Second Quarter letter to Covestor

Markets never go up straight or go down straight either. If you are a long term investor market jitters should not scare you. It is even better if you had purchased some of your watch list stocks when market went down recently.  Our overall economy trending up, fundamentals are good, housing market showing strength, unemployment, manufacturing numbers are getting better. As more people getting employed there will be more consumer spending. I see clear skies ahead. Occasional markets down turns are good; sometimes they will hand good stocks at great prices.

As I discussed in my earlier letters gold has started trending down. All these days gold traders were able to sell snake oil by scaring the masses with war premium, unexpected inflation and dollar depreciation.  So far none of them were materialized. Inflation is still at or below one percent for the long time. In fact dollar is going to appreciate as real interest rate is going to go up.  It takes longtime to form market bubbles but it takes one little pop to start the melt down. That is what happening in the gold market. Chinese and Indians can’t buy all the global gold output in the world.  Gold is neither consumable nor perishable good and there is no intrinsic value for it. It does not yield anything; the true value of the gold is whatever other person willing to pay for it.  As of now Hedge funds are dumping gold; sooner or later central banks around the world will start selling gold reserves while prices are still high.  That is what happened during recent internet bubble and housing meltdowns. Mark Twain once famously said “History does not repeat itself, but it does rhyme”.

In this letter we would like discuss one of an undervalued stock in our portfolio, Holly frontier. Holly frontier is an independent oil refiner, refines approximately 450,000 barrels of crude at its five refineries. Holly refinery products include gasoline, diesel, and jet fuel. One of its subsidiaries owns 39 percent including 2 percent general partnership in Holly energy partners a pipeline company. Holly’s refineries at El Dorado and Tulsa are very next to Cushing, Oklahoma a storage hub for mid-western oil and where it purchases crude oil cheaper than competition.

Refineries make profit from crack spread that is the price difference between crude oil input and refined products such as gasoline, jet fuel and diesel. Crack spread is generally priced on Brent crude (Global crude oil) prices. However Holly frontier acquires all of crude domestically known as West Texas Intermediate (WTI). West Texas Intermediate trades lower relative to Brent due to rapidly growing domestic oil production from Bakkan shale fracking technology. At some point the spread between WTI and Brent was twenty dollars and recently at six dollars. So Holly margins come from two fronts, one from crack spread in addition to spread between Brent and WTI oil. Due to its unique proximity Holly generally pays WTI price compared to its competitors at gulf shores pay Brent price. This spread may continue for couple more years until Seaway pipe line completes which transports oil from Cushing to Texas Gulf.  During first decade of the century, WTI traded on average $1 more than Brent, but Holly’s ROIC during that period was at average of 22 percent.

Whatever market perception may be, Holly Frontier is trading relatively cheaper to its peers and to its intrinsic value.  As of July 1st the PE ratio of Holly is 4.6 and trading 1.3 times the book value. Holly’s average five year return on equity is at 29 percent and return on investments is 20 percent.

As of now Holly has 204 million shares outstanding, and last year operating cash was $1.6 billion and spent $335 million on capital spending, that lest $1.3 Billion of free cash. In other words the free cash per share is $6.5.  Assuming there is absolutely no growth and industry stays same, at $42 per share, you will get your investment back within six and half years.  Holly balance sheet has $2.5 Billion of cash and minimum debt and last year it paid $2.50 special dividend and $0.60 on regular dividend, which is equivalent to 7.4 percent dividend.  Market seems to ignoring screaming value stock, but we think Holly is one of the stocks trading well below its intrinsic value and should trade lot higher than current price.