CVR Energy, Inc. CVI W
November 19, 2007 - 1:28am EST by
gatsby892
2007 2008
Price: 21.68 EPS
Shares Out. (in M): 0 P/E
Market Cap (in M): 1,770 P/FCF
Net Debt (in M): 0 EBIT 0 0
TEV: 0 TEV/EBIT

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Description

What some may see as an average domestic refinery play is actually an opportunity to own the single most valuable nitrogen fertilizer asset in North America at a deep discount to intrinsic value – we believe CVI is worth somewhere between $25 and $55 per share (implying more than 150% upside from current levels). In an uncertain economy, CVI is a scarce and valuable inflation protected resource with hard assets and significant, yet overlooked FCF generation potential.  Furthermore, any spike in natural gas prices or a multiple re-rating in the currently undervalued refinery sector would create meaningful upside to our valuation targets.  Perhaps most importantly, the first critical catalyst for realizing this value is imminent – the Company has already legally separated out its extremely profitable, yet heretofore overlooked and underappreciated fertilizer segment into a tax advantaged MLP structure and plans a public flotation within the next 6-9 months.  Until the MLP offering occurs, CVI falls through the cracks as energy investors don’t know how to value the fertilizer assets and vice versa.  In effect, there is currently no natural shareholder base, a situation which has temporarily obscured what we believe is tremendous underlying value.
 
What follows is an overview of the primary refining assets, then a look at the unique fertilizer assets (the real value driver here), followed by a detailed valuation analysis that supports our $55 potential price target.  There simply isn’t enough room in this posting to cover many of the interesting details here (but we’ve tried to at least briefly touch on them), so we would refer you to the Company’s extremely helpful S-1 that was filed in October.
 
 
 
PETROLEUM REFINING
 
Great assets & a great time to own them:
 
Supply is Shrinking – No new refinery has been built in the US in over 30 years due largely to environmental regulatory requirements, high capital costs and historical excess capacity.  In fact, domestic refinery capacity has decreased by 7% since 1981 even as domestic consumption has increased dramatically during that same time period.  More than 175 small, unsophisticated refineries were shut down as they were unable to economically process heavy crude (a competitive advantage that CVI possesses and even continues to improve upon).  Strict US fuel specifications and rising foreign demand for refined products also limit the threat of further refined product imports (which currently account for approximately 12% of US consumption).  The implementation of federal Tier II low sulfur fuel regulations is expected to only further reduce existing domestic refinery capacity as well as import suitability.  As a result of these supply-side shifts, average domestic refinery utilization increased from 69% in 1981 to 93% by 2004.
 
Scarce Asset – Because of the supply situation described above (no new domestic greenfield refinery in 3 decades), there is actually no real market by which to gauge true replacement costs today, however, there are recent US expansion projects that can give us a sense for underlying asset values as well as greenfield projects abroad we can look to (where environmental regulations are often less stringent).  Domestically, recent expansions have occurred in the range of $15,000 to $25,000 per barrel of refining capacity.  Abroad, the current newbuilds are expected to come in at or above the high end of this range.  We will cover the implications of these data points in detail in the valuation section below, but for now, suffice it to say that high quality domestic refining assets are scarce resources, new projects are virtually impossible to greenfield and expansions are extremely expensive (with construction cost estimates continually on the rise).  In general, it is our view that the public market valuations of the refining sector are currently underestimating this scarcity value (many are now trading below their estimated replacement cost) and we believe that there is a strong possibility of a significant sector re-rating as we remain in an environment of sustained high utilization rates (a scenario which would be incrementally positive to our valuation analysis).
 
Demand is Growing – Projections from the federal Energy Information Administration (EIA) indicate that US demand for refined product will continue to outstrip increases in domestic refining capacity for the next 20 years (1.5% per year vs. 1.3% per year).  Approximately 83% of this demand growth is expected to come from increased consumption of light refined products, which are more difficult and costly to produce, disproportionately benefiting the more complex refineries such as CVI.  As a result of continued anticipated demand strength (and extremely limited supply response), the EIA projects that domestic refinery utilization levels will remain between 92% and 95% for the next 20 years.
 
Regional Shortages Equal Higher Profitability – Demand in CVI’s region (Midwest PADD II) currently outstrips supply by 22%, providing strong support to regional utilization rates.  Local refiners also generally earn higher margins on product sales than those who must rely on pipelines for supply.  As a result, CVI has generated refining margins (2-1-1 crack spread) that have exceeded US Gulf Coast margins by $1.74/barrel on average for the last four years (and this is prior to the major investments and improvements that have recently been implemented, discussed below).
 
