Delek US Holdings: Why Sum Of The Parts Is A Mistake (NYSE:DK)

Weerapong Khodsom Delek US Holdings (NYSE:DK) has been an “obvious” sum of the parts story for nearly two years now. The problem with that situation is at the end of the last sentence. For two years, management efforts to unlock any sort of shareholder value have fallen flat outside of some share repurchases. Investors have grown impatient, and I’d caution anyone from getting involved until we actually see some meaningful announcements being made. While a fun theoretical story to unpack, I think it is worthwhile to outline why investors should steer clear of this one. The Three Legged Stool Delek US Holdings as a business has three distinct lines of operations: Refining. Delek owns four PADD 3 refineries (two in Texas, one in Louisiana, one in Arkansas) with a combined refining capacity of 302,000 barrels per day. These are relatively complex refineries, primarily running West Texas Intermediate (“WTI”) as a feedstock. Retail. Through a network of 250 convenience stores in West Texas and New Mexico, Delek distributes a portion of its refined products to customers. Midstream. Delek US Holdings owns a 73.4% stake in Delek Logistics (NYSE:DKL), a publicly traded master limited partnership. It also owns the general partner. Notable that Delek also owns a 15.0% ownership interest in Wink to Webster, which has not been dropped down to Delek US Holdings. Before getting too deep into the thesis, now is a great time to note that Delek US Holdings consolidated Delek Logistics, its midstream arm. As a master limited partnership (“MLP”), Delek Logistics generates a lot of cash flow, and like many midstream firms it can afford to carry a significant amount of leverage given the cash generative nature of the assets. Even though that debt is non recourse to Delek US Holdings, it is consolidated on its balance sheet because the parent company exerts significant control over the midstream arm via control of the general partnership and its 73.4% ownership of all the limited partnership units. At first glance, versus other refiners like Valero (VLO) or Marathon Petroleum (MPC), Delek screens as having significantly more leverage. But, once stripping away that Delek Logistics debt, Delek US Holdings borders on being debt free. Leverage (and actual risk) is minimal. Sum Of The Parts On its most recent earnings call, Delek US Holdings management suggested $800mm in EBITDA as sustainable, mid-cycle earnings. I don’t disagree with that. Of that, roughly $420mm is attributable to Delek Logistics, $50mm to its Retail Distribution arm, and $330mm in EBITDA to the four refineries ($1,100 per barrel of daily capacity). Napkin math is all that’s needed here: 34.3mm units of Delek Logistics valued at $1,355mm Retail business at roughly $400mm (8.0x EBITDA, plenty of comps higher) Refining at $1,320mm (4.0x mid-cycle EBITDA) With all the debt attributable to Delek Logistics, this backs into a value of $48.00 per share. Readers will find numerous research notes penned by amateurs and more savvy professionals alike all over the internet with similar price targets to this, which would yield 100.0% upside versus today’s prices. I just outline napkin math above because it’s really all that’s needed to pitch the story. With the market cap of Delek US Holdings currently at $1,524mm, the Retail and Refining businesses are basically free once backing out the value of Delek Logistics. Investors can quibble on whether Retail will fetch more (some sales comps of gas convenience stores have touched 11.0x) or the potential of the four refineries that Delek owns, but it’s pretty darn easy to see the sum of the parts story. Delek Logistics Value Unlock Now we get to the crux of this note: “What is the problem with this thesis?”. Sum of the parts stories rely on the value getting unlocked in some way: asset sales, spin-off, share repurchases, and other means. Both management and the Board of Directors have to break the business to force the market to see the “true value” of the assets. In Delek’s case, they have been tasked with this for years but have failed to do so. Why? The biggest problem here is with the most valuable asset: Delek Logistics. There are two big things that I think sum of the parts investors don’t necessarily get or understand when it comes to the MLP. It’s easy to say “Buy Delek US Holdings, the value of Delek Logistics is basically the market cap, investors get the rest of the business for free”. But divesting and shedding Delek Logistics in a way that does not destroy the current implied value is not an easy task and is arguably damn near impossible. The number one reason is the “captive” nature of the partnership. Delek Logistics was started with assets that solely support the parent’s refineries, a situation which hurts the ability to sell the partnership in whole to a willing buyer. Now, Delek Logistics has worked diligently on increasing its third-party revenue share, but roughly half of EBITDA still comes from the parent. Captive Refining Partnerships There were a number of captive refining midstreams spun out during the boom times of MLP IPOs, many of which do not exist anymore: BP Midstream, PBF Logistics, Shell Midstream, Valero Energy Partners, and several others. Precisely zero of those were bought by an independent third party; all of them were rolled back up into the parent. There have been two buyers of midstream assets over the past five or so years: the publicly traded companies looking to build massive size and scale (Energy Transfer (ET), Enterprise Products (EPD), etc.) and private money institutionals. For the public companies, owning and operating pipelines that serve refineries does nothing to further their primary goal: control of hydrocarbons from wellhead to water (export facilities). None of them are meaningfully involved in pipelines that feed refineries. They are just not interested buyers, and the management teams at