Sunoco (IL/A), Tesoro (IL/A): Refining outlook bullish, but valuations not inexpensive; prefer ConocoPhillips for R&M exposure - Goldman Sachs - May 05, 2006
We believe the combination of high asset valuations and cost inflation on the procurement/construction of new refinery units--as highlighted by Sunoco (IL/A) and Tesoro (IL/A) during its 1Q 2006 earnings conference calls--makes the risk/reward less favorable for the independent R&M equities vis-a-vis the integrateds and E&Ps. In particular, we see ConocoPhillips (OP/A) as a preferred way to own exposure to our otherwise bullish refining outlook. We estimate COP's 2007E implied R&M EV/DACF to be 2.7X, which compares to SUN's 6.4X, TSO's 4.9X, and the R&M average of 6.4X. Note, COP's overall 2007E EV/DACF is still only 5.1X, essentially in- line with TSO.
With that said, we maintain an Attractive coverage view on the refining sector as we see 25%-40% upside to "super-spike"-adjusted peak values, consistent with discounting a $9.50/bbl long-term Gulf Coast 3:2:1 crack spread.
COST INFLATION RAISES RISK THAT REFINERS COULD LOSE ITS ROCE ADVANTAGE OVER THE E&Ps IN THE MEDIUM- TO LONG-RUN
While the independent refiners have enjoyed disproportionate economic rent--and hence asset valuation and share price performance--relative to the E&Ps in the current energy up-cycle, we believe a new build cycle the refining industry appears to have embarked on raises risk for meaningful cost inflation and ROCE deterioration over the medium- to long-run. Sunoco and Tesoro management are the latest to join other integrateds and independent refiners in highlighting upward cost pressures in the procurement, labor, and overall construction of new refinery units. Tesoro management in particular raised CAPEX expectations dramatically by indicating it expects to be 50% over its budget on 2 coker projects. Tesoro now expects to spend $790 million on the Golden Eagle and Anacortes coker projects, relative to the previous $525 million budget. With that said, for the R&M industry overall, we do not expect cost inflation to impact profitability meaningfully in 2006, nor likely in 2007. In fact, should energy demand and commodity prices remain robust (if not trend higher) as we expect, R&M returns are still likely to be above those of the E&Ps over the next couple of years. Rather, our point is merely to highlight that refiners no longer appear to be shielded from cost inflation and as such the potential for refiners to extend its valuation premium over the E&Ps is likely small.
RISK/REWARD FAVORS OWNING INTEGRATEDS WITH REFINING EXPOSURE RATHER THAN PURE-PLAY
R&Ms We currently do not see independent R&M valuations being reflected in valuations for the integrateds with refining assets. In particular, we estimate that Conoco's 2007E implied R&M EV/DACF (enterprise value to debt-adjusted cash flow) is merely 2.7X relative to the R&M average of 6.4X. Although it is logical that pure-play refiners could garner a valuation premium over implied R&M valuations of an integrated company during an up-cycle, we believe a 3.7X discount is excessive. Note, we continue to have a bullish outlook on refining given virtually non-existent spare refining capacity, resilient demand, and potential supply disruptions stemming from the various gasoline/diesel specification changes in 2006. However, given the wide valuation discrepancy and the risk for potential ROCE deterioration due to cost inflation, we prefer an inexpensive exposure to refining via Conoco shares at this time. For investors interested only in pure-play refiners, we continue to prefer shares of Valero Energy (IL/A) given its execution track-record, geographical diversification, and complexity of its refineries.
SUNOCO, TESORO: MAINTAIN IN-LINE RATING RELATIVE TO AN ATTRACTIVE COVERAGE VIEW
Notwithstanding our continued confidence in Sunoco management team and its ability to execute on growth projects while maintaining capital discipline, we believe its refining system's relatively low complexity, exposure to chemicals cycle which appears to be approaching peak, and above-normal exposure to marketing make its shares less attractive relative to our favorite R&M pick Valero. On an absolute basis, we see 43% upside to our $113 "super-spike"-adjusted peak value and 26% downside risk to our $58 "traditional" mid-cycle value. Its shares trade at 6.4X 2007E EV/DACF, in-line with the peer group average of 6.4X. Sunoco remains In-Line rated in the context of an Attractive coverage view.
In terms of Tesoro, we continue to believe that a valuation discount for its shares is warranted given bottom-quartile returns on capital employed, concentration risk (i.e., its Golden Eagle refinery alone accounts for almost half of the company's gross margins), and earnings volatility. With Tesoro trading at 4.9X 2007E EV/DACF versus the peer group average of 6.4X, we see Tesoro's relative risk/reward as balanced at this time. We see 26% absolute upside to our $91 "super-spike"-adjusted peak value relative to a 32% downside risk to our $49 "traditional" mid-cycle value. Tesoro remains In-Line rated in the context of an Attractive coverage view.
SUNOCO'S 1Q 2006 RESULTS BELOW EXPECTATIONS
Sunoco's adjusted (and reported) 1Q 2006 EPS of $0.59 was below the $0.92 First Call consensus and our $1.09 forecast. The negative variance between actual results and our forecast was driven by lower-than-expected realized gross margins, throughput volumes, and chemicals earnings. In refining, we believe it was the combination of a warm winter weather (to which Sunoco is more exposed relative to other R&Ms via the East Coast heating oil market) and unfortunate timing of planned turnaround during weeks of high refining margins that led to lower realized margins and not asset quality, mix, or execution. On the other hand, chemical earnings disappointed as volumes and gross margins continued to struggle.
We have updated our 2Q-4Q 2006, and full-year 2006-2007 EPS estimates for Sunoco, which now stand at $2.14 ($2.25 before), $2.50 ($2.67 before), $1.78 ($1.90 before), $7.00 ($7.90 before), and $8.50 ($8.70 before). We have also updated our normalized 2008-2010 EPS estimates , which now stand at $4.35 ($4.50 before), $4.70 ($4.88 before), and $5.15 ($5.34 before). Our updated EPS estimates reflect actual 1Q 2006 results, lower assumed chemicals earnings, higher assumed refinery operating expenses, and minor other adjustments. See Exhibit 1 for a summary model of Sunoco.
TESORO'S 1Q 2006 RESULTS BELOW EXPECTATIONS
Tesoro's adjusted 1Q 2006 EPS of $0.67 was below the $0.69 First Call consensus and our $0.79 forecast. The negative variance between actual results and our forecast was driven by lower-than-expected realized gross margins at the Golden Eagle and Hawaii refineries, even after adjusting for Tesoro's crude and blendstock hedge positions in 1Q 2006. We have updated our 2Q-4Q 2006, and full-year 2006-2007 EPS estimates for Tesoro, which now stand at $1.95 ($1.83 before), $3.26 ($3.31 before), $2.76 ($2.81 before), $8.60 ($8.71 before), and $11.15 ($11.90 before). We have also updated our normalized 2008-2010 EPS estimates , which now stand at $3.30 ($3.70 before), $3.45 ($3.85 before), and $3.60 ($4.05 before). Our updated EPS estimates reflect actual 1Q 2006 results, lower assumed realized refining margins, updated throughput estimates, higher assumed depreciation charges, CAPEX, and interest expense, and minor other adjustments. See Exhibit 2 for a summary model of Tesoro.
Each of the analysts named below hereby certifies that, with respect to each subject company and its securities for which the analyst is responsible in this report, (1) all of the views expressed in this report accurately reflect his or her personal views about the subject companies and securities, and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report: Arjun Murti, Luis Ahn. |
