Par Pacific Holdings (PARR) is backed by a group of investors including Sam Zell’s Equity Group Investments and Whitebox Advisors holding together close to 50% of the equity outstanding. Recently, both investors reduced their holding in the company. Sam Zell and his team have been involved in a number of similar investments in the past namely investing in NOL shell companies via debt restructurings.
PARR has a massive potential asset in form of net operating losses (NOLs). Total NOLs sum up to USD 1.4 bn. Provided that the company produces taxable income, NOLs can be used to minimize tax payments. Based on a 35% tax rate, management illustrates the NOL’s value to PARR in the following tables:
As of October 2016:
As of June 2016:
Outcomes differ due to varying assumptions for the usage of NOLs. You can also see that management currently seems to be less bullish on future profits compared to June 2016. That is mostly due to current pressure on crack spreads in the refining industry. PARR owns two different niche refineries. They also own mid stream assets and PARR has an interest in an upstream joint venture. I will briefly recap PARR’s most important holdings in the following paragraphs:
Hawaiian retail, mid and downstream operations
The company fully owns a Hawaiian refinery, retail outlets selling gasoline, diesel and retail merchandise across the islands and logistics operations for distribution of refined products. PARR’s refinery is located in Kapolei and is one out of only two refineries in the state of Hawaii. The other one being smaller in throughput was recently sold by Chevron to a private equity investor. Refineries operate in a cyclical environment with profitability mostly depending on crack spreads and crude price differentials. The current decline in crack spreads and a regular turnaround of the refinery has led to a decline in earnings for the Hawaiian operations this year.
Over a full cycle management targets EBITDA of USD 100 m per annum.
Natural gas exploration and production
In addition to that, the company owns a stake in Laramie Energy, a joint venture entity focused on producing natural gas in Piceance Basin in Western Colorado. Other equity investors in Laramie include Avista, EnCap, APriori and Wells Fargo. After my initial investment, PARR participated in an equity raise contributing USD 55 m to Laramie and increasing its ownership in Laramie from 32.4% to 42.3%. Laramie used the proceeds from the equity raise to acquire properties in the Piceance Basin for a total of USD 157.5 m. A significant portion of the operations acquired are directly adjacent to existing Laramie operations. The acquisition is expected to contribute to substantial cost savings. Management estimates unit costs to decline by 40% in the first year of combined operations:
Management provided a lot of background in the latest conference call concluding with the following remark:
“In summary, Laramie proved reserves has increased to 1.1 Tcfe of natural gas. Total proved plus probable reserves are nearly 8.2 Tcfe without reflecting any of the considerable Mancos potential. Laramie’s probables at a PV20 result in discounted cash flow value of approximately USD 400 m. Combining this amount with the PV10 of Laramie’s proved reserves totals nearly USD 950 m of estimated 2P reserve value based on the June 30 NYMEX strip price.”
Laramie is modestly leveraged with no near term debt maturities. Laramie’s debt, which is non-recourse to PARR, is currently USD 121 m. Debt to EBITDA on an annualized basis was 3.2 times as of second quarter 2016. In addition, Laramie has USD 29 m of preferred units outstanding. PARR’s carrying value for its 42.3% holding is USD 112 m implying a USD 416 m enterprise value for 100% of Laramie. Hence, Laramie is not consolidated on PARR’s balance sheet.
Due to Laramie’s limited ability to participate in PARR’s usage of NOLs, a disposition of the holding in Laramie might provide a catalyst to PARR’s stock price in the future.
Wyoming mid and downstream operations
In July 2016, PARR completed the acquisition of a regional Wyoming refinery for a cash consideration of USD 213.4 m and USD 58.0 m of debt. The refinery has a relatively small throughput capacity of only 18,000 barrels per day. About USD 95 m have been invested in the refinery over the last four years by the former owner. The transaction includes a crude oil gathering system. The direct access and the proximity to the nearby Powder River Basin led to an average discount in crude procurement of USD 3.8 per barrel versus WTI over the last ten years. Compared to the Hawaiian refinery where the discount ranges USD 0.5 to USD 1.5 this is quite attractive. The refinery buys roughly 9% of total Powder River Basin production. A wholly owned clean products pipeline system serves nearby Rapid City, and a wholly owned jet fuel pipeline serves nearby Ellsworth Air Force Base. The next closest refinery is roughly 250 miles away. Hence, there is limited supply in this area. Consequently, the refinery has been highly profitable with crack spreads averaging USD 18.2 USD per barrel over the last 3 years.
According to management, the Wyoming refinery operations are expected to achieve mid cycle EBITDA of USD 50 m per annum.
PARR’s cost of capital
In the following paragraphs, I will have a closer look at PARR’s cost of capital. As PARR’s business model is based on buying positive cash flow generating companies to capitalize on tax savings, the cost to finance these acquisitions plays a pivotal role.
Cost of debt
So in the case of the Newcastle refinery acquisition in Wyoming the total purchase price is USD 271.4 m leading to a multiple of 5.4 times or a yield of 18.5%. At the last conference call an analyst made the following statement:
“Just as a sort of a general background, certainly you are financing for what looks like it’s about 18% that could return on investment right off of that in the Wyoming refinery and financing a chunk of it with 2.5% and 5% money. These two have enhanced your – that arbitrage the loans seems to enhance your sort of net asset value at the Company. At the same time of course, this is a time when 20% or even 25% if you take an inverse of operating profit to capitalization, this is not unusual in the refining industry these days. So, I guess my question is; one, do you think that you will continue to see opportunities to take advantage of high returns relative to your cost of funds on the money?…”
I think that this statement is at least partially wrong. Here is why: According to the analyst, the company finances the acquisition at a cost of capital between 2.5% and 5% while generating an 18% yield when investing the capital. The analyst is referring to a 2.5% bridge financing of USD 50 m and 5% convertible notes with a notional of USD 115 m which provide a large portion of the capital needed to complete the transaction.