Location is Key – CVI is located just 100 miles from Cushing, OK, one of the largest crude oil trading and storage hubs in the US, served by pipelines from the US Gulf as well as Canada.  As a result, the refinery will continue to benefit from convenient access to increasing supplies of much cheaper heavy crudes from the Canadian Oil Sands, increasing its refining margins versus peers more reliant on light sweet crudes.
 
Significant Recent Investments – Over the last 3 years, CVI has implemented a sweeping $673 million capital improvement plan (fully 30% of the Company’s entire current enterprise value) that has increased overall refinery throughput, enhanced yields of favorably priced distillates, diversified the crude feedstock variety (lowering raw material costs) and improved plant operations (increasing efficiency, reliability, flexibility and environmental and safety compliance).
 
Improving Long-term Profitability – Although refining margins can be volatile during short time periods due to seasonality of demand, refinery outages, adverse weather conditions and inventory levels, long-term average profits have been increasing for more than a decade as a result of the improving supply/demand fundamentals within the industry.  The following data from Platts illustrates this with a rolling average of the NYMEX based 2-1-1 crack spread from 1994 through the first half of this year:

Rolling NYMEX Crack Spreads
Spread
$3.88
$3.76
$4.22
$4.53
$4.53
$4.93
$5.83
$6.91
$7.95
 $9.76
% Change
(3)%
12%
7%
0%
9%
18%
19%
15%
23%
 
 
 
 
 
 
 
 
 
 
 
Period
 
 
 
 
 
 
 
 
 
 
Start
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
End
1998
1999
2000
2001
2002
2003
2004
2005
2006
6/30/07
 
 
 
 
 
 
 
 
 
 
 

 
Increasing Complexity – CVI’s complexity allows it to optimize the yields of higher value transportation fuels, which currently account for 93% of their liquid production output.  Furthermore, as a result of the recent investments described above, this complexity has increased significantly (from a Solomon score of around 9.0 to the most recently reported 11.1).

Regional Solomon Complexity
Crude
Solomon
% of
Company
Location
Capacity
Index
Mkt.
ConocoPhillips
Ponca City, OK
 187,000
       12.5
27%
CVR Energy
Coffeyville, KS
 115,000
       11.1
17%
Frontier Oil
El Dorado, KS
 110,000
       13.3
16%
Valero
 
Ardmore, OK
   88,000
       11.3
13%
NCRA
 
McPherson, KS
   82,200
       14.1
12%
Gary Williams
Wynnwood, OK
   52,500
         8.0
8%
Sinclair
 
Tulsa, OK
   50,000
         8.3
7%
 
Total CVR Supply Area
 684,700
 
 
 
 
 
 
 
 
 
 

 
Now is the Time to Buy Refiners – As much as we are fundamental research-driven value investors, we cannot help but point out the strong technical pattern that this sector’s securities have exhibited over the past two decades.  As the chart below shows, shares of publicly traded refiners have generated a positive return for the 6 months from December to May in 17 of the last 18 years and have bested their performance during the other 6 months of the year in 15 of those 18 years.

Seasonality of Refining Stocks
 
 
Dec.-May
 
Jun.-Nov.
 
Spread
1990
 
2%
 
(15)%
 
17%
1991
 
8%
 
(10)%
 
18%
1992
 
6%
 
(14)%
 
20%
1993
 
4%
 
16%
 
(12)%
1994
 
9%
 
(1)%
 
10%
1995
 
10%
 
(3)%
 
13%
1996
 
11%
 
(5)%
 
16%
1997
 
17%
 
17%
 
0%
1998
 
5%
 
(25)%
 
30%
1999
 
(10)%
 
(9)%
 
(1)%
2000
 
28%
 
(5)%
 
33%
2001
 
1%
 
(13)%
 
14%
2002
 
3%
 
(20)%
 
23%
2003
 
20%
 
22%
 
(2)%
2004
 
49%
 
36%
 
13%
2005
 
42%
 
29%
 
13%
2006
 
8%
 
(7)%
 
15%
2007
 
34%
 
(5)%
 
39%
 
 
 
 
 
 
 
As per Morgan Stanley report dated September 26, 2007 (therefore partial data for Jun.-Nov. 2007).

