US R&M: Like rig stocks, EPS revisions matter most now Goldman Sacks August 04, 2005
We continue to see significant upside potential in R&M shares and reiterate our Attractive coverage view. Although R&M equities are now at 90% of estimated replacement cost valuations and there is growing concern that capex will increase in coming years, we believe the lessons learned from the past cycles of the offshore rig stocks suggest that the trend of positive EPS revisions outweighs other concerns. Our 2006 EPS estimates for the R&Ms are 40% above the First Call consensus and correspond to 26% EPS growth versus 2005. We believe R&M stocks can reach 134% of replacement cost value this cycle, similar to the 132% offshore drillers reached in October 1997. This equates to 52% further upside potential for R&M shares and is consistent with our super-spike-adjusted peak values. Valero Energy and Premcor (both OP/A) are now our top picks, with Frontier Oil (U/A) our least favorite.
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VLO UPGRADED TO OP/A TO ALIGN WITH PCO RATING; FTO DOWNGRADED TO U/A
We are upgrading Valero Energy to Outperform to align our rating on it with our continued Outperform rating on Premcor, which Valero is expected to acquire by the end of the third quarter. We now consider Valero and Premcor our top R&M picks, followed closely by Sunoco (remains In-Line rated). A complex US refining system, a track record of execution following acquisitions, relative share price underperformance in recent months, and a bullish outlook for refining are the reasons we favor Valero.
We are downgrading Frontier Oil to Underperform from In-Line due to an expensive relative valuation. Frontier shares trade at 7.6X 2005E and 7.3X 2006E EV/DACF (enterprise value to debt-adjusted cash flow) versus the peer group average of 7.0X and 5.9X, respectively. On an EV per b/d of refining capacity basis, Frontier trades at $10,250 versus the peer group average of $8,772.
REFINING INDUSTRY AT AN INFLECTION POINT BETWEEN CAPACITY CREEP AND NEW BUILDS
Given significant spare refining capacity throughout most of the 1980s and 1990s, increases in refinery utilizations and capacity creep were historically sufficient to respond to demand shocks or supply disruptions. However, with no meaningful investments in grassroots refineries for many decades, demand growth has eaten away at spare capacity during the last two decades, resulting in critically low levels.
In our view, the lack of investment in refining is largely due to unfavorable project economics and not politically driven. This is in contrast to crude oil markets where, despite large resources in countries such as Iran, Iraq, Russia, Saudi Arabia, and Venezuela, upstream investments have been constrained due to a host of geopolitical and demographic challenges.
For a new refinery build to generate an 8% internal rate of return (IRR), we estimate that Gulf Coast 3:2:1 refining margins and Maya-WTI crude spreads need to average $8-$10 and $11-$13 per barrel, respectively, over 20 years.
In our opinion, refining margins will not average replacement cost levels over an extended period. Rather, we continue to believe that a super-spike in commodity prices-i.e., a multiyear trading band of $50-$105 per barrel WTI spot oil and commensurate refining margins-will resolve the current lack of spare capacity across the energy chain through multiyear demand destruction.
HIGHER MARGINS AND UPWARD EPS ESTIMATE REVISIONS SHOULD DRIVE SHARES HIGHER
What has been impressive about the refiners in the current up-cycle is that returns on capital employed (ROCE) have been commensurate with the rise in margins, in contrast to the E&Ps, where cost inflation appears to have eaten into profitability. For 2005 and 2006 we believe R&Ms are on track to generate ROCE comparable to the majors.
As long as refiners can continue to capture the economic rent, and given our bullish commodity price outlook, we believe the risk to consensus EPS estimates for 2006 is meaningfully skewed to the upside. Our 2005 and 2006 EPS estimates are 10% and 40% on average above the First Call consensus, respectively.
We see meaningful upside potential to R&M share prices. An important lesson learned in examining the previous cycles of offshore drilling companies is that the market values upward trending EPS more than it is concerned about supply growth, capital spending, or attainment of replacement cost valuations.
Despite our bullish near-term outlook, we believe refiners should be very cautious in making investment decisions on greenfield projects given our view that refining margins will ultimately revert to mid-cycle levels, similar to those seen during the 1980s and 1990s. Note that R&Ms historically have the worst risk-adjusted returns among various sectors within our coverage universe. In our view, capital discipline will be the key to lowering the volatility of returns, which should also reduce downside risk if commodity prices turn adversely.
WE SEE 52% UPSIDE POTENTIAL TO SUPER-SPIKE-ADJUSTED PEAK VALUES
We estimate 52% upside potential to super-spike-adjusted peak levels versus 32% downside risk to traditional mid-cycle valuations. In our view, for R&Ms to face the risk of falling below traditional mid-cycle to "doom and gloom" downside valuation levels, Gulf Coast 3:2:1 margins on a full-year average would need to fall below $4.50 per barrel, which we think is unlikely for the foreseeable future.
Our super-spike-adjusted peak values for R&Ms correspond to 134% of estimated replacement cost on average, consistent with the 132% of replacement cost at which offshore drillers traded on average during the October 1997 peak.
I, Arjun Murti, hereby certify that all of the views expressed in this report accurately reflect my personal views about the subject company or companies and its or their securities. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report. |
