Position Disclosure: Delek US
It's Definitely Cheap!
The challenges within the refining sector are clear: they sell a commodity product, in a highly cyclical industry, and are capital intensive. Crack spreads are down bad with the sector sitting at -43% on the year. I have no clue how future supply and demand will develop, but as Ben Graham said, “a sufficiently low price can turn a security of a mediocre quality into a sound investment”.
At $12 a share, Delek is most definitely below such a price.
Fun fact: there has not been a new refinery built in North America for 48 years.
48 Years!?
That’s right. The last major greenfield refinery went online in 1977. Since then growth in demand has been met by imports and expansions at existing sites.
Too Cheap to Ignore
Delek (DK) owns 34.1M shares of Delek Logistics (DKL), currently worth $22 per DK share. There are concerns over DKL’s low float and that MLP funds prop up the share price through forced buying. However, the current valuation is supported by peer multiples and an 11% distribution yield. DK consolidates DKL’s financials, adjusting for DKL’s non recourse deb puts DK level net debt at $159M.
Delek also owns 4 refineries in the Gulf Coast Region as shown below.
2025 guidance is for $160M of Capex, while G&A will be ~$220M and DK level net interest ~$50M. Taking guidance at face value and using historical crack spread capture rates, I estimate an all-in 2025 breakeven crack spread of a little under $14/bbl. Note that crack spread take rates are volatile making this hard to nail down.
Delek suggests a mid-cycle valuation of $27 - $34/share. I’m a little more conservative and have assumed slightly higher G&A with a 4x mid-cycle EBIDTA multiple for a value of $25/share.
Putting it all together we have: $22/share of DKL + $25/share for the refineries for a total of $47/share. Note that Delek receives $150M in annual DKL distributions which fully covers DK’s dividend ($60M) and interest expense ($50M).
Shares currently trade at $12/share… Regardless of how you cut it, Delek is definitely cheap.
Usually I like to stick with the low cost operator when investing in a commoditized industry. It’s safe to say that Delek is definitely not that. They’re generally considered one of the higher cost refiners on the continent, and their higher quality midstream business; DKL, is heavily tied into DK which puts it in a weaker position as well.
It’s not all bad though. Delek has been bringing costs down and DKL now derives more of its earnings from third party sources than ever before.
SOTP Unlock, Will It Happen?
Yes, but slowly…
Management have been talking up a value unlock for some time now and are finally starting to deliver results.
June 2022 - Delek brings in new management. They highlight the significant SOTP discount and promise to address it.
Sept 2022 - In the first investor presentation under the new CEO, Delek mentions unlocking the SOTP disconnect for the first time. They also hire a new head of corporate development whose focus will be “bringing the "sum of the parts" valuation to fruition”.
March 2024 - Management continues to reiterate their focus on unlocking the SOTP discount despite having made no real progress over the last year and a half. However, their Q4 earnings release suggest changes are coming. DKL priced a secondary offering diluting DK and increasing liquidity. They also suggest bankers have been hired to shop their retail segment
Aug 2024 - Delek completes the drop-down of its Wink to Webster pipeline to DKL in exchange for cash.
Sept 2024 - Delek closes the sale of it’s retail segment for $385M.
Oct 2024 - DKL completes another secondary offering.
Jan 2025 - DKL acquires water disposal and recycling operations from H2O Midstream using a mix of cash and units further diluting Delek, increasing float, and increasing third party earnings.
Concerns
Management is in no rush to address the SOTP discount as it gives them more time to accumulate shares on the cheap → This gives me time to do the same!
DKL is overvalued as it's price is set by MLP funds who are forced buyers → DKL trades at a forward EV/EBITDA of 8x and an 11% distribution yield, in line with peers.
DK's refining assets sit too high on the cost curve and are at risk of being shut down if supply/demand dynamics turn south → DK’s history of refining earnings suggest otherwise and management are executing on their cost reduction plan.
DK and DKL are too interdependent and cannot be split → This is my primary concern and it was indeed the case that DK/DKL had no hope of being separated until very recently. The ability to separate is gradually being proven out though as DKL continues to diversify away from DK (retail sale, secondary offerings, H2O purchase). Keep in mind the retail assets were viewed in a similar light but were ultimately able to be separated out.
DK is hated in the market because 1) management over hyped their SOTP discount, and 2) it makes for a great short in a pair trade. If DK shuts production, it and DKL are toast while competitors benefit from the decrease in capacity.
In Summary
Investors are clearly frustrated with Delek’s slow pace of progress. There are obviously complex tax, legal, accounting, etc. factors at play, but management haven’t helped themselves being so vocal about the unlock.
Despite this, management has made notable progress to address the SOTP and cost concerns. To summarize, over the previous 2 years Delek has:
Reduced G&A + OpEx from $11.27/bbl to $9.60/bbl, and is ahead of schedule on the $100M optimization plan announced in September.
Reduced it’s stake in DKL from 79% to 64%.
Reduced DK level net debt by $400M.
Repurchased $127M of stock.
Paid out $125M in dividends.
I’m buying at $12/share, a ~75% discount to fair value, and while I wait for the SOTP unlock to play out I’ll be collecting a 8.5% dividend.
Disclosure: This newsletter does not provide investment advice. Information presented is for informational purposes only and should not be considered a recommendation to buy or sell securities. The author may or may not own the securities discussed.
Great one!