Description

Long Delek US Holdings (DK)

Thesis

Delek’s shares are trading at a substantial discount to fair value on a mid-cycle basis. Near term volatility in crack spreads and crude differentials has caused the market to completely ignore a substantial improvement in DK’s underlying earnings power and growth potential after the close of the Alon (ALJ) deal in February 2018.

Company Description

Delek is a refining and midstream company that owns and operates four refineries in the US. Three of them are located in Texas, one in Arkansas. Delek also owns a controlling stake in the publicly listed Delek Logistics Partners (DKL). DKL owns a number of assets involved in the gathering, storing, and transportation of crude oil and refined products. In addition to the assets controlled under DKL DK has a substantial midstream asset base in the Permian Basin. DK is a partner on the on a proposed Permian to the Gulf-Coast pipeline (PGC Pipeline) with Enterprise, Magellan, and MPLX which are major players in the crude logistics space. DK’s Permian assets also include a substantial acreage dedication (>200k acres) that DK is planning to service by building out its own gathering business.

In 2018 DK closed its acquisition of ALJ, and grew from a two-refinery company to a four-refinery company and became a meaningful presence in the Permian Basin, the most advantaged crude oil producing region in the US today.

Management

I believe DK is well run. CEO Ezra Uzi Yemin (Uzi) has proven himself to be an astute allocator of capital by growing the business through deals that were timed to take advantage of periods of distress caused by the innate cyclicality of the refining business. Uzi has also proven that he knows when to exit assets, with the well-timed sale of DK’s retail business in 2016 as a key example. I am confident that he has the intelligence and drive necessary to create substantial value for shareholders going forward. Uzi also owns more than $24m of stock in DK and ~$9m of stock in DKL giving him a clear vested interest in DK’s equity performance.

Basic Description of the Refining Business

A refinery is a manufacturing plant that processes crude oil into finished products like gasoline, diesel and jet fuel. Profitability is driven by the price spread between finished products and crude oil, known as the “crack spread.” Crack spreads are extremely volatile and sensitive to economic trends, regulatory changes, and regional supply/demand dynamics. However, over time, they tend to average out at about the level necessary to keep the marginal global refiner generating a 10% rate of return.

Basic Description of the Energy Midstream Business

In general, midstream assets are those that collect pass-through fees that are independent of commodity prices. This tends to mean assets like pipelines, storage tanks, gathering systems and distribution systems.

Valuation

Approach

Due to the highly differentiated cash flow characteristics of DK’s major businesses, we believe a SoTP approach is the most relevant way to value DK.

For refining we believe that placing a multiple on near term forecasts is an incorrect approach. The best way to value a refining business is to use a mid-cycle crack spread and crude differential and apply a 6.0x EV/(EBITDA – Maintenance Capex) which we believe accurately accounts for the volatility and limited growth potential of refining assets. It is important to note that this approach tends to lead to much lower valuations than those reflected in recent M&A in this space. CEO’s and investors alike tend to lose sight of the cyclicality of these businesses in the up portion of the cycle, which is when most deals are done. In the down portion of the cycle companies are scrambling to save money and deals are rare.

For midstream, we again look to a normalized environment to perform our valuation, which tends to be much more closely linked to current earnings due to the relatively much-lower commodity exposure. We use a 10.0x EV/(EBITDA – Maintenance Capex) for the midstream assets we believe this accurately reflects the lower volatility and solid cash generation prospects of these businesses.

Refining Valuation

It is our view that DK’s normalized crack spread is roughly $11.00. We arrived at this estimate by calculating what crack the marginal refiner in the world for the foreseeable future (a reasonably large Chinese plant optimized to meet domestic demand) requires to stay in business. From that, knowing what the transportation costs are between regions, we can build up a normalized crack for each region of the globe that eliminates opportunities for arbitrage.

We also believe that due to DK’s advantaged locations they will enjoy a normalized crude cost advantage relative to the normalized crack of roughly $3.00 (DK Blended Crude vs Brent, currently substantially wider). This assumption is based on cost of transportation between the inland US and export terminals on the gulf coast, once the pipeline situation normalizes.

Using this $14.00 crude-advantaged crack, DK’s historical crack spread capture rates, and the operational ALJ synergies that DK has realized in 2018 (100m), and the alkylation project that is finishing this year (50m)  we get to a mid-cycle EBITDA of roughly 750m for DK’s refining business.

This comes burdened with roughly 130m of Corporate costs (whole entity, net of stub retail business), and 200m of maintenance capex.

Using a 6.0x multiple on the EBITDA-Maintenance Capex of 420m, the midpoint of the range provided before, we reach a EV of $2.5bn for DK’s refining business.

Refining Valuation Aside

$2.5bn is far below the replacement value of these assets. Building even a small greenfield refinery tends to cost in the ballpark of $1.0bn, DK owns four refineries. These assets do need to exist. Global supply/demand for refined products is well balanced, and given the massive potential growth in India and Africa as well as the long lead times for new projects the balance is unlikely to shift into structural over or undersupply within any reasonable investing horizon.

Logistics Valuation

To start, the public valuation of DKL’s equity is currently roughly $810m. DK owns ~63% of that so their stake is worth $510m. While we believe that DKL is actually shares are substantially undervalued (10+% dividend yield for low-risk assets with growth vs peers trading at much lower yields) we can use this valuation and DK is still an attractive investment.

This is due to DK’s future growth opportunities in the midstream space. The currently announced pieces of this total roughly 150m of growth.

Of this 150m,~ 60m will come from DK’s ownership of 1/4th of the PGC pipeline. ~60m will come from DK’s announced gathering projects, and the balance will come from additional gathering projects. Maintenance capex for these projects will be minimal, and DK will easily generate more than enough cash over the next few years to fund the construction of these assets.