 
Aligned Incentives – Goldman Sachs and Kelso (private equity firm) remain the 2 largest shareholders in the Company, with a combined 77% ownership.  They did not sell a single share in the CVI IPO.  We believe that this is because they recognize the value that remains to be unlocked when the fertilizer segment begins to trade publicly in mid to late 2008.
 
Experienced Management Team – Senior management team averages 28 years of experience each.  CEO has 35 years and has run a refinery nearly 5 times this size (at El Paso and Coastal) as well as a multi-plant fertilizer system.  COO has 33 years and was in charge of one of the largest fertilizer systems in the US.  CFO has 18 years and has been the CFO for 2 fertilizer manufacturers.
 
 
 
NITROGEN FERTILIZER
 
This is the real upside valuation driver here:
 
Unique Lowest Cost Producer – Literally the ONLY operation in North America that utilizes a revolutionary coke gasification process to produce ammonia, making it the LOWEST cost producer of ammonia and UAN on the continent.  As a result of this technology (which utilizes a low-value petroleum coke byproduct from the refinery), CVI requires only 1% of the high cost natural gas that all other nitrogen fertilizer producers depend upon for the production of ammonia.  CVI estimates that its production cost advantage is sustainable at natural gas prices as low as $2.50/mmBtu equivalent (66% below current market levels based on today’s spot price of $7.45).  The plant is also the newest fertilizer plant in North America (built in 2000 and expanded during a full scheduled turnaround in 2006).
 
INVERSE Exposure to Natural Gas Prices – Because natural gas is the primary cost component in manufacturing ammonia, fertilizer prices generally increase with natural gas prices.  As a result, CVI actually BENEFITS from higher natural gas prices not only because its cost structure is unaffected versus its competitors, but also because the price for its output increases right along with everyone else’s in the market, having a dramatic impact on margins in a tight supply/demand environment.  The current natural gas futures market runs through September 2011 and shows that current market expectations for natural gas during that time period fluctuate between $7.58 and $9.12 per mmBtu (2% to 22% above the current spot price), with an expected 4 year average price of $8.18 (10% high than current).  In other words, rising natural gas prices should be a significant benefit to CVI for years to come.
 
Although we have not included the following upside scenario in our valuation, there is a strong argument to be made that natural gas prices are headed much higher than this forward curve would indicate, and/or that prices are vulnerable to short-term spikes (either of which would obviously be extremely lucrative for CVI’s fertilizer operations).  The drivers that may cause such a situation to play out include interruptions as a result of hurricanes or other severe weather, rapidly rising exploration and productions costs both domestically and abroad, declining production curves, continued delays in LNG gasification projects and a lack of LNG imports due to sustained increases in foreign demand.
 
Strong Market Fundamentals – Nitrogen accounts for approximately 60% of worldwide fertilizer consumption and there are no substitutes for nitrogen fertilizers in the cultivation of high-yield crops such as corn.  A growing world population, increases in disposable income and associated improvements in diet (higher incomes = more beef = more feed corn) are all driving increasing high value food supply demands (particularly in India, Latin America and Russia) that are benefiting the nitrogen fertilizer industry.  The expanded use of corn for production of ethanol is also driving demand (2007 corn acreage exceeded 2006 levels by 19%).  As a result of these influences, over the past 45 years, growth in nitrogen fertilizer demand has outstripped growth in global fertilizer demand (by an annual rate of 4.8% vs. 3.7%).
 
Current strong industry fundamentals include US producer UAN inventories that are lower than they were during the prior year, a tight US import market which contracted sharply in late 2006 and nitrogen fertilizer global capacity utilization which is projected to be near 85% through 2010.  These fundamentals have been driven, in part, by increased US corn plantings and increasing worldwide natural gas prices.
 
There is certainly a debate about whether the recent increases in ethanol production (and therefore corn plantings) are sustainable and a significant amount of froth has come out of some ethanol related equities over the last year or so.  We believe that the best metric to consider when determining future fertilizer pricing (aside from future natural gas prices) is to go straight to the primary driver – the price of corn.  Farmers don’t care whether their produce is going to feed cattle or to produce ethanol – they just care how much a bushel of corn can sell for and this drives their planting decision, which directly determines their use of nitrogen fertilizer (roughly 100-160 pounds of nitrogen for each acre of plantings).  Therefore, we believe the best indicator to determine the future health of the nitrogen fertilizer industry is to look at the futures market for corn.  The following table illustrates that the market expects corn prices to remain elevated and in fact to rise as much as 25% from current levels over the next 3 years.  This is also consistent with long-term USDA forecasts.

