What Does Seth Klarman See in PBF?

Klarman is one of the world's most respected value investors, and he loves PBF

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Oct 17, 2016
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Seth Klarman (Trades, Portfolio) is one of the world’s most respected and followed value investors. His Boston-based Baupost Group, the $27 billion hedge fund that invests in both public stocks and private deals, has produced a return of around 19% per annum for investors since 1983 even though the fund tends to have a large cash allocation.

With this impressive record, when Klarman enters a position the market listens, and one company that has recently attracted his attention is independent refiner PBF Energy (PBF, Financial).

PBF accounts for just under 3.5% of Baupost’s equity portfolio, making it the fund’s seventh-largest position.

A contrarian position

Klarman has made a name for himself being a contrarian value investor, and PBF is certainly a contrarian position. Year to date shares in the refiner have lost 44% of their value, but Klarman appears unfazed.

Even PBF’s own management does not seem to be bothered by the refiner’s recent stock market performance. At the beginning of September CEO Thomas Nimbley shelled out $1.1 million to acquire 50,000 shares following a $1.4 million purchase only three months before. Nimbley’s purchases were followed by purchases from the group’s Senior Vice President Thomas O’Connor ($220,000) and President Matthew Lucey ($280,000).

So it’s clear that both Klarman, one of the most respected investors of all time, and PBF’s own management believe the refiner is undervalued at current levels. But why is the market offering such a discount?

For a start, PBF has missed Wall Street earnings forecasts for the past two quarters. For the first quarter, the company reported a loss of 65 cents per share compared to consensus expectations of 46 cents per share. For the second quarter, the company reported earnings of 14 cents per share compared to consensus of 21 cents per share.

Aside from the earnings misses, the other significant factor that is weighing on PBF’s earnings is the price of renewable fuel credits. The price of renewable fuel credits has surged over the past few months even as the price of oil has declined. These renewable fuel credits are playing havoc on the earnings of independent refiners such as PBF.

As Bloomberg explained in an article earlier this year:

“A Renewable Identification Number, or RIN, is created along with each gallon of ethanol or biodiesel that’s produced. Refiners and importers need to meet a biofuel quota set by the government, either through blending fuel with ethanol or buying RINs. Companies that don’t operate retail gasoline stations are feeling a growing financial burden from the rising costs as they are unable to generate the credits by blending biofuels with the petroleum-based fuels they produce.

“Prices for 2016 ethanol credits rose to 97.75 cents July 13, according to data from Progressive Fuels Ltd. compiled by Bloomberg, and were pegged at 91.25 cents Wednesday. The credits last rose this high in 2013, when government quotas for using biofuels such as ethanol were increasing faster than gasoline demand, leaving fuel makers with an obligation they couldn’t meet by blending ethanol into gasoline. This year, similar fears of a credit shortage are driving prices higher.”

Of all the independent refiners in the U.S., PBF is expected to receive the highest bill for biofuel credits this year. It is estimated that these credits will cost the company around $800 million, approximately double the next highest cost of $400 million which falls to HollyFrontier (HFC, Financial) to pay (see the Bloomberg link above for more information).

Along with the general negative sentiment toward anything to do with oil and the refining sector, the RIN credit debacle is the key reason why shares in PBF have plunged this year. Klarman and PBF’s management apparently believe that PBF’s problems are temporary.

Some of the most experienced in the business

PBF’s managers are some of the most experienced in the business. Thomas O’Malley founded the company with sponsorship from Blackstone and First Reserve. He has over 30 years of refinery industry experience, mostly leading turnarounds of failing refineries and selling them for huge profits.

He started his career in the oil industry in the mailroom of Philipp Bros. and then went on to become an oil trader and then ultimately CEO of Salomon/Philbro. He then brought approximately 26% of Tosco during the 1987 market crash, became chairman and CEO of Tosco and sold the business in 2001 to Phillips Petroleum for $7.4 billion. Soon after selling Tosco he ran Premcor, which was struggling when he took over, but O’Malley turned the business around and sold it in 2005 for $8 billion. Between 2006 and 2011 he was chairman of the board and CEO of Petroplus, a European refinery. O’Malley quit the firm in 2010 to focus on PBF.

Alongside O’Malley is Nimbley who has more than 40 years of experience in the refining industry. Between 2005 and 2010 he operated his own refining consulting firm.

It’s clear that PBF is led by two very experienced managers. PBF’s real value is in its assets. Under the stewardship of O’Malley and Nimbley, PBF has acquired some of the most advanced refineries in the U.S., which are worth decidedly more than the values the market has assigned to them. To distinguish between different assets the refining industry uses theNelson Complexity Index (NCI) which indexes the cost of various refinery components in relation to the cost of a basic atmospheric distillation unit.

The product of a refinery’s complexity and its basic crude throughput capacity is its Equivalent Distillation Capacity (EDC) or complexity-barrels capacity. The firm’s first three refineries in Toledo, Ohio, Delaware City, Delaware and Paulsboro, New Jersey have a weighted-average Nelson Complexity Index of 11.3. The two additional refineries the company has acquired over the past few months (Chalmette and Torrance) have a Nelson Complexity Indexes of 12.7 and a 14.9, making them some of the most complex refineries in the world (the most complex refinery has a Nelson Complexity Index of 15.3).

It’s likely Klarman believes the value of these high-quality assets is not being accurately reflected on PBF’s balance sheet. According to this highly informative blog post on (recommended reading) PBF’s assets, reconciling PBF’s Equivalent Distillation Capacity to an estimate of fair value gives an asset value of its first three refineries that’s more than double their initial purchase price at $5.1 billion up from the initial cost of $1.7 billion. At the time of writing PBF’s enterprise value is only $2.7 billion and the company’s shares are trading at a price-book (P/B) value of 1.2. At the end of 2015 the value of the company’s assets (example, current assets and long-term investments) was $2.7 billion. Overall, a balance sheet analysis shows that PBF is cheap.

Conclusion

So why does Klarman like PBF? Well, the company is run by two extremely experienced industry heavyweights, the company owns some extremely attractive assets, and the shares are dirt cheap. There are some negative factors hanging over the company, but these don’t detract from the quality of the firm’s assets, and the issues are unlikely to prove terminal.

Disclosure: The author owns shares in PBF Energy.

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