cause serious builds in Cushing which will become more evident as refiner utilization ticks down.  To read more on this, please refer to Paul Cheng from Barclays recently authored piece from 8/23, “Brent-TI: Brace Yourselves, Big Builds are Coming”.  The same day, Manav Gupta, refining analyst at Credit Suisse also put out sector update that also highlighted Cushing inventory hitting an inflection point. 

3)      From an oil price perspective, the aforementioned points are bearish for the price of oil.  I also think there is a funds flow argument that can be made to be long US refining vs. E&P or integrateds.  As we saw during 2q earnings season, lots of E&Ps raised capex budgets - some of that spend discipline has eroded in a $70+ Brent world.  So any weakness in commodity oil prices will dampen investor upstream appetite.  Most large cap refining have compelling return of capital stories so I think the sector is a relative winner, along with midstream.

4)      Hurricane optionality

I want to emphasize that my bullish refining view is pretty short term oriented.  Lots of good news is already priced into sector (note various YTD stock price returns) with the Brent / WTI forward curve pricing in >$8 crude diffs are far as the eye can see.  Enthusiasm over IMO 2020 is no secret and RIN worries have gone away, for now at least.  We are about 2 years into this refining rally, and I am thinking we have another 6-9 months left.  So I am not telling you to go buy VLO or HFC here.  The thesis here is to buy CVI, offering direct leverage to WTI, at a discount to sector, that also happens to be owned by a savvy financial owner that might be concluding we are nearing the peak of the cycle. 

I think Uncle Carl sells CVI

First off, I want to be clear – I have absolutely zero knowledge of any potential sale.  I will make my case using publicly available data / events to build a mosaic for you…

Mosaic Point #1: May 29, 2018 – CVR Energy Announces Intention to Commence Exchange Offer

http://www.cvrenergy.com/NewsRoom/pdfs/2018-05-29%20CVI%20Exchange%20Offer%20News%20Release--FINAL.pdf

This exchange offer is to offer CVRR unitholders the option to convert to CVR Energy stock (CVRR -> CVI).

CVR says they are doing this “in light of recent tax reform, many CVR Refining unitholders may wish to hold their investment in the form of common stock rather than partnership interests.” 

And then, interesting enough, they say:

“An exchanging unitholder will also participate directly in the performance of CVR Energy as a stockholder of CVR Energy, including any future premium that may be received by stockholders of CVR Energy in connection with a sale or other corporate transaction.”

So theoretically this would be on top of the 25% premium CVI is offering to convert CVRR unitholders.  If this isn’t a big enough carrot, then CVI warns about Icahn’s big stick:

“Pursuant to the partnership agreement of CVR Refining, once the general partner and its affiliates own more than 80% of the common units of CVR Refining, the general partner and its affiliates will have the right, but not the obligation, to purchase all, but not less than all, of the common units of CVR Refining held by unaffiliated unitholders of CVR Refining at a price not less than their then-current market price, as calculated pursuant to the terms of the partnership agreement. Accordingly, the general partner and its affiliates will be entitled to exercise this call right after the consummation of the exchange offer. Pursuant to the partnership agreement, the general partner is not obligated to obtain a fairness opinion regarding the value of the common units of CVR Refining to be repurchased by it upon exercise of the call right. Pursuant to the partnership agreement, the general partner may use its own discretion, free of fiduciary duty restrictions, in determining whether to exercise the call right. The general partner and its affiliates (including CVR Energy and Icahn Enterprises L.P. and its affiliates) have no current plans to exercise the call right at this time or upon the consummation of the exchange offer. However, there can be no assurance that the general partner and its affiliates will not exercise the call right in the future.”

After the recent offering, CVR Energy and affiliates (Icahn Enterprises) own ~84.5% of CVRR.  So if you refuse to convert and remain a minority, then Icahn can sell CVI for a premium, and CVRR unitholders will get zero participation as Icahn can cram out minorities at the last 20-day average price. 

Mosaic Point #2: HFC, DK and PBF are hoarding cash.  

HFC (1bn of cash on B/S) and DK (1.1 bn of cash on B/S) are currently minting cash and bought a laughably small about of stock back in 2Q18.  PBF, as already mentioned, issued equity.  It is widely known that HFC, DK and PBF are looking to do deals.  HFC has been busy buying lubes businesses.  DK says they are looking at Midstream opportunities.  PBF says they need money for IMO related projects.  I call bull….

