ikkyu2 (99.51)

A "refined" pitch

April 24, 2010 – Comments (5) | RELATED TICKERS: TSO , VLO

Pitch is tar; it is, approximately, what is left over after the petrochemical refining process extracts all the lighter stuff out of crude oil.  So when I say this is a 'pitch', it is a pitch on pitch!

Cutesy stuff aside, I was looking at TSO (Tesoro Corp.)'s balance sheet yesterday.

At today's price of 13 and change, the market cap is about 1.86 billion.  The company has 2.22 billion in current assets.  Now back out the total debt and liabilities, which comes to about 1.9 billion of current liabilities, 1.8 billion of long term debt, and 750 million in "other liabilities."  Let's leave aside deferred income tax for the moment as it has a way of staying deferred for a long time.

Just looking at the current assets minus all the liabiities, Tesoro is about 2 billion dollars in the hole.  If Tesoro ended today and all its long-term assets were marked worthless and all the creditors came up to the door demanding satisfaction, they'd be about $2 billion short.

OK, fine, let's throw those creditors a bone.  Let's liquidate all the gas stations and the corporate offices and throw those to the creditors.  Those are worth, in TSO's estimation, about a billion dollars book value.  We're still about a billion in the hole.  Now what have we got left to liquidate?

Tesoro's other asset is a large network of refineries.  They estimate it's worth 5.7 billion.  Okay, we liquidate one of the refineries for a billion dollars and pour that down the debt hole.  We've still got about 80% of our refineries left.  And they're on sale; TSO has them booked at a depreciated value of 4 billion, but we can buy them, lock stock and barrel, at this price for about $1.86 billion.

Peter Lynch used to boast of companies he would find, companies with ongoing operations and no debt and a big cash pile, selling for less than the value of the cash pile.  He would swoop in with his Fidelity Magellan fund dollars and buy $50 per share in cash for $40 a share - and get part of a cash flow positive company for free.  This was what he called an 'asset play'.

TSO isn't quite at that level.  First of all, they're not cash flow positive.  Decreased demand has boosted inventories of their outputs, depressing crack spreads (which determine TSO's profit margins) even while some of their refineries have to be idled.  This is how recessions hit refineries with a double whammy - profits decline even while demand declines.  Idle refineries aren't cheap - they still cost money to maintain, pay taxes on, pay environmental reparations on, even when they aren't actively cracking.  So TSO is cash flow negative and expects to remain that way for at least another year.

But here's the upside: the output will eventually increase, and crack spreads will widen, as the general economy takes off.  There is nothing more certain than that.  When economies run, they do so on the backs of the products of refineries.  There is no substitute.  And due to the NIMBY problem - no one wants a refinery in their back yard! - it is very difficult for a competitor to suddenly enter the market and take TSO's share.  This is what Warren calls a 'moat', and a refinery's moat is about as wide and shark-infested as anybody's.

Why aren't people snapping up TSO - why is it only up 25% off the March 2009 bottom?  Well, two reasons.  One is that it's not possible to predict accurately how long until TSO is operating near capacity again and crack spreads start to widen.  We saw this scenario in late 2007 - all refineries operating near capacity, talk about peak oil, crack spreads through the roof, TSO's share price over 100.  When will we see that again?  2010?  No.  2011?  Probably not. No one knows.  Could be many years.  A lot of people don't want to park their money here  without a better idea how long it's going to 'stay parked' without moving.

Reason #2 is that TSO's cash flow negative.  That means they're financing continuing operations with debt.  I'm not so very tearful about this - the debt is mostly at 6.25%, which is an excellent rate and which I predict is going to look pretty good in 2012's rate environment.  But the risk here is that they may have to soak up so much more debt from here, that they sell the farm to the creditors.  If, by the time the economy picks up again, they are $10 billion in the hole instead of $2 billion, that will mean that common shareholders don't have any room to benefit from the company's recovery because all the cash flow will be going towards interest payments.

There are also minor risks (terrorism target, alternative energy squelching demand, environmental disaster reparation) that I mention only to dismiss because I don't think they're of the scale or likelihood to impact operations substantially. 

Still, a set of refineries selling at 50 cents on the dollar seems like quite a bargain to me, especially since they're the country's only refineries.  What do Fools think?