Analysis

I was really disappointed in the analysis I performed on my last round of MFI picks. I feel as though I was just being lazy, and forgetting a lot of the great stuff that I learned. Since then, I read The Dhando Investor and for some reason, the explanation in that book of discounted cash flow analysis just clicked for me. I'd heard of them before, but I just did not understand them with the clarity that I think that I do now. DCFs and the Kelly Formula were the biggest takeaways from Dhando.

I formed an Investing Club with a few friends in order to force ourselves to kick our analysis up a notch. Basically it forces us to ante up. With that in mind, here is the analysis I did of Tesoro (TSO). If anyone has the time or inclination, I would greatly appreciate comments on this analysis: Is there more information you would want to see that I haven't provided? Have I misinterpreted any of the data that is presented here? Etc. (By the way, for the DCFs, I used the Motley Fool online DCF calculator. I'm sure that there are others available online.)

Factors in considering purchase of Tesoro (TSO)

1. About TSO from Yahoo! Finance, Profile: Tesoro Corporation and its subsidiaries engage in refining and marketing petroleum products in the United States. It operates in two segments, Refining and Retail. The Refining segment manufactures and sells gasoline and gasoline blendstocks, jet fuel, diesel fuel, and heavy fuel oils to the commercial customers primarily in the midcontinental and the western United States. This segment also manufactures liquefied petroleum gas, petroleum coke, and asphalt. The Retail segment distributes motor fuels to wholesale and retail customers, as well as to commercial end-users through a network of gas stations. This segment sells gasoline and diesel fuel to retail customers through company-operated retail stations and branded jobber/dealers in the midcontinental and the western United States.

2. ‘Magic formula’ characteristics:
- 21% earnings yield (reverse of PE, indicating a calculated PE of 4.76). ie – it is a cheap stock.
- Return on invested capital of 25 – 50%. ie – it is a good company.
i. According to Yahoo! Finance Key Statistics, Return on Equity is 37%, Return on Assets is 15%
ii. By my own calculations of Return on Capital (earnings before interest and taxes divided by total stockholder equity), result in rather higher numbers: >70% for each of the last two years.

3. Discounted Cash Flow analysis
- Discount rate: 12% - I believe that this is mildly conservative considering the size of the company.
i. I found online a DCF of TSO from 2003. At the time, they estimated a discount rate of 8.4% and then to be conservative jacked it up to 11%.
- FCF calculated as $647M from annual reports.
- Assumed growth in FCF for the next 5 years: 15%. This is very conservative when compared to growth over the last two years. From the annual reports, FCF growth was 38% 2006 over 2005, and 41% 2005 over 2004.
i. Assumed growth after initial 5 years: 3% for years 6 – 10, and 0% for years 10 onwards. 3% is conservative; I think that it’s more typically about half of the first five years. 0% is less conservative; I think that it’s more typically 3%, but some of these analyses say that you can’t count on anything ten years out, so assume a 0% rate after 10 years.
- Current stock price = $49.30
- Shares outstanding: 138.83M
- Excess cash and equivalents (from Key Statistics) = 169M
- Total debt = 1.79B
- Value of operating leases = $39M (the value at the end of 2006. The minimum repayment for 2007 is $5M)
- Value of outstanding stock options = $151M
- Results: Intrinsic value = $63.12 / share, with a 21.9% MOS. If it is agreed that my estimates are conservative wherever possible, then the MOS is probably greater.
- HOWEVER, I am estimating future growth rate based on past performance. Analyst estimates consider that the next five years will be considerably lower than the past, only 6% per year over the next 5 years. If correct, then this will be a LOSING proposition. I disagree with analysts because i) I think that oil alternatives will be a lot slower to come to market than popularly considered, and ii) we may or may not hold on that long; in the nearer term, I suspect that oil will continue closer to its current trajectory. With a 12% average growth rate in FCF over the next several years, we might expect a CAGR of ~ 15%.

3. This quarter TSO paid down all debt on their short-term line of credit. The CEO says that they don’t have any more debt that they can pay down early, so future cash flows will be put towards organic growth of the company. They had originally targeted paying off all of this debt by the end of the year.

4. Current assets (not including inventory, in order to be conservative) = $1,939,000. Current liabilities = $1,672,000 (at year-end ’06). That assets outweigh liabilities is a Good Thing. A 2:1 ratio would be better, but this is pretty good.

5. They acquired a refinery near LA, further strengthening their presence on the West Coast. (Other refineries are near SF, in Washington, Alaska, Hawaii, North Dakota and Utah.)

6. They also sell gasoline and diesel retail, at gas stations under the Tesoro and Mirastar brands, as well as through unbranded gas stations. This seems to be a no-growth part of their company, in terms of actual volume of gas sold, but it has grown revenue, due to increasing gas prices. Management is trying to take advantage of this, having made a deal in January to acquire 140 additional gas stations in CA. If gas prices fall, this may turn out to be a bad idea, but in the short term, it’s probably a great move. It depends on how much effort (ie cost) it takes to max out the volume capabilities of each gas station. I might try to focus more on finding new retail stations to sell to.

7. From the Yahoo! Finance Profile page: Tesoro Corp.'s Corporate Governance Quotient (CGQ®) as of 1-Aug-07 is better than 100% of Russell 3000 companies and 99.6% of Energy companies.

8. Some recent insider purchase: 10,000 on Aug. 9 at ~$48; May 7, 5,000 and 1,000 at $58 by two different directors.

9. Competitors: Valero seems to have a similar model – refining and retail sales. It’s about 5 – 6 times the market cap, DCF analysis gives a similar MOS given the same assumptions, it has a similar PE and a ROC of ~56% last year and ~70% the year before. It’s comparable to TSO.
- However, I like that TSO has the smaller market cap, as it typically implies more possibility of growth. Look at how VLO’s ROC declined dramatically last year relative to the year before, while TSO’s ROC was much more stable.

10. My major concern with TSO is this: it is in a hot industry. If the demand for oil were to drop, or even if the market were to suddenly stop investing in oil companies, TSO could be in for a stall, or even a drop. The recent drop in share price, from a high of ~$64, may provide a margin of safety against this possibility.