First on HFC.  They bought Suncor’s lubes business and I think it has been a bust.  The asset has underperformed their expectations.  HFC just did another small lubes deal in July (Red Giant), it was small, so terms not disclosed.

DK.  Uzi is a masterful buyer of assets.  Say what you want about his colorful personality, but the guy knows how to buy stuff on the cheap and rarely overpays.  Which is all the more reason I think Uzi never buys a large midstream asset.  He simply can’t afford it to pay anywhere near market price for assets that might trade at 10x+ EBITDA.  DK’s own MLP (DKL) trades at 9x EBITDA on 2018 and 7.6x on 2019.  And here you have a guy with a $4.5bn market, $1.1bn of cash, and somewhere between $1.5-2.0bn of windfall EBITDA coming over the next 6 quarters .  If Uzi does nothing, he will have 50% of his market cap in cash by end of 2019.

PBF.  I don’t know what else I can say here.  The issuance of equity is very suspect. 

So here is what I think happened during 2Q18 or perhaps in 1Q.  Icahn informally shopped CVI.  Lots of interest but no deal for whatever reason – I suspect price.  As a buyer, I would have two objections:

1)      CVI is very RIN exposed.  If RIN prices soar again, CVI’s EBITDA could get wacked.  So buyers are not willing to put a full refining multiple on CVI.  Notice how the last two CVI earnings calls, CEO David Lamp making it a point to say: “Several deals are in the works and we believe we can increase our internally-generated RINs by approximately 25% by the end of 2018”. 

2)      Existence of CVRR entity complicates acquisition of CVR Energy.  When Uzi bought Alon USA, consolidating ALDW turned into somewhat of a nuisance.  So this is the real reason why Icahn did the exchange of CVRR into CVI.  By going over 80% in CVRR, CVI provided the future buyer a cram down mechanism at zero percentage premium. 

Lastly, if you really think DK, HFC or PBF will end up buying CVI, then the right call would be to short them against a CVI long.  Also would want to be long their midstream MLPs (DKL, PBFX and HEP) as CVI will come with about $75 million in droppable EBITDA.   

Mosaic Point #3.  Since leaving HFC, anything David Lamp touches gets sold. 

Ok this point is pretty weak, but worth noting…

·        David Lamp becomes NTI CEO March 2014.  NTI announces sale to WNR on October 2015. Lasted 19 months.

·        David Lamp becomes President WNR on June 2016 .  WNR announces sale to ANDV on November 2016.  Lasted 5 months.

·        David Lamp becomes CEO of CVR Refining January 2018.  How long will he last?  BTW, he is 61 years old.

Mosaic Point #4.  Icahn might think this is refining peak. 

 Icahn is 82 year old.   He has been in CVI for a long time and has ridden a huge upcycle in refining.  Let me just highlight what a difference two years has made.  Compare 2016 to 2018:

·        RINS now 20c.  Back in 2016 they averaged 82 cents

·        Brent / WTI now $7, curve showing >$8 for 2019-2025.  Back in 2016, Brent / WTI averaged $1 under

·        CVI probably going to make $650 million in 2018 and over $800mm in 2019.  They didn’t even make $200 million EBITDA in 2016.  Notably CVRR didn’t even declare any dividend in 2016. 

·        IMO 2020 on the horizon and well understood

 So obviously fundamentals have improved… but I think there is some political calculus here as well.  Icahn had a near death experience being Trump’s “advisor”.  Conflict of interest on RINs at best, and insider trading on RINs at worst.  If you really go through CVRR quarterly numbers, you can probably make a case that CVR was probably shorting RINS as Icahn was doing his Washington two-step dance with the EPA behind the scenes.  Pure speculation on my part but Lipinski gone by end of 2017 probably had something to do with this.

So this election in November poses a risk to Icahn.  If we get a Blue Wave, then RIN policy is incrementally at risk.  Worst case scenario would be Trump impeachment.  From Icahn’s perspective, this is probably as good as it gets as it relative to RIN policy.  On the other hand, if GOP does fine, and Icahn sells CVR, he now has no conflict to come back as Trump’s advisor and help with whatever floats his boat (China trade policy).   

Catalyst

Catalysts:

·        Weekly DOE Cushing inventory data

·        David Lamp will be attending Barclays Energy CEO conference in early September

·        3q earnings for CVI and broader refining sector

·        November election

·        Cram down of remaining public units of CVRR

Risks:

·        Cracks roll over as refiners delay turnaround

·        Diffs don’t widen from here

·        Failed M&A sale so Icahn starts selling CVR via public secondaries

·        China trade war spirals out of control