Frontier Oil (U/A): Large valuation premium over R&M peers unsustainable; maintain U/A - Goldman Sachs - May 08, 2006
[ U/A - that means they like the sector but they think Frontier is a stinker :^o ]
We maintain an Underperform rating on Frontier Oil shares in the context of an Attractive coverage view as we believe its large valuation premium over its R&M peers is likely unsustainable. We see Frontier trading at 8.2X 2007E EV/DACF versus the 6.4X R&M average. On a per barrel of refining capacity basis--a valuation metric commonly used in looking at acquisition multiples--Frontier trades at over $22,000, which appears more expensive than recently proposed grassroots complex refinery new builds. With respect to the particularly wide crude differentials seen in 1Q 2006, we believe Frontier already discounts roughly $30/bbl WTI-Canadian Bow River differentials for 2007E and as such see its relative risk/reward in its shares to be unfavorable at this time.
TO OWN FRONTIER, INVESTORS MUST HAVE EITHER AN EXCEPTIONALLY BULLISH VIEW ON WTI-CANADIAN HEAVY OIL CRUDE DIFFERENTIALS...
We estimate that WTI oil-Canadian Bow River differentials need to average at least $30 per barrel for Frontier to trade at 6.3X 2007E EV/DACF (enterprise value to debt-adjusted cash flow), which is consistent with where Sunoco and Valero trade today. This compares to our $19 per barrel forecast for 2007E, $23 per barrel year-to-date average, and $9 per barrel spot differentials. Such an analysis would also need to assume that other crude differentials (for example WTI-Maya or WTI-Arab Heavy) that benefit refiners such as Valero remain unchanged. In our view, the particularly wide crude differentials seen in the Rockies in 1Q 2006 (i.e., Canadian heavy oil, West Texas Sour, and Wyoming sweet) was primarily due to low refinery utilizations from deferred turnarounds following hurricanes Katrina and Rita coupled with a lack of pipeline capacity to transport excess crude out of the Rockies market, rather than a sustainable glut of crude supply. We believe this is supported by the now narrower Canadian Bow River and WTS to WTI crude differentials, which on average stand at $14.48 and $3.71 per barrel 2Q 2006-to-date versus the 1Q 2006 average of $26.73 and $6.53, respectively.
Even if we are ultimately too conservative on differentials for Canadian heavy relative to other heavy-sour crude, we believe the fact that Frontier shares already discount a $30 per barrel differential for 2007E likely suggests muted relative upside in Frontier shares.
...OR BE WILLING TO ATTRIBUTE "GRASSROOTS" REPLACEMENT COST VALUATION ON FRONTIER
When speaking of replacement cost valuations, we continue to believe that "effective" replacement cost valuation multiples of $10,000-$15,000 per b/d of refining capacity are more appropriate than multiples based on grassroots projects given that global refining capacity additions are likely to be a blend of capacity creep (costs virtually nothing), brownfield expansions ($5,000-$10,000 per b/d of capacity), and grassroots projects ($15,000-$20,000 per b/d). However, we believe the market appears to be giving disproportionate credit to "single-asset" refineries such as Frontier, Alon (Not Covered), Holly (Not Covered), and Western Natural Resources (Not Covered) vis-a-vis a higher EV per barrel valuation. Indeed if one were to assume that single-asset refineries deserve valuations consistent with costs to build grassroots refineries, Frontier at $22,053 per b/d of capacity would be trading only slightly above $20,000 per b/d of grassroots replacement cost, versus trading at 183% of effective replacement cost. Further, assuming that investors would be willing to attribute 135% of replacement cost (per where the offshore drillers peaked in October 1997), it is not illogical for Frontier shares to trade toward $27,000 per b/d. With that said, we do not believe grassroots replacement cost valuation to be appropriate for Frontier nor for the R&Ms overall.
WE ESTIMATE 16% DOWNSIDE RISK BASED ON OUR $51 "SUPER-SPIKE"-ADJUSTED PEAK VALUE
We see Frontier shares trading 16% above our $51 "super-spike"-adjusted peak value, which is consistent with discounting an $11.50 per barrel long-term Mid-Continent 3:2:1 crack spread (equivalent to $9.50 per barrel Gulf Coast 3:2:1 crack spread and $60 per barrel WTI oil). This compares to Sunoco, Tesoro, and Valero Energy (all IL/A) showing 37% upside on average to "super-spike"-adjusted peak values.
1Q 2006 RESULTS ABOVE EXPECTATIONS
Frontier's adjusted and reported 1Q 2006 EPS of $1.02 was above the $0.82 First Call consensus and our $0.79 forecast. Both realized gross margins and total refinery throughput volumes were better than expected at $12.06 per barrel (versus our $10.19 forecast) and 166,202 barrels per day (versus our 164,750 forecast).
UPDATED ESTIMATES
We are updating our full-year 2006 EPS estimate to $5.19 from $4.95 before to reflect actual 1Q 2006 results. We have made no change to our 2Q-4Q 2006 and full-year 2007-2010 EPS estimates based on updated crude throughput assumptions, higher assumed realized margins and operating costs, and minor other adjustments. Note, we maintain our $12.25 per barrel Mid-Continent 3:2:1 and commensurate other regional crack spread assumptions for 2Q 2006, which could ultimately prove too conservative given 2Q-to-date spot commodity prices. As is our usual practice, we will revisit our margin and other commodity price assumptions later in 2Q 2006 and update our estimates, if appropriate, at that time. See Exhibit 1 for a summary model of Frontier.
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. |