By reading through the notes of the financials, it becomes pretty clear however that the actual cost of capital for these two financings is much higher than between 2.5% to 5.0%.
The capital for the 2.5% bridge financing was provided by two shareholder groups including Sam Zell’s Equity Investment Group and Highbridge Capital Management. In addition to interest payments, they also received a 5% fee or USD 2.5 m. At the end of September 2016, 94% of the bridge financing was repaid by raising equity of USD 50 m in gross proceeds (the rest was converted into equity at USD 12.25 per share). Hence, from the deal closing in mid July 2016 until the end of September 2016, Sam Zell and Highbridge Capital received USD 2.8 m in payments or an annualized total return of 26.5% on their capital.
The 5% convertible notes with par value of USD 115 m were issued at 97%. Hence, in fact the company paid an additional fee of USD 3.5 m to creditors (and offering expenses of USD 0.9 m). In addition, the notes can be converted to equity at USD 18 per share in 2021. Consequently, the effective interest rate is significantly higher than 5% when accounting for the discount at issuance and the conversion option.
In addition to that, the company had to pay a consent fee to the creditors of an existing term loan in an amount of USD 2.5 m to allow for the issuance of the bridge financing and the convertible notes. Thereof, USD 1.3 m was paid to an affiliate of Whitebox Advisors, one of the creditors and one of PARR’s largest shareholders.
Consequently, there have been at least USD 8.5 m of additional financing costs for a notional of USD 165 m. That is a substantial portion and puts the analyst’s statement above into question.
The table below provides a summary of the company’s current debt financing:
Excluding the USD 50 m bridge financing which has been repaid/converted into equity already, the weighted average interest rate is between 6.0% (cash interest rate) and 6.4% (PIK interest rate). With the additional costs involved as described above all in marginal cost of debt should be at least 150 bps higher.
Cost of debt between 7.5% and 7.9% is pretty high in this low interest rate environment especially with high yield bonds currently trading around 6.0%.
Cost of equity
Before the Wyoming refinery acquisition, PARR used to finance acquisitions with private placements and/or loans from the major investors. Minority shareholders could not participate in equity raises. For instance, the add-on acquisition of Laramie (see above) which was announced in December 2015 and completed in March 2016 was financed with a private placement. New shares were offered to certain pre-existing shareholders and other investors in a registered direct offering at USD 22 per share in November 2015. The price of the shares sold in the offering represented a 6.0% discount to the 30-day volume-weighted average. Offering expenses were roughly 1.3% of gross proceeds. Currently the share price is at USD 14.
At that point in time, I was not really happy about being excluded from the capital increase. However, in hindsight I believe that this method of raising equity is one of the more efficient ways for this type of company. This is because issuance costs are relatively low and more importantly the pressure on the share price seems to be higher when shares are offered via a public rights offering. This method also provides more flexibility from a timing perspective when a window of opportunity opens. Of course, one major reason for the recent stock price decline seems to be deteriorating earnings in 2016, but I believe that the recent volatility in the stock price was also triggered by the equity issuance.
A stable/increasing share price for this type of company making acquisitions on a regular basis and depending on equity as a relatively cheap source of financing is crucial. If market participants believe that the management made the right acquisitions enabling the company to make use of its NOLs, the share price will increase. Consequently, the company is in a more convenient position to issue equity and to finance the next acquisition with the goal to accelerate the use of NOLs. Hence, successful acquisitions provide the company with easier access to relatively cheap capital potentially accelerating the use of NOLs and leading to further stock price increase. In the case of PARR, this self-enhancing process seems to be broken as the recent capital increase took place almost 60% below the 52 week high.
Costs for the equity issuance were pretty high. At USD 12.25 per share, the company has an equity value of USD 557 m. Excluding Laramie’s carrying equity value of USD 112 m (pls see above) PARR has an equity value ex Laramie of USD 444 m.
Management has confirmed a couple of times that mid cycle earnings potential is USD 150 m for the combined operating businesses excluding Laramie. From 2017, management expects maintenance capex spending to be approx. USD 15 m. I expect financing costs to be another USD 30 m annually. In this scenario, normalized pre-tax cash earnings reach USD 105 m.
Consequently, the equity issuance was priced at an earnings yield of 23.6% reflecting strong doubts by market participants that PARR will be able to realize management’s profit expectations.
The earnings yield at equity issuance implies a four times multiple on earnings. PARR’s net debt to EBITDA ratio is 2.9 times and there are no major debt repayments before 2018 with the majority of debt financing maturing after 2020.
From an operational perspective, refineries seem to be part of a declining industry due to increasing environmental regulation and the prospect of electric transportation /renewable energies providing a valid alternative to conventional solutions. In Colorado (Laramie) and Hawaii (Par refinery) environmental groups and politicians are putting pressure on the “old” oil and gas economy.
However, PARR’s refineries are also special with regard to proximity to their customers and limited competition. The Hawaiian refinery is in the process of extending higher margin on-island sales potentially leading to higher profitability. The Wyoming refinery is already generating above industry average crack spreads due to its favorable location and infrastructure assets.
Consequently, I believe that the operating risks are covered by the current valuation. At the same time, earnings surprise and a potential disposition of Laramie might provide a catalyst going forward. However, PARR’s cost of capital is very high due to (i) relatively high costs of debt, (ii) majority shareholders squeezing out fees of the company (ii) and a low stock price making equity issuance very costly. Therefore, for the time being I will not increase the current position size of this investment.
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