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October 1, 2012

Higher “Crack Spreads” Generate Profits for Tesoro

by Sridharan Raman.

Tesoro is poised to once again beat analysts’ expectations when it reports its third-quarter earnings, while a recently announced strategic acquisition may produce even more benefits in the coming months.

U.S. oil refining companies have generated healthy returns for investors during 2012, delivering stronger earnings and increasing their dividends amidst a highly favorable environment. As domestic oil production has surged, U.S. oil can be purchased by these refiners at a discount to global prices; that means they can sell the gasoline and other refined petroleum products they produce at relatively high prices while benefiting from lower costs – they can profit from what is referred to as a wide “crack spread”. Some companies have gone a step further, managing to restructure their operations in such a way as to make it likely that their profits will grow still more – and few have done better at that than Tesoro (TSO.N).

In August Tesoro scored a coup when it agreed to buy a package of assets – that included BP’s refinery in Carson, California. The transaction – assuming it wins approval from antitrust regulators – will make Tesoro the largest refiner on the West Coast from Alaska to California, beating out Chevron (CVX.N) for the title. It also will enable the Texas-based company to save at least $250 million a year in operating expenses.

The deal, at this point, looks like one of the savviest struck by a U.S. corporation this year: after taking into consideration the value of some of the other businesses involved in the transaction – such as pipelines and other energy infrastructure assets – that may be sold once the deal is complete (as some analysts have suggested),Tesoro acquired the refinery at a knock-down price. At the same time, the acquisition is very strategic: Not only is the Carson refinery immediately adjacent to one of its own refineries, but the new assets give Tesoro access to the ports, pipelines and the distribution channel (via ARCO) on the West Coast.

While the new acquisition is still awaiting regulatory approval, the company already is doing a great job of beating analysts’ expectations when it comes to earnings. The third quarter appears likely to keep Tesoro’s winning streak intact, thanks in part to a fire at a Chevron refinery near San Francisco. That not only hurt its rival’s sales but boosted the price for refined products as supplies dipped in the aftermath of the conflagration. Analysts have become significantly more bullish: 90 days ago, the I/B/E/S consensus estimate for Tesoro’s third-quarter earnings stood at $1.92 per share, but since then it has risen to hit $2.21. The StarMine SmartEstimate stands even higher, at $2.41, giving the company a positive Predicted Surprise of 8.7%. That signals that analysts covering Tesoro may well boost their forecasts for the company’s results between now and November 5, when it will report its Q3 earnings, or else that the company will deliver yet another positive surprise to investors. One highly-rated analyst is calling for the company to fare significantly better, and post earnings of $2.70 a share. That Bold Estimate reflects the degree to which analysts are becoming bullish on Tesoro’s ability to turn refining into big profits; in another signal, Tesoro scores the highest possible score – 100 – on the StarMine Analyst Revisions Model.

The company already is using assets more efficiently than its peers within the industry; its return on net operating assets over the last four quarters stands at 26.7%, more than double the industry median, which is a mere 10.4%. Analysts expect the acquisition of the Carson refinery likely will boost that operating efficiency still further and widen the gap between Tesoro’s RNOA and the industry median in the coming quarters.

Tesoro’s stock currently changes hands at about $41.88 per share, up from $25 at the beginning of the year . At the current price, the company’s market-implied growth rate is a mere 2.8%; in other words, earnings only have to grow at an annualized rate of 2.8% for the next 10 years to justify the current stock price. Odds are, they’ll do much better than that. The StarMine SmartGrowth rate calculates (combining forward-looking estimates and adjusting for analyst biases) stands at closer to 9.9% — a significant premium, and one explaining why Tesoro earns a score on the StarMine Intrinsic Value model of 89, signaling that the stock may still be undervalued, despite its gains over the last few months.

Investors also may be able to capture some income from Tesoro in the shape of dividends. After suspending dividends in 2010 due to poor cash flows and low crack spreads, Tesoro reinstated a dividend policy in the last earnings call in August. After reporting second-quarter earnings that beat analysts’ expecations, Tesoro announced a quarterly dividend of 12 cents a share, or an annual yield of 1.15%. That level may grow, given Tesoro’s strong cash position. During the second quarter of 2012, the company generated $607 million in free cash flow.

As reported previously on AlphaNow, metals and mining companies have been suffering as they bring costly new capital projects online just as the prices for their products have plunged. In contrast, Tesoro is seeing its own new projects, including the Mandan and Anacortes refineries, both of which will increase Tesoro’s capacity, come online during the second half of 2012, a time period in which crack spreads have reached three-year highs, as portrayed in the chart below. Wider crack spreads usually lead to higher margins for refiners like TSO, making this a good time for new projects to come onstream.

SmartEstimates: StarMine Professional quantitatively analyzes the earnings estimate accuracy of sell-side analysts and uses this information to create proprietary SmartEstimates®. SmartEstimates help you better predict future earnings and analyst revisions with estimates that place more weight on recent forecasts by top-rated analysts.
Predicted Surprise %: The Predicted Surprise% is the percentage difference between the SmartEstimate and the I/B/E/S consensus estimate. When SmartEstimates diverge significantly from consensus, it serves as a leading indicator of the direction of future revisions and/or surprises. In aggregate, this indicator gets earnings surprises directionally correct 70% of the time.

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