HollyFrontier Is Undervalued

Little went right for

Unlike the market, which has cut the share price nearly in half over the past year, we do not think second-quarter results are indicative of HollyFrontier’s long-term earnings potential. While we don’t expect conditions to improve meaningfully this year, the shares appear to be overly discounting a recovery in market conditions and contributions from self-help initiatives during the next several years. As a result, we still see HollyFrontier as undervalued based on various valuation metrics, leaving it as one of the most attractive names we cover in the energy sector. We plan to update our forecast with the latest guidance and market conditions, but we don’t expect a material change in our fair value estimate or narrow economic moat rating.

Three key elements are currently hurting HollyFrontier’s profitability: weak product margins, narrow crude spreads, and high RIN prices. Near-term improvement in each of these areas is unlikely, but we do not view current conditions as sustainable.

Product margins are under pressure from high inventory levels, which originally started with a mild winter last year that reduced distillate demand and, along with previously robust gasoline margins, prompted refiners to switch to max gasoline production. While gasoline demand has maintained last year’s strength, increased production has led to much higher levels of inventory and much weaker margins. Continued strong demand, as well as run cuts from marginal refiners and turnaround activity, should moderate inventory levels, but it will take time.

Light crude spreads have come under pressure on reduced U.S. production, and heavy spreads narrowed as a result of wildfires in Canada during the quarter. Heavy spreads have recovered, but light spreads are still tight and will probably remain so until U.S. production growth resumes and reduces excess pipeline capacity.

High RIN prices are also unlikely to abate anytime soon. The industry continues to pursue lawsuits and petition the Environmental Protection Agency to move the point of obligation for blending further downstream. However, ultimate relief may rely on congressional action. Either way, it’s unlikely any resolution will occur this year, given the election. As a result, HollyFrontier will continue to see depressed earnings as a result of the RIN obligation. RIN cost during the second quarter was $57 million and is expected to rise to $70 million in the third quarter, based on current RIN prices of about $1.

The poor results have derailed management’s previous plans to repurchase about $1 billion in shares this year, as adequate free cash flow has not materialized. While we do not expect any repurchases this year as management seeks to preserve the balance sheet in an uncertain environment, we see the dividend as safe, given sufficient coverage through a mix of cash flow, increased debt, and proceeds from drop-downs to Holly Energy Partners. HollyFrontier expects to raise upward of $250 million in cash from dropping down Woods Cross assets later this year. In an effort to preserve cash, management also reduced its 2016 capital spending outlook by $40 million and expects spending to fall by almost $160 million next year.