FTO Looks Refined

After its share price peaked above $49 last year, refiner Frontier Oil (FTO - commentary - Cramer's Take) sunk to intraday lows in the $20s last month before starting a rally on the news of Valero's (VLO - commentary - Cramer's Take) positive outlook on that company's latest conference call. My biggest surprise, looking over the data for Frontier and the industry, is why it hasn't rallied even more.

First of all, Valero indicated that "Current industry conditions are setting the stage for rebounding gasoline margins." If true, that would be equally positive for Frontier and others.

Not that I don't believe Valero, but I thought a check of the PPI industry statistics could provide an unbiased second opinion.

Petroleum Refineries PPI, 12-Months Percent Change

Click here for larger image.

Source: Bureau of Labor Statistics

Lo and behold, year-over-year price increases for petroleum refineries have suddenly shot straight up. If that doesn't set the stage for rebounding margins, what will?

Hardly a week later, there was actually speculation that Valero would buy Frontier. According to the Reuters article, however, Fadel Gheit, an Oppenheimer oil analyst, also questioned the rationale behind Valero buying Frontier, especially since Valero has already sold one refinery and has said it would sell two and maybe three others.

Sold a refinery, you say? That sounds like a ripe opportunity for a comparables analysis to see how Frontier's valuation stacks up against an arms-length transaction between industry experts. And, at first glance, Frontier doesn't come out looking so hot.

Valero's Lima, Ohio, refinery was sold last year to Canada's Husky Energy for $2.1 billion. Lima's 165,000 barrel per day stated capacity being quite close to Frontier's total capacity of 162,000 barrels per day, the comparison initially looks valid. And with Frontier's enterprise value at $3.6 billion, the implications could be that Valero's management got ripped off, Frontier is overvalued, or the assets aren't really comparable.

Valero is a good company, and I don't believe that its experienced managers got ripped off. The other two theses can be tested by comparing the assets. According to Husky's road show slides, it seems as though Lima was something of a fixer-upper. Running well below the stated throughput, its sales and profitability were not close to those of Frontier. Taking the 2006 performance as an example, I was able to compare the valuation relative to various fundamental metrics.

Although Frontier looks more expensive on the basis of throughput or sales, its full-throttle capacity utilization has resulted in a far more efficient operation. As a result, Frontier is cheaper based on EBIT or EBITDA, which are the valuation measures most frequently used in the industry.

Of course, running at full capacity also means there is little room for further improvement other than through the commodity prices themselves. Even considering a fair valuation, that could mean there is significantly more downside risk than potential upside.

I also looked at Frontier on the basis of my favored valuation tool, its free cash flow yield. In this regard, Frontier's yield on trailing free cash flow is about 6.2%, which is sufficiently above the yield on five-year Treasuries that I don't need significant growth to justify a purchase. The potential rebounding margins, in other words, is a bonus.

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At the time of publication, Trent had no positions in the stocks mentioned, although positions may change at any time.

William A. Trent, CFA, is a freelance equity analyst based in the New York metro area. He has been an equity analyst since 1996 and is co-author of Understanding and Evaluating Prospectuses, Offering Documents, and Proxy Statements. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Trent appreciates your feedback; click here to send him an email.