Applying a time-discounted multiple of 8x (vs the 9.0-10.0x discussed before) to these assets we get to a EV of 1.2bn for DK’s logistics growth opportunities.

Moreover, we have good reason to believe this 150m figure is too conservative. In our conversations with management we have learned that there will be meaningful acreage dedication expirations in 2019, and that DK is in good position to grow their current base of dedicated acres, meaning they will likely have a strong pipeline of gathering system growth projects going forward.  

Valuation Conclusion

Using the figures from above we get to a EV of roughly 4.1bn (consisting of the refining business, DKL shares, and the logistics growth projects). DK currently has about 1.0bn of DK-attributable cash on its balance sheet, and 1.0bn of DK-attributable debt (the rest is attributable to DKL and is captured through our usage of only the value of DK’s equity holding in DKL as part of this valuation).

As a result we reach an equity market cap of 4.1bn on a current share count of 82m (ongoing buyback). This gets us to a fair value of $50/share or 38% upside.

Areas we were conservative/Margin of Safety

Cash Flow Generation – For simplicity’s sake we used rough time-adjustments to multiples and assumed that capex to build the logistics growth assets would eat up all of DK’s cash flow before startup. This is why we assumed a constant net-cash in our Conclusion. In reality, unless there is a major recession, DK will definitely generate meaningful excess cash flow before the logistics growth projects are completed. Depending on the crack assumptions this amount could be between 100m and 500m, enough to add additional upside to the valuation. DK has demonstrated through substantial recent buybacks that excess cash will be used for shareholder returns.

Logistics Growth Projects Quantity – It is possible that 150m of EBITDA is too conservative here. We only assume 30m of un-announced projects. The Permian will continue to grow in most crude price scenarios. As it grows it will require more gathering systems, and DK is in position to build some of those systems.

Logistics Growth Projects Valuation – Private Equity multiples for Permian Logistics assets are closer to 14-15x versus the 9-10x (time-discounted to 8x) that we use in our valuation. There is a fairly robust set of transactions justifying the higher multiples here. Utilizing those higher multiples would goose the upside dramatically.

Refining Valuation – as noted above, our Refining valuation is a massive discount to replacement value. Using a replacement value (close to $4.0bn) for the refining business would result in a huge increase in DK’s fair value

IMO 2020 - DK is not a heavy refiner, but if IMO 2020 exerts upward pressure on cracks DK would be a beneficiary.

Due to all of these factors we believe a $50 share price for DK has a substantial margin of safety. There are a number of things that could go better than forecast which could drive the valuation substantially higher.

What the Market is Missing

The refining sector does not trade rationally. Investors chase near term earnings which are driven almost entirely by commodity volatility and the space whips back and forth around fair values as a result. This volatility often causes fundamental improvements in businesses to be ignored. For DK this has resulted in the company receiving essentially no credit for the synergy delivery from the ALJ deal and its large, attractive portfolio of Permian growth projects. These two factors are enough, especially for a company of DK’s size to create an exceptional opportunity for an investor who can ride out commodity cycles.

In 2018 commodity volatility had an outsize impact on DK’s trading. DK benefited hugely from the widening of the Brent-Midland crude differential and had some exceptionally cash-generative quarters. Investors capitalized these obviously temporary windfall earnings, chased the stock up, and ignored the things DK was improving under the hood. When the windfall dissipated DK was aggressively sold due to negative earnings momentum. This selling created the opportunity we currently have.

Risks

Crack Volatility – Over time this presents opportunities to both buy and sell DK, Currently the crack is fairly low and DK’s valuation is very attractive, volatility from here is more likely to bring us up towards fair value than to continue to drive down DK’s stock. If by some chance cracks fall apart due to temporary factors, DK would become an even more attractive investment

Price of Crude Oil – if crude falls into the $20-30 range even the Permian will stop growing. This would impair the value of DK’s Permian logistics growth assets. However, DK would still be able to generate cash from its refining business. There would be limited downside from current trading levels, and such a scenario is likely to be temporary.

M&A – Uzi has a track record of doing deals. These deals have been fairly successful as the he focuses on buying distressed assets. At the current time, given where DK’s stock is, it is very unlikely that he sees anything external that would justify a deal. His commitment to a rapid buyback for the past several quarters provides a concrete data point that supports my view that DK’s management sees the stock as undervalued and is willing to put money behind that view.

DK is much more likely to be acquired than to acquire anything at this point, the logistics growth portfolio would be exceptionally attractive to a number of peers who are looking to grow their Permian businesses.

Midland Diffs – Currently narrow, expectations are muted on this point, unlikely to be a source of further downside.

Electric Vehicles – If EV technology becomes so cost competitive that it eliminates forecast refined products demand growth from developing regions refining supply/demand will be thrown out of balance and DK will have serious issues. I do not expect this to be a major issue for at least the next ~10 years. Demand growth is entirely in very cost-conscious emerging markets where electric vehicles are a ways from being competitive. The scale of the market and demand growth is so large that EV has plenty of runway before it starts shifting the marginal refiner and changes our mid-cycle assumptions meaningfully

PGC Pipeline – May not be built given narrowing in Permian diffs, while this would hurt the upside on DK’s midstream growth, it would free up substantial cash flow for a share repurchase program that the market would probably like.

Notes on Financials

Long Term Debt – while DK’s statements show 1.8bn of LT Debt, 700m of that is attributable to DKL and is non-recourse to DK’s assets.

Catalyst

Over 2019 DK will continue to deliver strong cash flows despite the absence of 2018’s windfall factors. This will highlight the impact that the ALJ synergies have had on DK’s underlying profitability.

In addition, the details of DK’s gathering system growth plans will come to light. As details emerge investors are likely to start ascribing value to those assets.