Corn Futures Market
 
 
 
 
 
 % Change
 Contract
 
 Delivery
 
 $ / Bushel
 
 from Current Spot
C Z7
 
 12/18/2007
 
 $3.75
 
10%
C H8
 
 3/18/2008
 
 $3.92
 
15%
C K8
 
 5/16/2008
 
 $4.02
 
18%
C N8
 
 7/16/2008
 
 $4.10
 
21%
C U8
 
 9/16/2008
 
 $4.15
 
22%
C Z8
 
 12/16/2008
 
 $4.21
 
24%
C H9
 
 3/17/2009
 
 $4.27
 
26%
C K9
 
 5/18/2009
 
 $4.31
 
27%
C N9
 
 7/16/2009
 
 $4.35
 
28%
C Z9
 
 12/16/2009
 
 $4.21
 
24%
C H0
 
 3/16/2010
 
 $4.26
 
25%
C N0
 
 7/16/2010
 
 $4.31
 
27%
C Z0
 
 12/16/2010
 
 $4.22
 
24%
 
 
 
 
 
 
 
Current spot price is for USDA Iowa North Central No. 2 Yellow Corn.
 
 

 
Location is Key – Because shipping ammonia requires refrigerated or pressurized containers and UAN is more than 65% water, transportation cost is substantial for ammonia and UAN producers.  CVI’s fertilizer assets are located directly in the corn belt, creating a geographic advantage to supply products in this significant region without incurring intermediate transfer, storage, barge or pipeline freight charges.  This substantial cost benefit only further widens CVI’s structural competitive advantage over all other nitrogen fertilizer producers.
 
Upcoming Expansion – CVI is now embarking on a $50m fertilizer plant expansion, which could increase the plant’s capacity to upgrade ammonia into higher margin UAN by 50% to more than 1 million tons per year.  We estimate that this project could generate an incremental $36 million in annual EBITDA at expected market prices (based on independent pricing estimates as per fertilizer experts Blue, Johnson).
 
Secure Raw Material Source – Refinery byproducts provide 80% of the feedstock necessary for fertilizer production.  A recent 20 year inter-company supply agreement ensures that this will remain the case even after the separation.
 
Upcoming MLP Spin-Out – CVI has already separated the nitrogen assets into a separate legal entity structured as a tax advantaged Master Limited Partnership (MLP) – this was done in conjunction with the CVI IPO.  We believe that this structure will attract yield focused investors and garner a higher valuation as a result – the MLP universe, on average, tends to trade in the range of 15x forward EBITDA.  Management has indicated that they expect to complete this transaction within the next 6-9 months.
 
 
 
THE VALUATION
 
The bottom line is that we think CVI is worth somewhere between $25 and $55 per share (as much as 155% upside) over the next 2 years.  The table below summarizes our valuation analysis and what follows is a more detailed look at some of our key assumptions: 

CVI – Preliminary Valuation Analysis
 
 
 
 
 
 
 
Low
 
Medium
 
High
Refining Production Capacity (per Day)
 
    119,000
 
    119,000
 
    119,000
 
Modified Solomon Complexity
 
       11.1x
 
       11.1x
 
       11.1x
Production Equivalent Capacity (per Day)
 
 1,320,900
 
 1,320,900
 
 1,320,900
 
 
 
 
 
 
 
 
 
 
 
 
EV / Equivalent Barrel
 
 
      $1,400
 
      $1,700
 
      $2,000
 
 
 
 
 
 
 
 
 
 
 
 
Implied Refinery Enterprise Value
 
      $1,849
 
      $2,246
 
      $2,642
 
 
 
 
 
 
 
 
 
 
 
 
Nitrogen Fertilizer Pro Forma EBITDA
 
      $162.6
 
      $169.9
 
      $177.3
 
EBITDA Valuation Multiple
 
 
         6.0x
 
       10.5x
 
       15.0x
Implied Fertilizer Enterprise Value
        $975
 
      $1,784
 
      $2,659
 
 
 
 
 
 
 
 
 
 
 
 
CVI Enterprise Value
 
 
      $2,825
 
      $4,030
 
      $5,301
 
Pro Forma Total Debt
 
 
         (493)
 
         (493)
 
         (493)
 
Economic Drag from CF Swap
 
         (190)
 
         (190)
 
         (190)
 
Payments Deferred by J. Aron
 
         (124)
 
         (124)
 
         (124)
 
Flood Rebuilding Costs
 
 
           (90)
 
           (90)
 
           (90)
 
