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Tesoro Corp: Massive But Volatile Off-Balance-Sheet Assets (TSO)

July 26, 2011 | About:
Tesoro Corporation (TSO) is an independent petroleum refiner located throughout the western United States. The company sells its refined products in the wholesale and retail markets. Its retail division distributes through nearly 900 gas stations.

The company is trading (as of 7/5) for $23.06, which is approximately equal to its book value per share of $23.16. However, due to a common accounting choice, the company has a fairly significant (though volatile) off-balance-sheet asset that may create a value opportunity.

Unless a company can keep track of the cost of specific items in inventory, they are left to choose between two main methods for accounting for this asset class: First-In, First-Out (FIFO) which assumes the oldest inventory is sold first or Last-In, First-Out (LIFO) which assumes newest inventory is sold first.

When companies choose to use the LIFO method, the amount they carry their inventory at reflects the oldest purchases. For companies that choose LIFO and have input costs that are rising, their carrying value of inventory won’t accurately reflect its replacement cost. Companies who use LIFO are required to disclose a “LIFO Reserve” which reflects the difference between what inventory is being carried at (LIFO) and what it would be carried at if the company were using FIFO.

FIFO is a more accurate representation of the replacement value of inventory, so when you analyze a company that uses LIFO, it is best to adjust the balance sheet for the LIFO reserve.

Back to TSO: let’s look at their LIFO reserves over the last 15 years:

TSO-LIFO-Reserve3.jpgTesoro Corp LIFO Reserve, 1996 - 2010

The company’s LIFO reserve has grown quite dramatically this decade, both in absolute terms and in relation to the stated value of inventory. This is to be expected both as a result of the company’s growth (see next chart) and the increasing price of petroleum products (price inflation exacerbates the LIFO reserve).

TSO-Revenues-1024x739.jpgTesoro Corp Revenues, 1996 - 1Q 2011

Now let’s take a broader perspective and look at the effect of this LIFO reserve on stated equity.

TSO-Equity1.jpgTesoro Corp Equity Adjustments, 1996 - 2010

As you can see, the size of this off-balance-sheet asset represents significant value in relation to the size of the company. Recall from above that the company is trading at its book value. The current (1Q 2011) value of the company’s LIFO reserve is ~$1.9B, or $13.22/share. This represents a 57% increase over its current share price.

All of this means little if the market perpetually ignores the LIFO reserve. The following shows the company’s historical price-to-book ratio, using both the stated book value, and the adjusted book value (including the LIFO reserve):

TSO-Price-to-Book-1024x734.jpgTesoro Corp P/B, 2001 - 2010

From this chart we see that the company traded above its book value (both adjusted and unadjusted) from 2003 to 2008, and that it is trading at close to its low point in terms of adjusted P/B. This indicates that the company could have significant upside if its LIFO reserve is taken into account.

So where does all this leave us?

TSO is trading at a significant (~36%) discount to its adjusted book value, yet the company’s track record shows it is not a value destroyer (the company has done a good job of improving its book value per share over the last decade) so it shouldn’t be trading at such a discount on that basis. Additionally, the company recently spun off its logistics operations, which will remit to the company ~$24.5M per year (with potential upside as that business builds its third-party clients). This action allowed the company to bank $330M in cash, $150M of which went toward paying down debt due next year.

On the other hand, the company is in a highly cyclical industry, and is exposed to swings in the price of both crude oil (its input) and refined petroleum products (its output), neither of which it has any control over. This impacts both its returns (see chart below) and the value of its assets, which introduces significant risk for those of us uncomfortable with projecting the future price of petroleum products. I should note that TSO also has a disproportionate exposure to the California market, which has the highest unemployment rate in the nation, further adding riskiness to the enterprise.

TSO-Returns-1024x734.jpgTesoro Corp Returns, 1996 - 1Q 2011

What do you think of Tesoro Corp? Does the discount to adjusted book value offset the riskiness of the industry?

About the author:

Frank Voisin
Frank is an entrepreneur who owned four restaurants by the time he was twenty. He sold his businesses and returned to school, completing a concurrent Law / MBA degree. At the same time, he successfully completed all three levels of the CFA exams. He now invests full time with a focus on value investing. Frank Voisin writes about value investing topics at http://www.frankvoisin.com.

Visit Frank Voisin's Website


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