HollyFrontier: Buy for income; Stay for the capital gains

HollyFrontier’s current weakness offers long-term investors a prime buying opportunity.  Mid-cap value stock HollyFrontier (HFC) is one of the largest independent petroleum refiners in the U.S., with operations focused in the Mid-Continent, Southwest and Rocky Mountain regions.  

On May 3rd, HollyFrontier reported a first quarter net loss of $(45.5) million, or $(0.26) per diluted share. The Company also declared a quarterly dividend of $0.33 ($1.32 annually) per share to shareholders. At the end of the qtr., book value stood at $26.00.

First quarter results were negatively impacted by planned and unexpected refinery outages for repairs and routine maintenance.  There is no major downtime planned until Nov, and these issues could be considered as “one-time”. For the balance of the year, quarterly earnings per share are expected to be $0.77, $0.62, and $0.22. EPS for 2017 is expected at $1.47 to $1.52 and for 2018 between $2.26 and $2.77.  

HFC rallied after the election from around $23 to a high of almost $34, but fell back in May after the earnings disappointment to $25.   

Driving investor interest was the belief the current administration would reduce the regulatory cost of renewable identification numbers, or RINs.  RINs are a bio-fuel tracking mechanism that is like “carbon credits” where bio-fuel companies generate RINs that can be sold to refiners like HFC to offset production of fuels like E85. RINs are a positive for ethanol makers and an expense for refiners. HFC currently spends over $100 million a year to purchase RINs.  The thought process is that presidential advisor Carl Icahn, a large investor in refining firms, would be instrumental in reducing the burden and expense of the RIN program.  

However, that has not yet happened.  From HFC 1st qtr. 2017 10-Q:  The (RIN) regulations, in part, require refiners to add annually increasing amounts of “renewable fuels” to their petroleum products or purchase credits, known as renewable identification numbers (“RINs”), in lieu of such blending. Compliance significantly increases our cost of products sold, with RINs costs totaling $66.0 million for the three months ended March 31, 2017. Year-over-year increased costs of ethanol blended into our petroleum products, which exceeded the cost of crude oil, also contributed to lower refining margins for the quarter.  

RIN payments are somewhat volatile and during the first quarter, the RIN program reduced profits per share by $0.38.  Annualized, a 50% reduction in RIN expense could add between $0.30 and $0.68 per share to profitability.  At a 10x valuation, this increase could add $3 to $7 a share to HFC valuation.    

HFC maintains one of the most complex refinery operations.  HFC’s complexity ratings is 12.1, on a scale of 1.0 to 14.0, with a US average refinery complexity of 9.0. For investors, this means that HFC operates one of the most complex and potentially profitable chains of refinery assets in the US. The higher complexity factor allows HFC to refine lower grades of crude into gasoline and diesel, potentially expanding comparable margins.

This advantage shows up as a substantially higher ROIC than its peers. In 2016, HFC exceled in generating returns on invested capital. At a ROIC of 17%, HFC bested its peer 5-yr average of 13% by 30%, and was second only to Western Refinery’s 19%. HFC has generated first class operating profits per barrel and its 5-yr average profit per barrel is best of its peers. In 4 of the last 5 years, HFC has been either #1 or #2 in industry profitability.

In Feb, HFC completed the acquisition of the Canadian lubricant business from Suncor (SU). Wall Street is expecting the acquisition will stabilize commodity-driven refinery spreads and overall operating profitability.  

HFC owns 22.4 million limited partner units of its midstream MLP spin-off, Holly Energy Partners (HEP), representing a 39% stake, and also holds a 2% general partner interest.  At current valuations, HEP shares owned are worth $4.75 per HFC share and contributes $0.30 per share in distributable income for HFC stakeholders. 

Catalysts for higher share prices are: 
1) improving refining margins, partially created by a higher spread WTI to Brent; 
2) reduction in the RIN program; 
3) reduction in federal income tax rate;
4) increased profitability from the lubricant business expansion; 
5) increased contributions from Holly Energy Partners.

At the current price, HFC offers a 5.7% dividend yield, providing strong support to total stock returns.  While patience may be needed for HFC to realize its full potential, buy for its current income and stay for the capital gain potential.  

This article first appeared in the June 2017 issue of Guiding Mast Investments. Thanks for reading, George Fisher