Delek US Holdings Inc: Shares Presently Offer Unattractive Risk/Reward Trade-off. Delek US Holdings Inc. (DK, Financial) is a diversified downstream energy company launched in 2001 with the acquisition of retail and convenience stores from a subsidiary of The Williams Companies. The company focuses on petroleum refining, wholesale marketing, and retail sales. Delek's refining division (44.8% of 2010 revenues) operates 140,000 barrels per day in production capacity of high conversion, moderate complexity oil at two facilities. Delek's retail operations consist of a network of 384 company-operated retail fuel and convenience stores located throughout the southeast and comprised 42.4% of 2010 sales. The marketing division, which contributed 13.4% of 2010 revenues, sells refined products on a wholesale basis in west Texas through company- and third-party operated terminals and crude oil pipelines.
Consensus Estimates Indicate Delek at Peak Earnings
From a valuation standpoint, although shares of Delek appear inexpensive on a P/E basis (5.5x using trailing EPS or 4.0x forward earnings), it's important to recall the company's earnings are cyclical and, more importantly, have already peaked (see chart below). As a cyclical company, it's more appropriate to view the company for market multiple valuation and comparison purposes using "normalized" EPS.
Shares of Delek Trading at 30% Premium to Market
Though there's no universal standard for calculating normalized EPS, most approaches employed are based on averaging a company's annual earnings. This is generally done using a fixed, arbitrary number of years. The methodology I've found to be most accurate uses the volatility of a company's historical return-on-investment (ROI) in the calculation of the appropriate number of years to average. The underlying principle of this approach is earnings of companies with highly volatile ROI are averaged over a greater number of years than those with more stable ROI historical results.
Recent EPS results of companies with a demonstrated ability to generate a consistent ROI are more relevant, under this theory, than those that do not; as such, fewer number of years are needed to get a clearer picture of normalized EPS.
I use a maximum of seven years when calculating normalized earnings for a cyclical company. Given Delek's highly volatile ROI, normalized EPS are the average of the latest seven years or $0.78. Shares of Delek closed at $12.18 on Nov. 18, 2011, leading to a normalized P/E of 15.8x. The S&P 500 index presently trades at 12.2x, which implies DK is trading at a 30% premium to the index.
First Call consensus estimates for the S&P 500 indicate EPS is expected to grow 11%, 7%, and 20% in 2011, 2012, and 2013, respectively (though I don't find the 20% EPS growth for the S&P 500 in 2013 credible, it isn't relevant for purposes of this report).
By comparison, consensus estimates for Delek (shown in the chart above) reveal a significant, steady decline in earnings over the same time frame. Further, the current yield on the S&P 500 of 2.2% is almost twice that of Delek's 1.2% dividend yield. Both factors, particularly after accounting for the more volatile nature of Delek's earnings, support the argument a 30% P/E multiple premium is unwarranted.
Expect Shares of Delek to Trade Inversely with Price of Oil
By way of background, there are three general types of oil companies: upstream (exploration and production), downstream (refining and marketing), and integrated. Absent significant hedging contracts into which an oil company may enter, the shares of upstream and downstream oil companies trade very differently from one another and it's important to understand the difference when investing in energy companies.
From the perspective of an exploration and production (E&P) company, oil is regarded as an asset. An increase in oil prices increases the value of the company's inventory. As a result, there is a generally positive correlation between oil prices and shares of E&P companies.
Alternatively, shares of downstream or refining and marketing (R&M) companies, including Delek US Holdings as well as Sunoco (SUN), Marathon Petroleum (MPC) and Valero (VLO), tend to trade inversely with oil prices. As management stated in the most recent SEC Form 10-K, "Sudden change in petroleum prices is our primary source of market risk." This is due, in part, because petroleum products are viewed as an expense (cost of goods sold) rather than an asset already owned. Earnings for R&M companies are substantially determined by the difference between the price of refined products (e.g., gasoline or jet fuel) and the price of crude oil, also known as the "refining margin."
Risks Associated with Delek Group Ltd. Holding Company
Delek Group Ltd., an Israel-based, publicly traded conglomerate, holds 74.2% of DK's shares outstanding with other strategic entities retaining an additional 8%. This results in fewer number of Delek U.S. Holdings shares available for trading (the "float") on the NYSE — 17.8% of the company's shares outstanding, to be precise. As such, shares of this roughly $850 million market cap company are relatively thinly traded and more vulnerable to high share price volatility than companies of similar size.
Furthermore, should Delek Group Ltd. decide to decrease its ownership of DK, this could create a sizable overhang on the stock due to the sustained selling pressure. This risk is exacerbated by DK's light trading volume.
Conclusion
At first glance shares of Delek appear attractive: Several recent years of accelerating earnings combined with an attractive, presently low P/E ratio. This generally makes for an intriguing investment opportunity.
However, a closer look reveals DK is likely trading at peak earnings, consensus estimates indicate earnings are likely to decline over the next several years, and the normalized P/E ratio almost reaches 16x translating to a 30% premium to the S&P 500. Furthermore, DK appreciated 68% year-to-date with an ominous short interest as a percentage of float at 16.1%. As a result, at this time shares of Delek US Holdings appear to offer a relatively unattractive risk/reward trade-off and are likely fairly valued.
Disclosures:
Neither the author nor CastlePoint Investment Group LLC own shares of any company mentioned in this report.
