Previously, I have discussed various oil and gas companies that have the potential to outperform in 2017. A refining company that has the potential to outperform in fiscal 2017 and beyond is Tesoro Corp. (TSO, Financial).
Company and business overview
Tesoro operates as an independent petroleum refining, logistics and marketing company in a strategically concentrated location of the western United States. The company operates seven refineries with a combined capacity of 895,000 barrels per day. Its refining segment refines crude oil and other feed stocks into transportation fuels, such as gasoline, gasoline blend stocks, jet fuel and diesel fuel. The retail and marketing segment sells refined petroleum products via commercial, wholesale and retail channels. Commercial marketing trades in commercial and military jet fuel and heavy fuel products.
The wholesale program markets gasoline and diesel fuel to independent marketers, commercial end-users and high-volume retailers. The segment caters to around 2,400 retail stations in 16 states. The marine segment charters U.S. and foreign-flagged tankers to optimize the transportation of crude oil, other feedstock and refined products within the refinery system.
Tesoro has been involved in creating a more integrated business model, which is essential for the company’s growth. There has been a significant portfolio transformation since 2010. The company has reduced its refining EBITDA composition from 80% to 63% in 2015 and is expected to further reduce it to 45% by 2018.
At the same time, Tesoro estimates to increase EBITDA composition in the logistics and marketing segments to 30% and 25% respectively. The company aims to achieve this portfolio transformation through a combination of organic growth opportunities and strategic acquisitions. This is primarily because a diversified portfolio will have lower earnings volatility with less dependence on commodity price fluctuations and more focus on stable fee-based business.
Western Refining acquisition is a boon
Tesoro’s acquisition of Western Refining (WNR, Financial) will have a long-term positive impact on its shareholder value creation. The acquisition is expected to increase the company’s refining capacity to 1.1 million barrels per day. It will further strengthen the company's integrated business model along with access to growing markets. The deal will also result in geographical diversification with complimentary business in attractive regions and will create $350 million and $425 million in synergies, which is expected to be realized within the first two years of the deal. Moreover, the deal will help Tesoro gain access to a well positioned, highly reliable and advantaged refining system with access to wide array of crude oil. The deal will also expand the opportunities for logistic growth in crude oil production basins and product regions.
The acquisition is expected to create significant shareholder value primarily through increases in the share repurchase plan from $1 billion to over $2 billion. At the same time, Tesoro expects to maintain annual dividends of $2.20 per share and increase it further as the company grows. In addition to return of capital to shareholders, the transaction is expected to provide strong growth and financial discipline in terms of balance sheet and liquidity.
Combined operations are expected to increase earnings per share by 10% to 13% in fiscal 2018, the first full year of operation. The strategic acquisition of Western Refining will help Tesoro achieve its target of a more diversified integrated business model while creating significant stock upside potential.
Liquidity and shareholder wealth creation
As of Sept. 30, 2016, Tesoro had cash and cash equivalents of $1.3 billion and revolving credit facility of $5.1 billion. With estimated cash flow from operations of $1.6 billion for fiscal 2017 (same as expected for fiscal 2016 since the nine-month operating cash flow is $1.2 billion), the company would have total liquidity of $8 billion. With estimated capital expenditure of $870 million for 2017, no near-term debt maturities and a share repurchase plan of about $2 billion, the company has sufficient liquidity to meet its future obligations while simultaneously creating shareholder value through stock repurchases and dividend growth.
Valuation
Tesoro’s valuation looks attractive and further convinces me that the stock has the potential to outperform in the long run. Tesoro is trading at an EV/EBITDA of 6.7, which is attractive compared to its peers. Marathon Petroleum (MPC, Financial) is trading at an EV/EBITDA of 10.0 and Phillips 66 (PSX, Financial) is trading at an EV/EBITDA of 11.7.
The company’s valuation is also well below the industry median of 9.7, which implies undervaluation for the stock. With the acquisition of Western Refining and possible acceleration in growth, the valuation gap that exists will be covered as the company outperforms peers going forward.
Conclusion
Tesoro has a very strong portfolio of assets. With the acquisition of Western Refining, the company will have significant upside in terms of its refining capacity.
Considering the company is undervalued and the fact the stock has been almost sideways over the last year, I believe Tesoro Corp. is worth buying at current levels. The stock can be an outperformer in the long term as the company moves toward shareholder value creation.
Disclosure: No positions in the stocks discussed.
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