Tesoro: Refiner a Buy on Two Big Positives

NEW YORK ( TheStreet) -- Tesoro ( TSO) is one of the leading independent refiners and a marketer of petroleum products in the Western United States. The company operates through six refineries, with a combined capacity of more than 845,000 barrels per day while its marketing arm includes more than 2,000 retail stations, of which nearly 600 are operated by the company.

Tesoro recently reported its quarterly results in which it managed to beat the revenue but missed the earnings estimates. However, despite the mixed results, there are several catalysts at work that could give a boost to the company's shares in the near future.

Tesoro is eyeing considerable improvements in its output as well as its margins. With impressive growth prospects, a PEG ratio of just 0.45, which is the lowest in the industry, and a price-to-sales ratio of just 0.2, the company looks seriously undervalued. Therefore, I believe that Tesoro could be a healthy addition to your portfolio.

In its quarterly results announced earlier this month, Tesoro reported a 77.4% year-over-year drop in adjusted earnings to 44 cents per share, missing analysts' estimates by 5 cents per share. The massive decline was due to the 43% increase in operating expenses and a significant reduction in refining margins.

However, Tesoro's throughput increased by an impressive 57% year-over-year to 863,000 barrels per day. Earlier in June, Tesoro acquired BP's ( BP) Carson refinery and other related assets for $2.33 billion, including more than $1 billion of inventory. This acquisition has given a boost to the company's output from its Los Angeles operations, which now includes the Wilmington and the newly purchased Carson refineries. With the exception of its Mid-Continent business, where its output fell 2%, Tesoro's refineries in all other regions reported an increase in throughput.

Meanwhile, Tesoro's retail segment delivered a better performance with 124% increase in fuel sales (also a result of the acquisition) and a 6% increase in merchandise sales from the same quarter last year.

With this output increase and a better performance from retail segment, Tesoro ended the quarter with a solid 42% year-over-year increase in revenues to $11.24 billion, zooming past the market's consensus estimate of $9.45 billion.

Tesoro is a company in transition towards becoming a bigger, more efficient organization. For a refiner, this would translate into three primary objectives; an increase in output, better utilization and improvement in margins. Based on the results discussed earlier, Tesoro has clearly delivered a strong performance in terms of output and utilization. This was the first of the two big positives from its earnings release. On the other hand, the weakness in refining margins has led to the significant drop in earnings.

So what is Tesoro's plan for the future? It has increased its capacity after the massive acquisition, but how is it going to improve its margins? This brings us to the second of the two big positives: Tesoro looks poised to significantly increase its earnings in the coming years.

Firstly, Tesoro has just acquired the Carson refinery a few months ago so its full benefits have not been realized yet. The company has been working to integrate the new refinery with its Los Angeles operations. Through integration, Tesoro will be able to bring down its manufacturing, crude oil shipping and distribution costs. In other words, Carson will not only give a boost to Tesoro's bottom line (its base assets will add around $500 million to Tesoro's annual earnings), but it will also enhance its margins.

Investors should note that during the conference call, Tesoro's management has repeatedly pointed out that the synergies coming from the integration of Carson refinery have been "even greater than we originally thought". The management will provide an update on this on Dec. 10.

That is an important date to remember. Its shares could continue to rise in anticipation of any positive news, which itself, could turn into a catalyst for an upside.

Secondly, the ongoing development projects at its refineries are going to considerably increase Tesoro's income in the coming years. Tesoro has also recently completed the expansion of its diesel desulfurization unit's capacity which will add around $11 million to its annual earnings. Currently, it is working on its Salt Lake City conversion project which will improve Salt Lake refinery's output and yield. The project will be completed by the end of 2014 and will increase Tesoro's annual operating income by $100 million.

Thirdly, and perhaps more importantly, Tesoro will increase its deliveries of inland U.S and Canadian heavy crudes to its West Coast refineries. These crudes are cheaper as compared to other imported oil. This shift towards low-cost alternative will give a boost to Tesoro's profitability. Add its massive throughput capacity to the equation, and this translates into a significant increase in earnings in the long run.

In September, Tesoro started shipping the cheaper North Dakota Bakken oil to its refineries and so far, it drastically increased the shipment volume by 3 times. However, the company has now reached the limit of the offloading capacity, which is operated by a third party. It cannot get any additional Bakken oil than what it is getting right now. But Tesoro has even bigger plans.

Tesoro is currently developing a $100 million rail-to-barge oil terminal, with unit train unloading and marine loading facility, through a 50/50 joint venture with Savage Services at Washington. The terminal will have an initial capacity to handle 120,000 barrels per day, with expansion capability which could more than double its capacity. The project will be completed by the end of 2014 or early 2015 and will significantly increase Tesoro's oil sourcing flexibility, which will enhance its margins.

Moreover, the facility can also be used to generate revenue by providing services to other refiners in the West Coast, such as Phillips 66 ( PSX). Like Tesoro, Phillips 66 has also invested in infrastructure to get more inland U.S. and Canadian crude.

At the time of publication, the author held no position in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.
Sarfaraz A. Khan is a capital market analyst and finance writer. Khan earned an MBA from the University of Aberdeen, located in the heart of the UK's oil and gas industry. Not surprisingly, his specialty lies in energy stocks. He also covers consumer goods, services sector, technology stocks, emerging markets and ETFs. His work appears on Seeking Alpha, Motley Fool and TheStreet.