About the author:
John G. Alexander, CFA, is managing partner and portfolio manager for CastlePoint Investment Group where he achieved and sustained a record surpassing the S&P 500 eight of past nine years and 98% of all 36-month rolling, overlapping periods. During his 12-year career as an equity portfolio manager, his annualized returns through September 30, 2011, exceed the S&P 500 and Russell 1000 Value indices by 532 bps and 467 bps, respectively. John earned his M.B.A. degree from the Wharton School of the University of Pennsylvania and a B.S. degree from Indiana University. He co-authored "The Future of Value Investing" published by the Journal of Investing in 2000. Please visit the CastlePoint website (www.castlepoint-inv.com) for additional information.
Consensus Estimates Indicate Delek at Peak Earnings
From a valuation standpoint, although shares of Delek appear inexpensive on a P/E basis (5.5x using trailing EPS or 4.0x forward earnings), it's important to recall the company's earnings are cyclical and, more importantly, have already peaked (see chart below). As a cyclical company, it's more appropriate to view the company for market multiple valuation and comparison purposes using "normalized" EPS.
Shares of Delek Trading at 30% Premium to Market
Though there's no universal standard for calculating normalized EPS, most approaches employed are based on averaging a company's annual earnings. This is generally done using a fixed, arbitrary number of years. The methodology I've found to be most accurate uses the volatility of a company's historical return-on-investment (ROI) in the calculation of the appropriate number of years to average. The underlying principle of this approach is earnings of companies with highly volatile ROI are averaged over a greater number of years than those with more stable ROI historical results.
Recent EPS results of companies with a demonstrated ability to generate a consistent ROI are more relevant, under this theory, than those that do not; as such, fewer number of years are needed to get a clearer picture of normalized EPS.
I use a maximum of seven years when calculating normalized earnings for a cyclical company. Given Delek's highly volatile ROI, normalized EPS are the average of the latest seven years or $0.78. Shares of Delek closed at $12.18 on Nov. 18, 2011, leading to a normalized P/E of 15.8x. The S&P 500 index presently trades at 12.2x, which implies DK is trading at a 30% premium to the index.
First Call consensus estimates for the S&P 500 indicate EPS is expected to grow 11%, 7%, and 20% in 2011, 2012, and 2013, respectively (though I don't find the 20% EPS growth for the S&P 500 in 2013 credible, it isn't relevant for purposes of this report).
By comparison, consensus estimates for Delek (shown in the chart above) reveal a significant, steady decline in earnings over the same time frame. Further, the current yield on the S&P 500 of 2.2% is almost twice that of Delek's 1.2% dividend yield. Both factors, particularly after accounting for the more volatile nature of Delek's earnings, support the argument a 30% P/E multiple premium is unwarranted.
Expect Shares of Delek to Trade Inversely with Price of Oil
By way of background, there are three general types of oil companies: upstream (exploration and production), downstream (refining and marketing), and integrated. Absent significant hedging contracts into which an oil company may enter, the shares of upstream and downstream oil companies trade very differently from one another and it's important to understand the difference when investing in energy companies.
From the perspective of an exploration and production (E&P) company, oil is regarded as an asset. An increase in oil prices increases the value of the company's inventory. As a result, there is a generally positive correlation between oil prices and shares of E&P companies.
Alternatively, shares of downstream or refining and marketing (R&M) companies, including Delek US Holdings as well as Sunoco (SUN), Marathon Petroleum (MPC) and Valero (VLO), tend to trade inversely with oil prices. As management stated in the most recent SEC Form 10-K, "Sudden change in petroleum prices is our primary source of market risk." This is due, in part, because petroleum products are viewed as an expense (cost of goods sold) rather than an asset already owned. Earnings for R&M companies are substantially determined by the difference between the price of refined products (e.g., gasoline or jet fuel) and the price of crude oil, also known as the "refining margin."
Risks Associated with Delek Group Ltd. Holding Company
Delek Group Ltd., an Israel-based, publicly traded conglomerate, holds 74.2% of DK's shares outstanding with other strategic entities retaining an additional 8%. This results in fewer number of Delek U.S. Holdings shares available for trading (the "float") on the NYSE — 17.8% of the company's shares outstanding, to be precise. As such, shares of this roughly $850 million market cap company are relatively thinly traded and more vulnerable to high share price volatility than companies of similar size.
Furthermore, should Delek Group Ltd. decide to decrease its ownership of DK, this could create a sizable overhang on the stock due to the sustained selling pressure. This risk is exacerbated by DK's light trading volume.
Conclusion
At first glance shares of Delek appear attractive: Several recent years of accelerating earnings combined with an attractive, presently low P/E ratio. This generally makes for an intriguing investment opportunity.
However, a closer look reveals DK is likely trading at peak earnings, consensus estimates indicate earnings are likely to decline over the next several years, and the normalized P/E ratio almost reaches 16x translating to a 30% premium to the S&P 500. Furthermore, DK appreciated 68% year-to-date with an ominous short interest as a percentage of float at 16.1%. As a result, at this time shares of Delek US Holdings appear to offer a relatively unattractive risk/reward trade-off and are likely fairly valued.
Disclosures:
Neither the author nor CastlePoint Investment Group LLC own shares of any company mentioned in this report.
About the author:
John G. Alexander, CFA, is managing partner and portfolio manager for CastlePoint Investment Group where he achieved and sustained a record surpassing the S&P 500 eight of past nine years and 98% of all 36-month rolling, overlapping periods. During his 12-year career as an equity portfolio manager, his annualized returns through September 30, 2011, exceed the S&P 500 and Russell 1000 Value indices by 532 bps and 467 bps, respectively. John earned his M.B.A. degree from the Wharton School of the University of Pennsylvania and a B.S. degree from Indiana University. He co-authored "The Future of Value Investing" published by the Journal of Investing in 2000. Please visit the CastlePoint website (www.castlepoint-inv.com) for additional information.
