Description

Tesoro – Long

Business Description: Tesoro is a US-based petroleum refining and marketing company with assets in California, Washington, North Dakota, Alaska, and Utah.  Tesoro uses its refining asset base to process crude oil into end products like gasoline and diesel fuel, uses its logistics asset base to store and transport these products, and uses its retail marketing base (gas stations) for distribution to the end consumer.  Tesoro also owns a 36% stake in Tesoro Logistics (TLLP), a publicly traded Master Limited Partnership (“MLP”) which houses many of Tesoro’s logistics assets, and 100% of the valuable General Partner thereof. Tesoro consolidates TLLP in its reported financial results.

Summary: We believe Tesoro is a late stage turnaround. CEO Greg Goff has been at the helm since May 2010 and overseen a 6.5x increase in the company’s market cap. Greg and his team have a strong track record of delivering on their commitments and allocating capital at high rates of return. An example of the latter would be the company’s acquisition of BP’s Carson refinery. Based in Los Angeles, and literally adjacent to an existing Tesoro refinery, the Carson refinery was put up for sale in the aftermath of the Gulf Coast oil spill.  BP made a strategic decision to reduce exposure to the US market. Tesoro was the only bona fide bidder who came to the table, and they knew it. They paid $2.5Bn for the asset, then immediately sold $1.0Bn of logistics infrastructure to TLLP, sold down $1.3Bn of accompanying crude inventory, and got a $100MM credit for closing ahead of schedule. For the bargain basement price of $100MM Tesoro found itself with a refinery capable of generating normalized EBITDA of $500 million before expected synergies of $250MM.  Additional opportunities existed to optimize the crude slate ($250+ million annual EBITDA potential), and there were retail assets worth an estimated $250MM to boot. This deal alone appears to have created $30/sh of value vs. the company’s current trading price of $85/share. In addition to spending on high return M&A and capital projects, management has returned $2.1Bn to shareholders via share repurchases ($1.6Bn) and dividends since the end of 2012.

Management has outlined a path to normalized earnings significantly above the world’s expectations. 2017 Consensus EBITDA is $2.8Bn. This is composed of (Refining EBITDA + Retail EBITDA) of $1.8Bn plus $1.0Bn of TLLP EBITDA. If you simply sum the organic improvements outlined in its analyst day presentation, you arrive at 2017 EBITDA of $5.2Bn. $4.2Bn of Refining & Retail EBITDA plus $1Bn of TLLP EBITDA. If management gets close to delivering on its latest promises, then the stock should appreciate materially.

Management Case:  

2014 Consolidated EBITDA was $2.3Bn, and $312M of this was driven by TLLP. In other words, refining and retail combined for $2.0Bn. Management has outlined organic refining and retail EBITDA improvement objectives of $1.4Bn for 2014-2017. $895M of this was reportedly achieved in 2014 and 2015. We back out half of 2014’s achieved amount to get to $1.1Bn of incremental EBITDA from 2014-2017 initiatives. In addition, refining margins vary from year to year, and the 2014 level was $2/bbl below Tesoro’s long term guided levels. Normalizing for “mid-cycle” margins adds $600M EBITDA. Furthermore, management believes you should add $550M due to 2015 labor disputes that shouldn’t be repeated. You then need to back out the $60M of EBITDA TSO “dropped down” to TLLP via an asset sale in 2015. $2.0Bn + $1.1Bn + $600M + $550M - $60M = $4.2Bn EBITDA for their retail and refining business.

Valuation:

The value of TSO’s publicly traded stake in TLLP’s LP units is $1.9Bn as of 3/4/16. TSO’s GP stake is likely worth another $3.6Bn (15x estimated 2018 distributions of $240M). This value for TSO’s TLLP stake ($1.9Bn + $3.6Bn) implies a $4.9Bn valuation for TSO’s refining and retail businesses. TSO’s refining and retail businesses are trading at a whopping 1.2x management’s organic 2017 EBITDA target. 80% of management’s EBITDA estimate would be driven by refining which has historically enjoyed a 4-5x EBITDA multiple. 4.5x $3.3Bn is $15Bn. Publicly traded retail businesses trade at 6-11x EBITDA. 8x $830M is $7Bn. $15Bn + $7Bn + $5.5Bn for TLLP as described above - $300M of net TSO debt = $27.2Bn vs. the current $10Bn market cap.

Management’s EBITDA targets imply EPS and FCF/share well north of $20/share vs. today’s $85 stock price. While very difficult to nail, we believe replication value for Tesoro’s refining and retail assets is likely greater than $20Bn. The very limited, material greenfield capacity expansions over the past 30 years would suggest a higher # (see Shell Motiva’s expansion cost of $3,000/complexity barrel). As a result, management’s implied normalized FCF guidance of $2.5Bn+ for Refining + Retail passes the test of reasonableness in our opinion.

However, it’s virtually impossible to due diligence each of the levers Tesoro is pulling to improve underlying earnings. As a result, we cannot conclude from the outside looking in that all of the achieved and expected improvements will a) come to fruition and b) prove durable. Similar to management, we underwrite normalized 2018 Retail EBITDA of $830M which we believe should garner an 8x EBITDA multiple. We think normalized 2018 Refining EBITDA is approximately $2Bn (vs. management’s $3.3Bn) and gets 4.0x. If you add the public TLLP stake plus its GP stake ($5.5Bn combined) and subtract the debt, then we get to an equity value of $20Bn vs. the current price of $10Bn.

If we’re right, then you’re buying $1 for $0.50. If management is right, then you’re buying a $1 for closer to $0.40. Incremental accretive M&A is a call option.

Impact of Low Oil: Each of TSO’s 3 businesses, each of roughly similar significance to the company, respond differently to fluctuations in oil prices. The MLP (TLLP) seems to be the most negatively impacted as it is an infrastructure play on Bakken and Northwest U.S. crude production; lower oil prices equal less production and thus less need for infrastructure. Fortunately, TLLP has relatively high quality 3^rd party customers and strong sponsor support from TSO in addition to contractual volume protection. TSO is 55% of TLLP’s revenue and is, in our opinion, low risk. TLLP’s crude gathering and processing asset are located at the core of the Bakken. The MLP seems to be as protected as we could reasonably hope for, but we don’t have perfect visibility and there is risk to this portion of the business in a sustained low oil price environment. Oil price fluctuations are less material for the refining business (lower prices should lead to more vehicle miles driven, a positive, but also potentially reduce crude production and thus limit its ability to source advantaged crude). The retail business (i.e. gas stations) enjoy a 1x benefit from falling oil prices due to latency in prices at the pump matching declines in crude prices.

Other Notable Risks: Tesoro buys commodities (crude oil) and sells commodities (refined products). Commodity prices can fluctuate significantly. As a result, in the short and medium term management has less control over its destiny than management teams in many other industries. Lastly, the business of refining is capital-intensive and marked by much higher than normal regulatory risk.

Disclosure:

We and our affiliates are long Tesoro and may buy additional securities or sell some or all of our securities, at any time. We have no obligation to inform anyone of any changes in our views of Tesoro. This is not a recommendation to buy or sell securities. Our research should not be taken for certainty. Please conduct your own research and reach your own conclusion.

I do not hold a position of employment, directorship, or consultancy with the issuer.

I and/or others I advise hold a material investment in the issuer's securities

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