Description

I think Delek represents one of best stories on the stock market today. The company is undervalued, gushing cash flow, and returning capital to shareholders. More importantly, the company is on a path to unlock substantial value, yet the market has missed multiple critical signs to just how soon and aggressive this value unlock could be. I think fair value for Delek is >$50/share today, and that's with multiples and assumptions that I think will prove quite conservative given the current supply/demand dynamics for refining and how much cash flow Delek will generate in the short term.

Delek was last written up on this site in 2019; that write up provides good background and the thesis today has lots of "rhymes" with the thesis then, though (as I'll describe) I think the thesis is much more actionable / catalyst rich today.

Anyway, Delek is mainly a refining company (they own four refineries in the Gulf Coast area). However, they also get a major amount of value from their ~79% ownership of Delek Logistics (DKL), a growth MLP.

There are a lot of different pieces to Delek thesis, but I would boil them down to three key points

• Using normalized margins, Delek is trading well below the sum of its parts
• Delek will make moves to unlock the sum of its parts in the very near term
• While Delek is trading at a reasonable multiple on normalized earnings, earnings are currently elevated and will likely remain so for the near to medium term, resulting in a huge cash inflow.

So let's dive in.

To start, let's begin with point #1: Delek's sum of the parts.

Delek has value from three different places: their refineries, their convenience stores (C-stores or retail), and their ownership of DKL.

I'll walk through each of those in a second, but now is a great time to note that DK consolidates DKL. That creates some complexity for DK that I think is (partly) responsible for the opportunity here. Over the past year, core DK has generated enormous cash flow, but because they consolidate DKL and DKL levered up to make an acquisition, DK screens like a levered company that is not making any progress on its leverage.

The image below is from DK's December 2022 investor deck and I think does a nice job of showing this. Net debt at delek excluding DKL (what I call core Delek) has dropped from $466m at the start of 2022 to $146m at the end of Q3'22; however, net debt for the whole company has gone up (from $1.36B to $1.58B) because DKL took on ~$600m of debt for a bolt on acquisition.

Obviously, I think consolidated is not the right way to look at it. DKL's debt is not recourse to DK; I think the right way to value DK is to value each of the individual pieces and then take out core Delek's net debt. So let's do that.

The easiest piece of Delek to value is their stake in Delek Logistics. Delek owns ~34.3m shares of DKL. DKL is currently trading for $48.82/share, so the market value of DK's DKL shares is ~$1.675b. DK has ~71m shares outstanding as of Q3 (I expect share buybacks to have driven that number down nicely in Q4), so DK's stake in DKL is worth ~$23.50/ DK share at market price.

Obviously, that's almost all of DK's value right there (as I write this, DK trades for <$27/share). Pessimists could argue that DKL is a thinly traded stock given DK's massive ownership (<40k shares traded yesterday). Perhaps they are right, but at current prices DKL trades for a 8.4% dividend yield, <10x EBITDA, and ~8x P/DCF. There aren't a ton of publicly traded MLPs left out there, but DKL's multiples all look reasonable to me. Feel free to haircut DK's DKL stake for liquidity if you want, but I don't think it's necessary given the valuation and it doesn't really change the outcome here!

DK's second piece of value is their C-stores / retail segment. These are small so I won't spend a ton of time on them. Basically, DK currently owns ~250 C-Stores. DK plans to get to 300 stores by building out new stores at 4-5x implied multiples, and once DK gets to 300 stores they'd like to sell all of them to a strategic acquirer at ~10x EBITDA. DK has done something similar before; they sold MAPCO for a low teens multiple in 2016. DK's retail segment did $66m in segment margin over the past twelve months. If we assume it's worth 8x, that's another ~$525m in value for DK, or ~$7.40/share.

The final piece of DK's value is their refining business. The 2019 write up valued DK's refiners at $2.5B; that's actually right in line with how I value them! But to show my work a little bit, you generally want to value a refiner by figuring out their mid-cycle earnings and slapping a multiple on it. Delek used to include the slide below in their earnings deck that suggested mid-cycle earnings for their refiners are ~$715m; the 2019 write up suggested mid-cycle earnings were ~$750m. Take away ~$165m/year in corporate expenses, and you wind up with ~$600m/year in EBITDA. Slap a 4x multiple on that, and we get to ~$2.4B in value for the refiners (I understand I'm being generous with the rounding, but it won't make a big difference either way!).

However, there is one complexity I need to toss in here. DK runs a hefty G&A balance; in 2021, their corporate segment generated $97m in losses, and they had another $229m in G&A expenses (see table below)

I've talked to DK about this, and they've suggested they are charging some things to SG&A that peers include in refining opex. That seems reasonable; on an all in basis, DK's cost structure seems in line with to better than peers.

