This article is part of our Rising Star Portfolios series.
Roughly once a quarter, I run a screen looking for companies that have very low expectations for growth in free cash flow priced in. Here's the latest set of results from when I ran this screen about a month ago. What I'm looking for are companies that have a sustainable business in an industry that's temporarily out of favor, which gives rise to the low expectations. Oh, and it must not have an artificially inflated level of free cash flow, as Dr Pepper Snapple Group does. Today, I believe I have found one.
Spread that crack
Western Refining (NYSE: WNR ) is an independent refiner, breaking down (or "cracking") oil into gasoline, diesel, and jet fuel, among other products. It operates two refineries in the Southwest, one in El Paso, Tex., and the other near Gallup, N.M. A third refinery near Yorktown, Va., is offline and being converted to a pipeline terminal and storage facility. It also operates a wholesale business -- selling fuels, lubricants, and various automotive chemicals -- and a retail business in the Southwest.
Refiners make their money off what is called the "crack spread." This is the difference between the price of the raw material (oil) and the finished products (e.g., gasoline). The wider that spread is per barrel, the more profitable the refining business is.
Right now for Western Refining, that spread is fairly wide, averaging better than $18 per barrel in the first quarter, up from just $7.40 a year previously. Currently, it is expected to stay about $20 per barrel all the way through 2012.
What this means for Western Refining is that it will be able to expand its operating and net income margins, especially the net income margin, from their current low levels. It's already begun to do this, as shown in the graph below.
Source: Capital IQ, a division of Standard & Poor's. TTM = trailing 12 months.
As you can see, as the country moved out of the recession, Western Refining has turned its declining margins around and became profitable on a trailing basis in the last quarter. I expect this to continue, with net margins climbing back up to more historic levels above 2% or 3%.
In 2010 and so far in 2011, Western Refining's two active refineries are operating at higher margins than all but one of the refineries operated by Tesoro (NYSE: TSO ) , Frontier Oil (NYSE: FTO ) , and Holly (NYSE: HOC ) , and all the refineries operated by Valero (NYSE: VLO ) .
With growing margins, you'd expect free cash flow to also grow. However, at last night's closing price of $15.06 per share, the market has priced in no growth at all, using my normal 15% hurdle rate to discount future cash flows. In fact, the expectation is for a decline in FCF of 0.6% per year for five years followed by a decline of 0.3% for the next five years before flat-lining at no growth forevermore.
What I believe is driving that is uncertainty in both the stability of oil supplies, caused by what is happening in the Middle East, and the stability of the U.S. economy and thus the demand for gasoline. Unlike some of its peers, Western Refining doesn't get its oil from the Middle East, purchasing oil produced from the Permian Basin in Western Texas, as well as oil produced in the Four Corners area. While oil prices are set on the world market, its supplies aren't threatened by Middle East turmoil.
Regarding the economy, I don't have room to argue every reason why I believe the economy is not in as much trouble as the news would have us believe. Instead, let me give one example from the many companies that my colleagues and I cover for Stock Advisor. Canadian National Railway has reported rising car loads for both the fourth quarter last year and the first quarter this year. In other words, increased rail shipments of raw materials and products have been moving from suppliers to manufacturers to customers indicating to me that the economy is not as troubled as people seem to think.
If Western Refining continues to grow its margins and the market's fears about oil and the economy are eased, the company's stock price should rise.
Tomorrow, I'll open an initial 2% position in Western Refining. As long as the crack spread remains as healthy as it is now and operating and net margins at the company continue to improve, I'll hold the shares and even consider adding more.
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