Western Refining (NYSE:WNR): Deleveraging, Restructuring Drive Upside; Overweight - Morgan Stanley

Morgan Stanley is making a big call in Western Refining (NYSE:WNR) upgrading the refiner to Overweight from Equal-Weight with a $9 price target (prev. $6).

MSCO believes WNR is in the early stages of a strategic restructuring that will significantly deleverage its balance sheet, remove restrictive debt covenants, refocus its portfolio to more attractive markets, and unlock shareholder value. In the next twelve months they believe WNR will: 1) monetize ~$560MM of assets, 2) repay its high cost and covenant heavy term loan; 3) reduce its debt to cap by 23% from 65% in 2Q10 to 42% by 2011YE; and 4) emerge as a pure-play mid-con refiner (with ~15% of EBITDA generated by retail marketing). MSCO believes both deleveraging (similar to TSO in 2002) and strategic repositioning as a mid-con refiner (favorable markets) will drive a re-rating of the stock. Into the seasonal refining trade (late November-May), they expect WNR’s stock to converge on their $9.00 target price as it executes on this plan. Firm assumes limited commodity driven upside in their call with only 1% improvement in Gulf Coast indicative margins, risk the asset sale execution at 25%, and assume a target multiple at ~15% discount to mid-con peers.

Asset monetization to drive deleveraging: two prong driver for future performance.

De-levering balance sheet provides a path to improved valuation. MSCO believes WNR will be able to pay down the covenant-heavy term loan of ~$348MM and ~$210MM of $256MM Floating Senior Secured Notes in 2011 with asset sales. The company has reportedly commenced discussions to restructure its revolver that would remove restrictive maintenance covenants and may be completed by mid-November. Firm believes deleveraging alone will drive a multiple expansion, similar to FTO and TSO in 2002-2004. Their $9.00 price target assumes a 25% discount for execution risk associated with asset sales. Firm's bull case target of $12.50/sh removes the execution risk factor yet assumes no margin lift y-o-y.

Restructured refining is in niche and profitable markets and should be re-rated. WNR’s Southwest refining consists of two strong cash generating assets: El Paso and Gallup (2 consolidated assets) and associated marketing. For the last 3 years, these two refineries have averaged net refining margins of $5.42/bbl and $7.53/bbl versus Yorktown of $0.09/bbl. Both assets are niche, mid-con markets sheltered from imports and benefiting from growing local crude production (Permian) providing advantaged crude pricing. The removal of Yorktown in 2010, pro-forma, would improve WNR’s 2010E EBITDA by $58MM. Assuming no y-o-y improvement in cracks, MSCO believes WNR’s total company 2011 EBITDA will be $268MM,
pro forma for asset sales, reducing ~$35MM of EBITDA related to asset sales.

Background: how we got here? WNR became public in the golden age of refining in 2006 at $17/sh and traded as high as $65/sh in July of 2007. In May 2007, the month US cracks reached multi-decade highs, WNR completed the acquisition of Giant Industries in a largely debt financed transaction. WNR financed the Giant acquisition with $1.5Bn of debt comprised of $1.25Bn Senior Secured Term Loan and $275MM Senior Secured Revolving facility. Giant owned several refineries including the 70mbpd Yorktown refinery, an asset that had historical operating issues (formerly a BP asset divested in 2002) and is exposed to competitive East Coast markets (Yorktown, Va.). The combination of the high leverage, high interest expense, poor operations at Yorktown (Marlim discount also closed), and the cyclical downturn in refining triggered covenant violations and raised concerns regarding WNR’s solvency in 2008/2009.

In June/July of 2009, WNR recapitalized and repaid $927MM of Term Credit facility issuing 1) 20MM shares of equity, 2) $600MM senior notes (10.25-11.25%), and 3) $215MM convertible debt. These transactions increased the implied interest rate, yet provided covenant relief. The legacy Western refinery in El Paso (128mbpd) and the New Mexico refinery acquired from Giant (23mbpd (Gallup) have remained profitable as niche refineries.

MSCO notes that when they initiated on WNR with a Neutral rating in October 2009 (WNR at $6.20), they were concerned about: 1) a potential covenant breach in 2010, and 2) Yorktown’s operational and competitive position. In firm's view, management has solved the Yorktown issue by shuttering the loss-generating refining, avoiding future capex and allowing for monetization of unvalued storage assets. They believe management is committed and will solve the leverage issues in 2011 with asset sales. The restructured company would become a mid-con pure play with sustainable leverage by 2012. They think WNR is a turn-around, deleveraging, and re-rating story.

Notablecalls: So what do we have here?

- A forgotten mo-mo stock that has been crushed over the past 3-4 years.

- Tier-1 firm upgrading it with a Street high target saying it can only get better from here. Firm says they see positive 4:1 risk reward between their base and bear cases: bull case offers additional upside to $12.50.

- Short interest stands at 25%.

- $500M market cap.

Not bad. Expect a large move up today. Goes above $6, possibly $6.25 or up 10%. Would not rule out $6.30-.40. if general tape plays ball.