Solid Income Growth Picks for your Portfolio

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Although crude prices have risen in 2012, it was mainly due to its strained supply. But according to International Energy Administration, global demand for crude will increase by 840,000 barrels per day in 2013. High crude prices are good for oil E&P companies, but its higher demand benefits oil refining companies.

Moreover, natural gas is used as an ingredient in crude refining, and lower natural gas prices adds to the margins of oil refining companies. To their delight, natural gas futures recently plunged to their 5 week lows due to high inventory levels, and weather forecasts hinting towards warmer-than-normal temperatures in February. This is double delight for oil refining companies, and I believe that investors should load up on companies like HollyFrontier (NYSE: HFC), Tesoro (NYSE: TSO) and Marathon Oil (NYSE: MRO).

A Solid Income Growth Pick

HollyFrontier is one of the largest independent oil refiners in the US, with a refining capacity of 443,000 barrels. Recently its management announced that it would be expanding its Woods Cross refinery, to ramp up its refining capacity by 13.85% (or 60,000 barrels per day). Its Q3 throughput stood at 433,000 bpd on a capacity of 443,000 bpd, which shows that its refineries were operating at nearly 98% of their capacity. This expansion would not only allow a higher throughput, but would also reduce the workload in each of its refineries. It’s called spreading the risks.

As of Sept. 30,its total cash balance including marketable securities totaled $2.3 billion, which rose by 43.5% on a quarterly sequential basis. Its LT debt/equity and debt/capital equate to just 23% and 18%, respectively, which suggests that the company has no debt problems whatsoever. To be precise, its total debt stood at just $471.8 million (excluding non-recourse HEP debt).

On quarterly basis, the company reported an impressive 9% growth in gross margin per barrel (above $30/barrel). As a result, its EBITDA also jumped from $895 million to $1 billion. During the earnings call, its board bumped its regular dividend by 33%, but yesterday its regular dividend was boosted by 50%. This the 5th dividend hike over the last 2 years and at the CMP, its yield equates to 2.2%. Additionally, the board also approved a special dividend of $0.50 per share, and its payout ratio stands at 48%, which is well within acceptable limits.

How do the Competitors Fare?

HollyFrontier shares its market space with Tesoro Corporation and Marathon Oil.

<table> <tbody> <tr> <td> <p>Company</p> </td> <td> <p>Forward P/E</p> </td> <td> <p>Gross Margin</p> </td> <td> <p>Debt/Equity</p> </td> <td> <p>Yield</p> </td> </tr> <tr> <td> <p>HollyFrontier</p> </td> <td> <p>7.77x</p> </td> <td> <p>19.53%</p> </td> <td> <p>23%</p> </td> <td> <p>2.2%</p> </td> </tr> <tr> <td> <p>Marathon Oil</p> </td> <td> <p>10.74x</p> </td> <td> <p>37.44%</p> </td> <td> <p>36%</p> </td> <td> <p>1.98%</p> </td> </tr> <tr> <td> <p>Tesoro Corporation</p> </td> <td> <p>8.65x</p> </td> <td> <p>12.05%</p> </td> <td> <p>33.5%</p> </td> <td> <p>1.5%</p> </td> </tr> </tbody> </table>

On taking a look at the metrics, all three companies appear to be undervalued. Although Tesoro Corporation has lower margins, I think it’s a value play here. For the recent quarter, its gross margin per barrel rose from $6.02 to $14.25, which is a massive 137% increase. Its management said that it continues to benefit from the less expensive Canadian and domestic crude. The management also added that it is searching for ways to bring more Canadian crude to its West Coast refinery, via rail or by road. This means that its margins would continue to head north in the coming months.

Marathon Oil is also firing all cylinders. The company enjoys the highest margins amongst the mentioned peers, and announced that it would be spending $5.2 billion on capital investment and exploration activities in the coming year. Analysts estimate its EPS to expand by 4.9% annually, for the next 5 years.

Conclusion

In my opinion, HollyFrontier makes a good income growth pick, with its upcoming throughput increases, fattening margins and expansion work underway. Talking about Tesoro Corporation, it has been under pressure due to stressed margins, but as its margin condition continues to improve, its share price could increase almost exponentially (due to a higher throughput). But one should also note that its low margins make it more susceptible to losses in cases of disasters or maintenance work. Hence, investors should determine their risk capacity, before going long on this value play.


PiyushArora has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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