Description
Tesoro Petroleum is an independent oil refiner and marketer with two major operating segments:
1. Refining crude oil.
2. Selling motor fuels and convenience products and services through its network of company owned and franchised gas stations.
The refining business is the dominant one for Tesoro and one that will drive valuation for atleast the next few years. While refining oil may appear to be a terrible commodity business, this is actually a terrific business with a wide and deep moat for Tesoro. There hasn’t been a new refinery built in the United States for well over 2 decades. Infact the number of refineries was about 220 in 1985 and is presently at 150. During the same time US Gasoline demand has increased from about 7 Million Barrels per day (bpd) to about 9 Million bpd. While fuel efficiency has improved, we are driving a lot more. The net net is that the US refining industry is operating near full capacity. See the write-ups on Valero (VLO) on Value Investors Club for more industry insights.
The real moat around Tesoro’s refining business stems from the varying environmental and gasoline formulation standards that exist throughout the nation. So if there is an oversupply of refining capacity in Texas, they cannot ship the extra gas to California or Illinois since those states have different formulation requirements. This further exacerbates the capacity issues. Tesoro has a total of six refineries with a total capacity of 558,000 bpd in the following states:
California: 168,000 bpd
Washington: 108,000
Hawaii: 95,000
Alaska: 72,000
North Dakota: 60,000
Utah: 55,000
In the markets that TSO operates in, they are either the #1 or #2 capacity player. They dominate the markets they are in. Also, the crack spreads in these markets are significantly higher than nearly every other part of the country due to unique formulation requirements and stringent environmental regulations. Over the last five years (1996-2002), here are the average refining margins in Tesoro’s geographies vs. the benchmark US Gulf Coast:
US Gulf Coast: $3.42 (per barrel)
Utah/North Dakota: $5.03
Alaska/Washington: $8.39
California/Hawaii: $8.84
California CARB: $10.97
Further, most of TSO’s refineries are able to process heavy (read cheaper) crudes – leading to higher refining margins. As an example, their CA refinery Gold Eagle had 94% of its feedstock as heavy crude in 2002.
CARB is a standard for cleaner fuel developed by the California Air Resources Board. The Gold Eagle refinery CARB capacity was increased by 20,000 bpd in 2003 to about 90,000 bpd of CARB fuel. This adds to the width and depth of the moat. When European refineries had more capacity than demand, they dumped cheap gasoline on the East Coast. They could not send product to CA due to the unique formulation requirements which in many instances requires tens of millions in changes to existing refineries. Hence the higher refining margins in all of TSO’s markets over the US Gulf Coast.
Last year when Valero bought Ultramar Diamond Shamrock (UDS), they were required to sell their Gold Eagle refinery due to anti-trust concerns. Tesoro bought the golden bird for a song and entered the lucrative California market. However, in doing so the company added substantial debt. This was coupled with 2002 having some of the lowest refining margins over the last 5 years and Tesoro got very close to the edge. They blew some of their covenants and had to renegotiate their facility with the banks –getting relaxed covenants in exchange for higher interest rates. Through this turmoil the stock went from $15.29 to $1.24 in 2002. Management at TSO is terrific. They do have a history of leveraging the balance sheet as they bought assets – but have successfully deleveraged each time. Here is their debt to capital ratio for the last 10 years:
1992: 84%
1993: 82%
1994: 55%
1995: 43%
1996: 23%
1997: 28%
1998: 56%
1999: 40%
2000: 32%
2001: 60%
2002: 69%
The company’s debt peaked at $2 Billion at the end of Q202. Since then the company has sold non-core assets and paid down about $322 Million on the debt. It intends to get debt to about $1.5 Billion by the end of 2003 – yielding about a 50% debt to capital ratio.
Here are the numbers:
Shares Outstanding: 64.7 Million as of 3/31/03
Market Cap: $482 Million
Enterprise Value: $2.2 Billion
The key issue to arrive at TSO’s intrinsic value is getting a handle on expected cash flows. These are a function of refining margins – which can vary significantly week to week and quarter to quarter. The accepted manner in estimating cash flows is to take average margins over the last 5 years and use that as a basis. At the average composite crack spread for TSO’s markets over the last 5 years (ended Q302) and assuming 520 Million bpd (production at 93% of capacity), management has guided the following numbers:
Average annual EBITDA: $625 Million
Cash Interest Expense: $165 Million
Cash Taxes: $50 Million
Average Capex: $250 Million
Free Cash Flow: $160 Million
After 2003, as interest expense declines and additional cost savings and synergies are driven, FCF is expected to increase by another $50-100 Million or $222-270 Million.
One means of arriving at a valuation is to assume TSO is debt free. In that case, FCF would be about $400 Million from 2004 onwards. Since earnings gyrate, perhaps a multiple of 8x FCF is reasonable or $3.2 Billion. If we back out the expected $1.5 Billion in debt, then it should have a market cap of $1.7 Billion or $26.27/share.
Even if cash flow ends up being lower, to get to $15/share, free cash flow needs to be just $120 Million. So, net net as the company delevers and if refining margins simply average out as per the last 5 years, TSO is likely to sport a stock price north of $15/share within a year or two – yielding a handsome 30+% annualized rate of return off its current valuation.
There are other goodies in this company as well. Bruce Smith is a shareholder oriented CEO as is the board. They have terrific corporate governance policies. They have a joint venture with Walmart for opening Mirastar branded gas stations on Walmart properties in the West. The retail segment has been challenged, but is being turned around. Over time as they scale with Walmart, that’s added gravy. Gas stations at Costco and Walmart do extremely well. Very high volumes with virtually no advertising etc.
Catalyst
Value is its own catalyst. As the company continues to deliver (and de-lever) quarter after quarter the street will learn to ascribe it an appropriate valuation. It’s unlikely to take more than 2 years, but even at two years, it’s a very healthy 30+% annualized rate of return.