Obviously we've caught a lot of the SG&A in the ~$165m we assigned to refining SG&A earlier (which took our refining EBITDA number from >$700m to ~$600m), but this is a value drag that needs to be accounted for. So I take out another $750m of value from my DK SOTP to account for "unallocated corporate", with the assumption that they're running another $150m in SG&A and I'm valuing it at 5x EBITDA.

All in, my SOTP looks something like this:

I'd note that crack spreads remained insanely elevated in both Q4'22 and YTD. I also expect DK to have been reasonably aggressive buying back shares in Q4. Elevated crack spreads should mean extremely strong cash generation (I expect over $2/share in cash generation in Q4, though given working capital swings it's tough to have tons of confidence in that number), and given the degree of undervaluation any share buybacks create significant value.

So, at this point, we've covered the Delek undervaluation / SOTP story. But we're value investors. I'm sure we're all aware of dozens of companies that look cheap on an SOTP basis!

What sets Delek apart is that I believe the company will make moves in the near to medium term to unlock their SOTP value.

The first and simplest of those moves is just continued share buybacks. After paying down most of their net debt in early 2022, Delek has started ramping up share repurchases. They guided for $75-100m in repurchases in Q4'22, which would reduce the share count by another 3-5% intra quarter (depending on prices, timing, etc.). And Delek seems committed to continuing to return capital to shareholders as long as the discount exists; on their Q3'22 call they noted, "I think you were asking, are we going to basically use cash to do buybacks. I think Avigal is of the opinion that we're looking to use free cash flow. I don't think we want to pinpoint anything specific. I think the robust buybacks that we're looking at right now are before the sum-of-the-parts scenario where we feel like the stock is really discounted." Or, more simply, earlier in the call the CEO noted "we are looking to continue with the buyback aggressively well into 2023."

So, in the short term, I expect continued share buybacks from Delek. However, over the medium term, I think Delek is extremely likely to make other moves to crystalize their SOTP. In particular, I think the company will explore a way to deconsolidate DKL and create a path to exit their DKL shares. The most likely path (IMO) is a sale of DKL (allowing DK to realize immediate value for their shares) or a merger of equals of DKL which gets creates a larger entity where DK can sell their stake over time.

Why do I believe such a move is likely?

Well, first, the company is telling us one is! Again, from the Q3'22 call the CEO said, "we started our initiative to unlock the sum of the parts value of our assets. We hired a head of corporate development and engaged banker to advise us on strategic options. We will communicate our plan to the market once complete."

That's nice... but Delek has been a SOTP story for a long time. Why the sudden rush to realize value / why should we believe them that now is the time?

Delek hired a new CEO last year; he took over DK in June, The first investor deck the company published with the new CEO came in September. Here's a link to their May deck for comparison. Eagle eyed readers will note that the September deck has a brand new slide right at the front (slide #5) that discusses the new CEO and all of the moves the company has made / is making under him. I've pasted it below (the red circle is mine).

Obviously, all of those items are great. Who doesn't like their company focusing on safety and returning excess capital? But the circled "sum of the parts" unlock is the real item. The new CEO stepped in and instantly started tieing his vision and reputation at the company to unlocking DK's SOTP value.

But there's more! In September, DK hires a new head of corporate development, and literally the first paragraph in the PR announcing the hire notes his role will focus on SOTP unlock. And, as noted above, DK talked multiple times in their Q3'22 call about how they are plannign to unlock their SOTP value.

There is one more thing that makes me think a value unlock in the very near term is possible. This is a little tin hat, but earlier this month Delek published two PRs noting they were speaking at the Raymond James conference and BoA conference (both in early March).

There's nothing crazy about the conference attendance; Delek has hit the March energy circuit pretty hard for years. What is notable is that Delek felt the need to PR both of those appearances and each PR notes "Delek US leaders will discuss the company's plans to advance strategic initiatives and deliver shareholder value."

Again, perhaps that seems innocuous.... but it is very out of character for Delek. You can go look at historical press releases for Delek here. In both 2021 and 2022 they didn't bother PR'ing any of their appearances (even though I believe they were at several conferences). Now, Carl Icahn was running a mini-activist campaign at the time (I believe he was tryign to get them to sell on the cheap to his CVR refining company), so maybe the company just was focusing on the Icahn issue. But if we step back to 2020, DK announced their conference schedule with a simple PR at the end of February 2020 that announced all of their appearances and certainly did not include lines like "management will focus on how to deliver shareholder value." If you go back to 2019, Delek would announce conference appearances with individual press releases.... but they would publish the press releases the day before the appearance, and (again) there was no discussion of shareholder value or strategy.

Delek has a new CEO, and it's been awhile since they PR'd conferences appearances. Maybe this is just how they do it now! 

But it's also just as possible that DK has a big value unlock announcement in store over the next month, and they're releasing PRs because they're excited about it / they're trying to have people clear schedules to focus on their presentations.

