Upside/Downside Analysis on 3 Refiners

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Refiners have been on a roll. For the year to date, they have soared in value. Valero is up 47.3%, Alon USA is up 59.4%, and Tesoro is up 76.2% to name just a few. This is particularly amazing in light of rising concerns about looming EPA regulations. Will this bull run continue? And does upside outweigh downside? These are the central question that drive my analysis below.

Valero Energy (NYSE: VLO)

As a major refiner, Valero has down particularly well for itself. Despite bouncing 66.3% from the 52-week low, shares are still trading at just around book value. Free cash flow generation also remains terrific at $1.9 billion, or a 11.1% yield, for the TTM ending 3Q12. In addition, management is taking the right steps to unlock shareholder value. The retail business spinoff and cost structure reductions at the Aruba refinery go a long way to hedge against rising input costs. With that said, the decision to cut capital expenditures by $100 million to $3.5 billion is indicative of a weaker outlook.

Assuming expectations are met, 2016 EPS will come out to $5.62. At a multiple of 13x, this translates to a future stock value of $73.06. Discounting backwards by 10% yields a present value of $45.36. This is at a more than 50% premium to the current market cap and easily warrants making an investment.

There are several reasons why the stock continues to trade under intrinsic value. First, operational missteps have detracted from the value story. In an attempt to turn an old facility into a place to ship fuel shipments, the restructuring got out of hand and cost the company $0.62 per share. Rising EPA regulations and a weak macro outlook further add to the bear thesis. But I believe these risk and singular missteps have already been factored into the stock price. While I am on the fence given management's reserved outlook, I don't encourage selling.s

HollyFrontier (NYSE: HFC) & Western Refining (NYSE: WNR)

A vote of confidence from Barclays to HollyFrontier in early November has sent shares soaring in the oil & gas refiner. Barclays is now calling HollyFrontier a $65 stock. This means that even after rising 126% from its 52-week low and achieving its 52-week last week, the stock may still be 50% undervalued. in my view, the fundamentals are strong. HollyFrontier trades at only 5.9x past earnings and generates a good amount of free cash flow. FCF has taken off like a rocket: growing from $0 around mid-2010 to $1.1 billion today, or a 12.1% yield. And, in the most recent quarter, EPS of $2.94 was 54 cents ahead of expectations.

The LLS/WTI differential alone should be enough to keep pipeline financials strong. And HollyFrontier has down well on its own terms. It maintains structural crude advantages to generate leading EBIT margins. Margins were particularly strong in the Mid-Con and the Rockies. While the company suffered from a fire at its Tulsa distillate hydrotreater, it was able to offset this negative impact through a 97.8 utilization rate. Payments of special cash dividends, in addition to a 33% hike in the regular distribution, help to reiterate confidence in the underlying fundamentals.

However, all strong businesses should reinvest to improve growth prospects, and HollyFrontier has been doing just that. First, there's the Woods Cross expansion project, where a second phase is planned to add up to 60,000 barrels of crude per day. The addition of a lubricants plant and exploration of potential de-bottlenecking the Mid-Con refining system further illustrates a moving business.

But is there any other attractive alternative? Western Refining is not a bad deal at 7.1x forward earnings and tremendous free cash flow generation. FCF has been on a terrific run since 3Q10, and it has climbed to $534.1 million today, or a 21.7% yield. At a market cap of $2.5 billion, I believe Western Refining could some day be a takeover for a large oil & gas company seeking vertical integration. While operational performance has been weaker-than-expected, the upside is large enough to merit an investment.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Western Refining. 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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