Crude Spill Remediation Costs
 
           (40)
 
           (36)
 
           (32)
 
Minority Interest
 
 
 
           (11)
 
           (11)
 
           (11)
 
Pro Forma Cash & Equivalents
 
            65
 
            65
 
            65
 
Flood Insurance Receivable
 
 
            95
            95
            95
Implied CVI Equity Value
 
 
      $2,037
 
      $3,246
 
      $4,521
 
 
 
 
 
 
 
 
 
 
 
 
 
Pro Forma Shares Outstanding
 
         81.6
         81.6
         81.6
 
 
 
 
 
 
 
 
 
 
 
 
Implied CVI Value per Share
 
      $24.94
      $39.75
      $55.37
 
Premium to Current ($21.68)
15%
83%
155%
 
 
 
 
 
 
 
 
 
 
 
 

Refinery Assets:
To avoid getting too much into the weeds here, it is worth referring you to a July 23, 2007, UBS research report initiating coverage on the US refiners that does an excellent job of providing an explanation of some of the various metrics by which to value refinery assets.  A good starting point (although it ignores profitability per barrel, which would likely favor CVI in this analysis) is to look at a refinery’s enterprise value per equivalent distillation capacity (a formula that effectively adjusts for varying complexities among refineries that impact their product mix).  The analyst provides the current market metrics for the key US refineries and shows that, at the time of the report, the most comparable assets (Valero, Tesoro, Sunoco and Frontier) were trading at a range of between $1,200 and $2,400 per equivalent barrel.  Because the CVI refinery assets are of fairly average complexity within this group (see the chart above), we have chosen a fairly conservative range in the bottom two-thirds of this spectrum for our valuation ($1,400 to $2,000 per equivalent barrel).  We ran our valuation on the demonstrated peak capacity after the improvements made in conjunction with the recent flood-related rebuilding (119,000 barrels per day).  The result is an implied enterprise value of $1.8 to $2.6 billion for the refinery assets alone.  Recall that we mentioned earlier that recent domestic expansion projects have been completing in the range of $15,000 to $25,000 per barrel (and even higher for newbuilds abroad).  For comparison purposes, our equivalent barrel valuation above translates into an implied value per barrel of roughly $15,000 (low case) to $22,000 (high case), entirely consistent (and perhaps conservative) with recent actual examples.
 
Fertilizer Assets:
We believe the real hidden value in CVI lies within the fertilizer assets, which in our estimation could actually be worth as much or even more than the refinery itself – especially considering the separate public MLP structure that Goldman and Kelso intend to pursue for these assets during the first half of 2008.  The table below shows our analysis of the potential earnings power of the fertilizer assets during 2006 (these pro forma figures were provided in the Company’s recent S-1); in their current form under prevailing market prices (2008 column); and once the anticipated gasification expansion is fully completed (2010 column).  All projections utilize current independent Blue, Johnson average corn belt pricing estimates for both ammonia and UAN.

Potential Fertilizer Segment EBITDA
 
 
 
 
2006
 
2008
 
2010
Total Ammonia Production
      369
 
      406
 
      406
 
On-stream Factor
 
89.3%
 
96.7%
 
96.7%
 
 
 
 
 
 
 
 
 
Production Volume
 
     
 
 
 
 
 
Ammonia
 
      123
 
      135
 
        -  
 
UAN (upgrade)
 
      633
 
      660
 
      990
 
 
 
 
 
 
 
 
 
Market Price
 
 
 
 
 
 
 
Ammonia
 
    $379
 
    $485
 
    $450
 
UAN (upgrade)
 
      183
 
      308
 
      293
 
 
 
 
 
 
 
 
 
Revenues
 
 
 
 
 
 
 
Ammonia
 
   $46.7
 
   $65.6
 
        -  
 
UAN (upgrade)
 
   115.8
 
   203.3
 
   290.1
 
 
Total Revenues
 
 $162.5
 
 $269.0
 
 $290.1
 
 
 
 
 
 
 
 
 
COGS
 
   $22.4
 
   $26.1
 
   $27.7
 
% of Sales
 
14%
 
10%
 
10%
 
$ per Ton of Ammonia Production
 $60.67
 
 $64.36
 
 $68.28
 
 
 
 
 
 
 
 
 
Direct Operating Expenses
   $63.6
 
   $67.5
 
   $73.1
 
% of Sales
 
39%
 
25%
 
25%
 
 
 
 
 
 
 
 
 