any of these firms will state that clearly. For private institutionals, the single party concentration and risk involved in contract renewals is often too much to overcome. They just won’t pay premium EBITDA multiples to take on that type of risk. Refineries close, peak oil is still a reality at some point. But even greater is the risk for Delek as the owner of refineries: getting involved with shrewd private money. Once again, these are captive assets, meaning there is no optionality to go to another provider. Competing lines would have to be built from scratch. If a private institutional comes in and wants to jack up rates on renewal, Delek has limited recourse that does not jeopardize its refinery being offline for many quarters, if not years. Right now, rates between the two parties are set by negotiation between the Conflicts Committee, but the end of the day, the power sits with Delek US Holdings as the general partner and majority owner of the limited partnership. That all goes away if someone like Arclight or EnCap buys in and decides to play hardball. Contract Headaches Making matters worse, Delek Logistics contracts with Delek US Holdings are nearly up on those assets supporting the Tyler and El Dorado refineries; the other contracts are also relatively short in duration. Private equity might feel more secure in contracts with longer duration (e.g., fifteen or twenty years), but Delek US will never agree to that kind of length. An analyst with Truist tried to pry into this during the Q1 call but got basically nowhere. No timeline was given on settlement of the issue. Question: Maybe just talk about your MVC contracts. Any update, particularly on Tyler or El Dorado? And then just, again, just how the other sort of — you’re looking at other contracts, are you continue to try to extend the duration or where do you sit with most of these other maybe prospective MVC contracts? Answer: Yes. So Neal, the intent of Delek Logistics is to renew this contract, and that’s something that Delek Logistics is working on. Harsh Reality In my opinion, Delek Logistics cannot be sold as a whole. Thus, there are two options here in my opinion: Break the business in half. Sell the third-party assets to a willing buyer and roll the captive pipelines back up to the parent, mirroring what other operators have done. Sell down the limited partnership stake to deconsolidate. Get the non-recourse Delek Logistics debt off the balance sheet, raise money via the sale of MLP units to third-party buyers in the public markets. This does not fully solve the sum of the parts discount, but it does bridge it. The simple sounding resolution is to just split the assets in half. Anything supporting the refineries can be rolled back up into Delek while the independent third-party business can be sold to willing buyers. Nothing here is that simple, though. The Storage and Transportation business is nearly entirely affiliate revenue which would go to Delek, but the other assets are comingled. For instance, in Wholesale Marketing and Terminalling, Delek Logistics owns eleven light product terminals in Texas, Tennessee, and Arkansas. These terminals are located nearby to Delek US Holdings assets, so they are integral to the business. But they also comingle third-party product on volumes that Delek does not fill, which it then ends up distributing into local markets. It’s not as simple as saying “This terminal is entirely third party so it is sold, this one is core to the refining business so it is kept”. It’s akin to the Judgement of Solomon; you can’t cut the child in half to make two parties happy. What about selling down the limited partnership stake? As of last quarter, Delek would have to shed roughly 11.0mm units to get below 50.0% ownership, at which point it could make the case to its auditor to deconsolidate Delek Logistics, all while raising hundreds of millions of dollars that could be distributed to Delek US shareholders. This is the playbook that Occidental Petroleum (OXY) took with Western Midstream (WES), arguably to great success to both. The problem is that Delek Logistics just fielded a secondary offering of 3.1mm units and had to eat a 13.5% discount to the trading price before the announcement. The unit price has still not yet recovered months later. Appetite would be even worse for a sale by the primary owner versus the clean secondary of new units that just happened, never mind the market digesting a sale of four times that volume even spread over time. The buying pool for Western Midstream was just much healthier, and I don’t see a way for Delek to drive similar interest. Takeaways There really is just no simple way for Delek to receive the full value of the units where they trade in the market, especially where units were trading before ($45.00 per unit, so 10.0x EBITDA). Even today, at the EV/EBITDA discount post secondary that now exists, I think limited partner owners (both smaller owners and Delek US Holdings) would risk severe harm to the value of their units if Delek US began selling down its stake. That’s why management continues to sit on its hands. It can’t unlock the value of the midstream partnership at near current prices, and also has to be careful not to create a situation where it might face higher – or even usurious – tariff rates on pipelines it now happily controls. It’s just easier to sit back and collect a 13.7% yield on those units. Make no mistake that cash has value. Management and the Board of Directors can put it to good use: share repurchases, upgrading and modernizing its refineries, or buying new assets entirely. Investors can and should place value on that, and investors can make a case for Delek US Holdings being a great buy on that basis. But I think the sum of the parts is a mistake here, given the inability to unlock that value.

Buy cryptocurrency

Source link

Refer And Earn Demat Account – Get ₹300 | Referral Program

Open Demat Account In Angel One For FREE