Description

Western Refining, Inc. is an independent crude refiner and marketer of refined products. The Company's refineries are in El Paso, Texas; Yorktown, Virginia; and in Gallup, New Mexico and it has service stations located in Arizona, New Mexico, and Colorado.

Western's stock price fell from $57.80 on 6-29-2007 to $5.5 on 3-31-2010 as the "golden era of refining" transitioned into a perfect storm caused by the Great Recession. During the most challenging recession in 80 years demand for refined products demand plunged by 2 mmpd since 2007 destroying 11 years of demand growth. Crack spreads fell in lockstep (the crack spread equals the value of the distilled products minus the value of the crude oil necessary to refine the distilled products). Refiners were hurt by lower profitability per barrel of oil processed at the same time they sold less units because demand for distillates.

We believe there is an investment opportunity for contrarian investors because sentiment could not be more negative on the refining sector and current valuation levels fail to reflect four positive developments that we expect: 1) A rebound in miles driven in the U.S.; 2) Crack spreads should trend above 2009 levels; 3) Cost savings should increase operational leverage and the impact to the bottom line from improving crack spreads; and 4) Less imports than expected into the areas served by Western (PADD 5 for example).  

Just like auto sales have rebounded from dismal depths, we believe that the drop in the annual vehicle-distance traveled (measured in billions of miles by the Department of Transportation) in the U.S. will rebound and is already in the process of "reversing to the mean". Since 1985 the miles driven by U.S. drivers have increased year-over-year by 2.2% on average. The only recorded 18 months of negative year over year change in the billions of miles traveled in the U.S occurred between May 2008 and October 2009 causing a significant drop in demand for gasoline. The drop in miles driven had not happened in over 23 years of collecting data, but distance travel is once again showing YOY increases as the economy has stabilized. We believe that U.S. drivers limited their driving as much as possible while the world was in the throes of the Great Recession, but driving is likely to pick up this year. We may even see an increase in recreational driving as vacationers may feel confident enough to take a vacation, shifting away from the "staycations" of last summer, but not confident enough to splurge on airplane tickets.

Crack spread 532 has increased from $7.84 a year ago to $8.99 this week, up 15%. The 321 crack spread has increased from $9.86 a year ago to $11.00 this week up 11.6% and significantly higher than the $3.67 low hit in the past 12 months. We believe gasoline prices bottomed in the first half of 2009, crack spreads bottomed on the second half of 2009 and 2010 will be year of improving fundamentals leading to a strong 2011 for refiners.

One of the main risks mentioned regarding refiners is the growing refining capacity outside of the U.S., but we believe that faster GDP growth rates outside of the U.S. and Western Europe will absorb part of the excess capacity. Distillate imports have been declined over the last three years and we estimate an increase in imports will not be meaningful enough to lead to lower prices. It is unlikely that imports will pick up dramatically during the summer given the different gasoline summer blend regional variations.

Western Refining indicated that they have lowered their costs by an estimated $50 million annual run rate, which means Western could generate $190M in operating cash flow (excluding a payment to Statoil for a legal settlement) without a rebound in demand or the nascent crack spread recovery that would translate to a 7.7 times EV / OCF. Given that we expect an increase in prices and volumes, the potential operational leverage could be significant.

We would note that Western is a highly indebted entity, but management did a decent job over the last two years extending debt maturities, raising cash, and renegotiating debt covenants in November of 2009. We believe that that concerns about covenant violations are valid, but overblown since the Company managed to stay cash flow positive during the downturn, lowered its cost structure and successfully negotiated with creditors and we expect a rebound in demand, pricing, and profitability.

An additional risk is that distillate inventories are on the higher end of their recent historical range and refinery capacity utilization is 81%, neither metric being bullish for refiners, but we believe this is already reflected in the stock price.

Trading at a discount to book value per share of $7.76 (which is already understating the market value of the refinery assets), 5x forward EV / EBITDA, and a peer-low $6,604 EV / Throughput with a possible operational rebound in the making, we believe that Western Refining shares are attractively valued for contrarian investors. Cost savings may boost operating cash flow by 25% without considering the 10 - 15% year-over-year increase in crack spreads registered at the end of March. If driving patterns in the U.S. were to go bounce back even to the low end of the normal range we could see significant upside with cash flow from operations between $250M - $300M, a significant increase from 2009's $141M. We would recommend buying the shares and for more-risk adverse equity investors perhaps writing the September $5 Calls against a portion of the position.

Catalyst

1. Operation leverage from cost savings initiatives enacted after a dismal second half of calendar 2009.

2. Improving crack spread leads to variable cost improvements.

3. Uptick in miles driven as drivers come back from the "Great Recession shock" of 2009 and driving patters return closer to the average number of miles driven in the U.S..