SG&A
 
   $12.0
 
   $12.8
 
   $13.5
 
% of Sales
 
7%
 
5%
 
5%
 
 
 
 
 
 
 
 
 
Fertilizer Segment EBITDA
   $64.4
 
 $162.6
 
 $175.8
 
% of Sales
 
40%
 
60%
 
61%
 
 
 
 
 
 
 
 
 

  
The ammonia capacity in 2006 was lower than true capacity (or historical reality) due to that year’s scheduled turnaround and a one-time hydrogen diversion.  For 2008 and beyond, it is management’s expectation that its on-stream factor should return to the nearly 97% utilization seen in 2005 (in addition to a further 6,500 tons as a result of spare gasifier improvements).  The end result is that CVI should be able to produce 660k tons of UAN next year by upgrading two-thirds of its ammonia production (just as it does now) and then nearly 1 million tons of UAN by the beginning of 2010 when the gasifier expansion project is completed.  Our cost assumptions increase by a 3% CAGR each year from the actual levels seen in 2006.  Due to the literally 99% fixed cost nature of the direct expense cost structure, the impact of anticipated fertilizer market pricing combined with the expected capacity improvements will result in a step-function increase in earnings power for the segment beginning as early as 2008 and improving going forward.
 
As mentioned, the pricing assumptions are straight from an October 2007 report from the pre-eminent independent source for fertilizer and agricultural chemical pricing analysis (Blue, Johnson).  Their current long-term UAN forecast is as follows:

UAN Price Projections
 
2007
2008
2009
2010
2011
2012
2013
2014
2015
 Avg. Corn Belt Price
$283
$308
$301
$293
$288
$290
$293
$298
$298
 % Change from 2006
44%
57%
54%
49%
47%
48%
49%
52%
52%
 
 
 
 
 
 
 
 
 
 
As per Blue, Johnson Associates as of October 2007.
 
 
 
 
 
 
 

 Finally, we apply a market multiple on the expected fertilizer segment EBITDA.  The pure play public fertilizer comps (POT, MOS, AGU, CF, TRA, TNH) currently trade at a wide forward EBITDA multiple range from about 5.5x to 16x.  We believe that the combination of factors described above (primarily the positive profitability correlation with natural gas prices) and the fact that the fertilizer segment will be spun out in a tax advantaged MLP structure (an analysis of public MLPs shows that they trade at an average implied forward EBITDA multiple of around 15x) gives us confidence that CVI’s fertilizer segment should command a market multiple at or above the high end of the current peer range.  However, we have capped the valuation range in our analysis at 15x and showed scenarios all the way down to what we feel is a very unrealistic 6x multiple to illustrate just how compelling the CVI valuation is at any of these levels.  The result is that we believe that the fertilizer segment alone is worth between $1.0 and $2.7 billion in enterprise value.
 
Net Debt & Other:
There are a number of adjustments to enterprise value other than the relatively straightforward calculations (pro forma debt, cash and minority interest).  These are broken out in the detailed valuation table above.  In short, we have endeavored to be as conservative as possible by essentially charging the equity with the full current value of the flood reconstruction costs, the crude spill remediation efforts, the back payments owed to J. Aron related to the cash flow swap agreement and most importantly, the current market value of completely eliminating the remainder of the dilutive swap agreement (something that management has indicated it does not believe makes economic sense at current levels).  We are treating the valuation as if these payments are all made today, even though no cash has left the Company for any of them yet (as of the last published pro forma balance sheet used herein).  More details on each of these issues is available in the Company’s S-1.  We believe that all of these items together represent a negative adjustment of approximately $780-$790 million.
 
As the valuation table above shows, adding these pieces together yields an implied enterprise value for CVI of $2.8 to $5.3 billion and a fully adjusted equity value of $2.0 to $4.5b or roughly $25.00 to $55.00 per share (an extremely attractive payoff structure at current levels that implies for that 150% upside within the next two years).  Of course, any spike in natural gas prices or multiple re-rating in the currently undervalued refinery sector would create meaningful upside to these valuation targets.

Catalyst

1) The first earnings release as a public company will highlight the beginning of the dramatic step change in fertilizer earnings power that we have laid out here. We believe this segment will very quickly become impossible to ignore any longer.

2) The Company’s timetable for the fertilizer MLP spin is within the next 6-9 months.

3) CVI’s $50 million gasification expansion should increase higher margin UAN production by 50%, yielding significant earnings benefits by 2010.

4) Refiners materially outperform from December to May (data above).