Ok, I'll take my tinfoil hat off now. Bottom line is I think a value unlock is coming. Maybe it's in the next month, maybe it's in the next year, maybe it's in the next three.... but it's coming, and given the degree of undervaluation here and the continued share buybacks, any value unlock should create a huge amount of value.

There is one other important piece to the thesis that I've alluded to but have not discussed yet: crack spreads remain really elevated right now.

If you go back to my SOTP valuation, you'll note that I valued Delek using what I thought was a midcycle earnings number. However, we are far, far from midcycle numbers. Over the past year, crack spreads (basically, the margins refiners operate on) have come in at numbers that were unthinkable just a few years ago.

At today's prices, I don't think you're underwriting anything in terms of elevated crack spreads.... but I do think elevated crack spreads are here to stay for the near to medium term, and that just adds another cherry to the DK story as continued elevated margins creates a continued gush of cash flow that will be returned to shareholders.

Why do I think crack spreads will remain elevated? There was a very long two part piece by a very handsome blogger that went in depth into the "refining higher for longer" thesis; given how long this post is running, I won't rehash that whole thesis here. But the simple answer is 

1. U.S. refining saw a wave of shutdowns around COVID. That capacity is not coming back, which creates a structurally tighter market.
2. Nat gas is a critical cost for refining, and the U.S. seems structurally advantaged nat gas versus the rest of the world.

#2 is the really interesting point here. DK's midcycle margins were probably in the low double digits pre-COVID (something like $12/barrel). Valero published the slide below discussing U.S. nat gas differential versus Europe; they estimated that nat gas alone gave the U.S. a $10/barrel cost advantage over Europe refineries.

I'm not calling for TTF to stay at $200 or anything, but it does seem like the U.S. will enjoy materially lower (and more stable) nat gas for the forseeable future, and that alone should give U.S. refining a sustained advantage against the rest of the world. 

So there you have my overall Delek thesis. It's gushing cash, I think that cash gush continues in the near term, it's trading way below its SOTP, cash flow will be used to buyback shares, and the SOTP value will likely be unlocked in the near term.

There are lots of other things we could discuss with DK (the potential upside and downside from RINs, renewable diesel exposure, etc.), but I think we've covered the core of the thesis here so I'm happy to discuss / engage with those in the comments.

However, there is one key piece I wanted to hammer home before wrapping this up. A key piece of this story is the DK SOTP and how undervalued it is. The two major pieces of DK's SOTP are their ownership in DKL and their refining assets.

On the refining side, I think I did a fine job laying out midcycle margins and using a pretty conservative multiple. Again, Delek is currently gushing cash given crack spreads, and my SOTP gave them absolutely no credit for this ongoing windfall.

But I didn't spend a ton of time talking about DKL, which is the other major driver, so I wanted to quickly address it because you could look at the SOTP and say "yeah, but DK will never be able to get value for DKL."

DKL is DK's MLP. Their assets are about what you expect from an MLP that was created out of a refinery; lots of pipelines and gatering in Texas.

I mentioned this a bit earlier, but one worry that a lot of investors have with DK is that DKL could be overvalued given DKL is a pretty thinly traded stock thanks to DK's huge ownership. I will be honest; I just don't see it. I look at DKL and I see average midstream assets trading for about an average midstream multiple (slide below is from DKL's november investor deck; nothing has really changed sicne then)

So could DK sell all of their shares in DKL tomorrow and realize its value? No, of course not. DK owns way too much of DKL to do that (plus a hundred other reasons why that wouldn't make sense!). But it's not like DKL is some thinly traded stock that has been squeezed to unreasonable levels. DKL is a normal MLP trading at a normal valuation. The generates an enormous amount of cash flow and has a long history of returning that cash flow to shareholders.

DKL is also a "growth oriented" midsteam, and they would argue they've done a better job growing than peers

Is that true? Meh! But what's most important is that nothing about DKL's valuation screams "overvalued" or "I have some questions about that mark." 

DK is enormously undervalued. Haircut the DKL stake for illiquidity if you want, but I think the DKL valuation is fine to fair, and given the degree of undervaluation at DK it would take a lot of value slippage at DKL before DK would even start to be fairly valued.

O PS- one last thing about the DKL stake. At DKL's current dividend level, DK is getting just under $2/share annually in dividends from their DKL shares. That's.... just kind of crazy? Again, DK has almost no net debt at this point and is gushing cash flow, and at current prices we're buying them at a low double digit multiple to their dividends from DKL. Obviously "price to dividends from your controlled subsidiary" is not a valuation metric, but it is pretty crazy!

Catalyst

1. Continued aggressive share buybacks
2. Massive cash flows given crack spreads
3. Near to medium term value unlock of DKL