Consolidation in the refining sector is a clear signal towards the expected fall in crack spreads. Although crack spreads were already falling, M&A activity in the sector cements this belief that the time of low oil prices might be coming to an end. Tesoro’s (NYSE:TSO) acquisition of Western Refining (NYSE:WNR) serves a number of purposes for the company. The issue of weakening crack spreads is there, but the strategic importance of this acquisition goes beyond just the cost control and synergies.
The acquisition will bring three new refineries to Tesoro’s portfolio and it will become the fifth largest refiner in the country. More than anything, this transaction brings a fair bit of geographic diversification to Tesoro’s business mix. It brings the company to Permian, which is the most productive area in the country. It is understandable that the upstream companies are focusing on this area due to the cost advantages. However, being close to this region allows the refiner to have access to the most productive area. Logistical problems are going to be lower here and the access to this crude will allow Tesoro to manage its cost efficiently. According to EIA, drilling is mainly focused on the Permian basin.
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Along with the diversification, this acquisition gives Tesoro the benefit of scale. Total refining capacity will reach 1.1 million barrels. Future growth in EBITDA for Tesoro was likely to come from the marketing business as the company was aggressively growing this segment. Addition of Western Refining’s retail business will further give it a boost.
Tesoro shareholders will be paying for the acquisition as the management has been able to convince Western Refining’s board to accept an all-stock transaction. This was a reason the stock price took a dive the day Tesoro announced the acquisition. However, as the short-termism dissipated, the stock price started to move up. The long-term benefits of the deal are plenty and the transaction terms will further strengthen the balance sheet. This will ensure growth in dividends. Total value of the deal is $6.4 billion and it includes $1.7 billion in Western Refining’s debt and a stake worth $604 million in Western Logistics.
It is an all-stock transaction offering 0.435 of Tesoro’s share for each Western Refining share. There is also an option of cash but that is limited to $404 million. If the Western Refining shareholders opt for cash, then the cash disbursed will be prorated. The structure of the deal is extremely favorable for Tesoro and will have a number of positive effects. Management was keen to highlight that the transaction will allow them to maintain the credit metrics. Moody’s also agrees with the management as the cash outlay is going to be small and the company will also not borrow to fund the transaction. As a result, the credit metrics will improve.
A possible challenge might come in the way of increased dividend. Tesoro wants to maintain its current quarterly dividend of $0.55 per share. Addition of new shares will increase the dividend payments. Furthermore, the management also doubled the share repurchase plan to $2 billion. This means that the commitment to shareholders has increased considerably and it looks like the management is trying its best to appease the shareholders. All-stock transaction is sometimes not favored by the shareholders and the addition of new shares creates doubts about a company’s ability to maintain or grow dividends. However, it looks like Tesoro will be able to generate enough cash flows from combined operations to grow its dividends. Rising oil prices mean the price at pumps will also increase. This will cause the marketing margins and cash flows to go up. Refining margins are not going to take a sharp dip in the short term because the oil prices are still expected to remain around $60 in the next twelve months. This is also the time frame that will be needed for this merger to start yielding synergies for Tesoro. $130 million worth of operating synergies should strengthen the cash flows.
EBITDA figures are good. The company has nine-month EBITDA of more than $1.8 billion, and full-year EBITDA will likely be in the region of $2.2 billion. This means that the total leverage ratio will be around 2.1x. These figures are without the addition of Western Refining’s debt or EBITDA figures. Moody’s is expecting the consolidated debt/EBITDA ratio to remain below 2.75x. As a result, Moody’s has changed the outlook to positive from stable for Western Refining, its subsidiaries and Tesoro Logistics. Tesoro already had a positive outlook. These metrics give support to Management’s claims of having an investment grade credit rating.
This deal is extremely attractive for Tesoro and its shareholders. Despite an increase in oil prices, the overall cash flows are going to remain strong. Growing marketing business will enhance the cash flows as the rising oil price will result in increased price at the pump. The structure of the transaction is favorable. This deal has made Tesoro a key player in the sector. In my opinion, it is now one of the best picks in the industry.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.