5) The Company details a number of other accretive expansion and improvement projects in its S-1 that are either already currently underway or are planned over the near to medium term.
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    Description

    What some may see as an average domestic refinery play is actually an opportunity to own the single most valuable nitrogen fertilizer asset in North America at a deep discount to intrinsic value – we believe CVI is worth somewhere between $25 and $55 per share (implying more than 150% upside from current levels). In an uncertain economy, CVI is a scarce and valuable inflation protected resource with hard assets and significant, yet overlooked FCF generation potential.  Furthermore, any spike in natural gas prices or a multiple re-rating in the currently undervalued refinery sector would create meaningful upside to our valuation targets.  Perhaps most importantly, the first critical catalyst for realizing this value is imminent – the Company has already legally separated out its extremely profitable, yet heretofore overlooked and underappreciated fertilizer segment into a tax advantaged MLP structure and plans a public flotation within the next 6-9 months.  Until the MLP offering occurs, CVI falls through the cracks as energy investors don’t know how to value the fertilizer assets and vice versa.  In effect, there is currently no natural shareholder base, a situation which has temporarily obscured what we believe is tremendous underlying value.
     
    What follows is an overview of the primary refining assets, then a look at the unique fertilizer assets (the real value driver here), followed by a detailed valuation analysis that supports our $55 potential price target.  There simply isn’t enough room in this posting to cover many of the interesting details here (but we’ve tried to at least briefly touch on them), so we would refer you to the Company’s extremely helpful S-1 that was filed in October.
     
     
     
    PETROLEUM REFINING
     
    Great assets & a great time to own them:
     
    Supply is Shrinking – No new refinery has been built in the US in over 30 years due largely to environmental regulatory requirements, high capital costs and historical excess capacity.  In fact, domestic refinery capacity has decreased by 7% since 1981 even as domestic consumption has increased dramatically during that same time period.  More than 175 small, unsophisticated refineries were shut down as they were unable to economically process heavy crude (a competitive advantage that CVI possesses and even continues to improve upon).  Strict US fuel specifications and rising foreign demand for refined products also limit the threat of further refined product imports (which currently account for approximately 12% of US consumption).  The implementation of federal Tier II low sulfur fuel regulations is expected to only further reduce existing domestic refinery capacity as well as import suitability.  As a result of these supply-side shifts, average domestic refinery utilization increased from 69% in 1981 to 93% by 2004.
     
    Scarce Asset – Because of the supply situation described above (no new domestic greenfield refinery in 3 decades), there is actually no real market by which to gauge true replacement costs today, however, there are recent US expansion projects that can give us a sense for underlying asset values as well as greenfield projects abroad we can look to (where environmental regulations are often less stringent).  Domestically, recent expansions have occurred in the range of $15,000 to $25,000 per barrel of refining capacity.  Abroad, the current newbuilds are expected to come in at or above the high end of this range.  We will cover the implications of these data points in detail in the valuation section below, but for now, suffice it to say that high quality domestic refining assets are scarce resources, new projects are virtually impossible to greenfield and expansions are extremely expensive (with construction cost estimates continually on the rise).  In general, it is our view that the public market valuations of the refining sector are currently underestimating this scarcity value (many are now trading below their estimated replacement cost) and we believe that there is a strong possibility of a significant sector re-rating as we remain in an environment of sustained high utilization rates (a scenario which would be incrementally positive to our valuation analysis).
     
    Demand is Growing – Projections from the federal Energy Information Administration (EIA) indicate that US demand for refined product will continue to outstrip increases in domestic refining capacity for the next 20 years (1.5% per year vs. 1.3% per year).  Approximately 83% of this demand growth is expected to come from increased consumption of light refined products, which are more difficult and costly to produce, disproportionately benefiting the more complex refineries such as CVI.  As a result of continued anticipated demand strength (and extremely limited supply response), the EIA projects that domestic refinery utilization levels will remain between 92% and 95% for the next 20 years.
     
    Regional Shortages Equal Higher Profitability – Demand in CVI’s region (Midwest PADD II) currently outstrips supply by 22%, providing strong support to regional utilization rates.  Local refiners also generally earn higher margins on product sales than those who must rely on pipelines for supply.  As a result, CVI has generated refining margins (2-1-1 crack spread) that have exceeded US Gulf Coast margins by $1.74/barrel on average for the last four years (and this is prior to the major investments and improvements that have recently been implemented, discussed below).
     
