photo credit: Gastev

This article is a reprint of my February 19, 2008 RealMoney column

After peaking above $49 per share last year, refiner Frontier Oil (FTO) sunk to intraday lows in the $20’s last month before starting a rally on the news of Valero’s (VLO) positive outlook on the latest conference call. My biggest surprise, looking over the data for Frontier and the industry, is why it hasn’t rallied even more.

First of all, Valero indicated that “Current industry conditions are setting the stage for rebounding gasoline margins.” If true, that would be equally positive for Frontier and others. Not that I don’t believe Valero, but I thought a check of the PPI industry statistics could provide an unbiased second opinion.

Petroleum Refineries PPI, 12-Months Percent Change

Source: Bureau of Labor Statistics

Lo and behold, year/year price increases for petroleum refineries have suddenly shot straight up. If that doesn’t set the stage for rebounding margins, what will?

Hardly a week later, there was actually speculation that Valero would buy Frontier. However, according to the Reuters article, Fadel Gheit, an oil analyst with Oppenheimer & Co, also questioned the rationale behind Valero buying Frontier, especially since Valero has already sold one refinery and has said it would sell two and maybe three others.

Sold a refinery, you say? That sounds like a ripe opportunity for a comparables analysis to see how Frontier’s valuation stacks up against an arms-length transaction between industry experts. And at first glance, Frontier doesn’t come out looking so hot.

Valero’s Lima, Ohio refinery was sold last year to Canada’s Husky Energy (HSE.TO) for $2.1 billion. Lima’s 165,000 barrel per day stated capacity being quite close to Frontier’s total capacity of 162,000 barrels per day, the comparison initially looks valid. And with Frontier’s enterprise value at $3.6 billion, the implications could be that Valero’s management got ripped off, Frontier is overvalued, or the assets aren’t really comparable.

Valero is a good company, and I don’t believe its experienced managers got ripped off. The other two theses can be tested by comparing the assets. According to Husky’s road show slides, it seems Lima was something of a fixer-upper. Running well below the stated throughput, its sales and profitability were not close to those of Frontier. Taking the 2006 performance as an example, I was able to compare the valuation relative to various fundamental metrics.

Sources: Company filings, compiled by William A. Trent

Although Frontier looks more expensive on the basis of throughput or sales, its full-throttle capacity utilization has resulted in a far more efficient operation. As a result, Frontier is cheaper based on EBIT or EBITDA, which are the valuation measures most frequently used in the industry.

Of course, running at full capacity also means there is little room for further improvement other than through the commodity prices themselves. Even considering a fair valuation, that could mean there is significantly more downside risk than potential upside.

I also looked at Frontier on the basis of my favored valuation tool, its free cash flow yield. In this regard, Frontier’s yield on trailing free cash flow is about 6.2%, which is sufficiently above the yield on five-year Treasuries that I don’t need significant growth to justify a purchase. The potential rebounding margins, in other words, is a bonus.

Disclosures: None

Disclosure: Author is long UNITED STS OIL FD LP UNITS (USO) at time of publication.