Thanks to Tesoro's (TSO +0.00%) high exposure to the West Coast and improving results from its subsidiary Tesoro Logistics Partners (TLLP +0.00%), the company was able to turn in a rather respectable earnings result this past quarter. That, of course, is grading on a scale because refiners have had a tough go of it lately.
In the coming quarters, however, we should expect big things from Tesoro. Not just because it will acquire Western Refining (WNR +0.00%) in a couple of weeks, but also because there are some unique opportunities for management to pursue. Here are several quotes from Tesoro's most recent conference call that highlight those opportunities and how management plans to attack them.
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On track for Western Refining acquisition
Last November, Tesoro announced it was buying Western Refining for $6.4 billion; it was one of several deals in recent years to consolidate the refining industry. According to CEO Greg Goff, the integration of the two companies remains on track, and the deal is expected to generate immense benefits over the long term.
In March, stockholders of both companies voted to approve Tesoro's expected acquisition of Western Refining. We remain committed to delivering $350 million to $425 million in annual synergies from operational improvements, value chain optimization and corporate initiatives with the run rate to be achieved by the end of the second year following the close of the transaction.
The details of those synergies won't come until after the deal closes on Aug. 1. At that time, the combined company will also change its name to Andeavor, and Tesoro Logistics Partners will change to Andeavor Logistics. The companies will then trade on the NYSE under the tickers ANDV and ANDX, respectively.
Consolidating the logistics business
The minute that Tesoro announced it was acquiring Western, one question immediately came to mind. What will Tesoro do with Western Refining Logistics Partners (NYSE: WNRL)? It doesn't make much sense to operate two separate subsidiary master limited partnerships that do the exact same thing. According Goff, Tesoro plans to consolidate these subsidiaries as well as make some big changes to the ownership structure.
Given the current commodity price environment, the progress on our planned growth initiative, integration of our acquisitions and expected drop down to TLLP [Tesoro Logistics Partners] in the second half of the year, TLLP is on track to delivering approximately $760 million of annual operating income and approximately $1 billion of annual EBITDA in 2017.
In addition, we recently updated our 13D TLLP ownership filing with the SEC, indicating our intentions to work with the Board of Directors and management of TLLP to consider, discuss and endeavor to negotiate a merger, consolidation or combination of TLLP and Western Refining Logistics and to consider, discuss and endeavor to negotiate changes to the capital structure of TLLP, including with respect to incentive distribution rights.
Perhaps the most interesting component of that statement is the part about incentive distribution rights. These rights are a management fee that a partnership pays to its managing partner and is a percentage of total distributable cash. As per-unit distributions increase, that percentage increases. While it can be useful for incenting management teams to grow payouts early on, it drastically increases the cost of capital over time and makes it harder for the partnership to grow.
As more and more of these partnerships mature, we're seeing a big trend toward eliminating incentive distribution rights. Fellow refiner Marathon Petroleum also announced it plans to eliminate the rights it holds over MPLX, and several other companies have executed other strategies to eliminate these distribution rights.
While it may be hard to value these companies as they currently stand, chances are that restructuring will pay off down the road.
Headed down Mexico way
For decades, the Mexican oil and gas market has been walled off from foreign investment. Only the national oil company, Pemex, was allowed to have a presence in the country. But thanks to some business reforms, the Mexican market is opening up to foreign investment, and Tesoro is one of the first companies through the breach. According to Goff, the company sees a great opportunity.
Mexico recently announced its plans for deregulating downstream markets and a scheduled for liberalizing fuel prices in 2017. We have been actively studying this market and evaluating relevant opportunities. Mexico presents a tremendous opportunity to optimize and grow our integrated footprint along the West Coast through both branded and unbranded retail growth and supply related agreements. Last week, Tesoro was awarded capacity on Pemex's oil products pipeline and storage terminals in the Phase 1 open season for Northwest Mexico. We believe the Baja California and Sonora regions of Mexico are an excellent fit with our U.S. West Coast system.
Tesoro just signed that deal with Pemex last week. The company's long-term plan will be to expand retail and marketing under its ARCO brand. The northwest part of Mexico is perpetually undersupplied with gasoline and diesel -- about 150,000 barrels per day, according to Goff. With such close proximity to Tesoro's Los Angeles refinery, moving product into Mexico seems like a natural fit. Tesoro also believes that, once the Mexican government holds similar auctions for the other northern states, it will be able to utilize its El Paso refining capacity that it will get as part of the Western acquisition.
Making the grade
One of management's stated goals for this year was to receive an investment-grade rating. To get that, of course, it needs to prove it has an adequate balance sheet. On its conference call, CFO Steven Sterin made the company's case.
Including the senior notes issuance late last year, to prefund the Western Refining acquisition, total debt net of unamortized issuance costs was $6.6 billion, or 44% of solo capitalization at the end of the quarter. Excluding TLLP debt and equity, total debt was $2.9 billion, or 34% of total capitalization. Keep in mind the consolidated leverage numbers include the $1.6 billion in borrowings for the pending acquisition of Western.
It would appear that this was an adequate balance sheet because both S&P and Moody's have recently upgraded Tesoro to investment-grade pending the closing of the merger. Getting an investment-grade rating will go a long way toward lowering the cost of capital and should make it easier for the company to grow. With the Mexican market opening up, it's an awfully opportune time to have that additional access to credit.
Share repurchases in a pickle
As part of the post-merger plan, Stevin says that Tesoro wants to buy back a lot of stock to offset the dilution related to the merger. Unfortunately, it can't do that right now.
Although we are precluded from repurchasing shares at this time, following the close of the acquisition, we remain committed to executing on the $2 billion share repurchase authorization we already have in place, given the strong cash generative capabilities of both companies and our desire to repurchase shares, given both the current price of our stock and the issuance of the new units for the acquisition.
Tesoro generated cash flow from operating activities of $100 million in the first quarter. As I mentioned before, this was largely impacted by the working capital build during the quarter.
Tesoro currently has $2.3 billion in cash. That includes the $1.6 billion from borrowings to acquire Western. Based on the company's recent free cash flow results, it looks like this share repurchase plan could take a while. If it can achieve the synergies management claims it can, then that should be less of an issue.