    Location is Key – CVI is located just 100 miles from Cushing, OK, one of the largest crude oil trading and storage hubs in the US, served by pipelines from the US Gulf as well as Canada.  As a result, the refinery will continue to benefit from convenient access to increasing supplies of much cheaper heavy crudes from the Canadian Oil Sands, increasing its refining margins versus peers more reliant on light sweet crudes.
     
    Significant Recent Investments – Over the last 3 years, CVI has implemented a sweeping $673 million capital improvement plan (fully 30% of the Company’s entire current enterprise value) that has increased overall refinery throughput, enhanced yields of favorably priced distillates, diversified the crude feedstock variety (lowering raw material costs) and improved plant operations (increasing efficiency, reliability, flexibility and environmental and safety compliance).
     
    Improving Long-term Profitability – Although refining margins can be volatile during short time periods due to seasonality of demand, refinery outages, adverse weather conditions and inventory levels, long-term average profits have been increasing for more than a decade as a result of the improving supply/demand fundamentals within the industry.  The following data from Platts illustrates this with a rolling average of the NYMEX based 2-1-1 crack spread from 1994 through the first half of this year:

    Rolling NYMEX Crack Spreads
    Spread
    $3.88
    $3.76
    $4.22
    $4.53
    $4.53
    $4.93
    $5.83
    $6.91
    $7.95
     $9.76
    % Change
    (3)%
    12%
    7%
    0%
    9%
    18%
    19%
    15%
    23%
     
     
     
     
     
     
     
     
     
     
     
    Period
     
     
     
     
     
     
     
     
     
     
    Start
    1994
    1995
    1996
    1997
    1998
    1999
    2000
    2001
    2002
    2003
    End
    1998
    1999
    2000
    2001
    2002
    2003
    2004
    2005
    2006
    6/30/07
     
     
     
     
     
     
     
     
     
     
     

     
    Increasing Complexity – CVI’s complexity allows it to optimize the yields of higher value transportation fuels, which currently account for 93% of their liquid production output.  Furthermore, as a result of the recent investments described above, this complexity has increased significantly (from a Solomon score of around 9.0 to the most recently reported 11.1).

    Regional Solomon Complexity
    Crude
    Solomon
    % of
    Company
    Location
    Capacity
    Index
    Mkt.
    ConocoPhillips
    Ponca City, OK
     187,000
           12.5
    27%
    CVR Energy
    Coffeyville, KS
     115,000
           11.1
    17%
    Frontier Oil
    El Dorado, KS
     110,000
           13.3
    16%
    Valero
     
    Ardmore, OK
       88,000
           11.3
    13%
    NCRA
     
    McPherson, KS
       82,200
           14.1
    12%
    Gary Williams
    Wynnwood, OK
       52,500
             8.0
    8%
    Sinclair
     
    Tulsa, OK
       50,000
             8.3
    7%
     
    Total CVR Supply Area
     684,700
     
     
     
     
     
     
     
     
     
     

     
    Now is the Time to Buy Refiners – As much as we are fundamental research-driven value investors, we cannot help but point out the strong technical pattern that this sector’s securities have exhibited over the past two decades.  As the chart below shows, shares of publicly traded refiners have generated a positive return for the 6 months from December to May in 17 of the last 18 years and have bested their performance during the other 6 months of the year in 15 of those 18 years.

    Seasonality of Refining Stocks
     
     
    Dec.-May
     
    Jun.-Nov.
     
    Spread
    1990
     
    2%
     
    (15)%
     
    17%
    1991
     
    8%
     
    (10)%
     
    18%
    1992
     
    6%
     
    (14)%
     
    20%
    1993
     
    4%
     
    16%
     
    (12)%
    1994
     
    9%
     
    (1)%
     
    10%
    1995
     
    10%
     
    (3)%
     
    13%
    1996
     
    11%
     
    (5)%
     
    16%
    1997
     
    17%
     
    17%
     
    0%
    1998
     
    5%
     
    (25)%
     
    30%
    1999
     
    (10)%
     
    (9)%
     
    (1)%
    2000
     
    28%
     
    (5)%
     
    33%
    2001
     
    1%
     
    (13)%
     
    14%
    2002
     
    3%
     
    (20)%
     
    23%
    2003
     
    20%
     
    22%
     
    (2)%
    2004
     
    49%
     
    36%
     
    13%
    2005
     
    42%
     
    29%
     
    13%
    2006
     
    8%
     
    (7)%
     
    15%
    2007
     
    34%
     
    (5)%
     
    39%
     
     
     
     
     
     
     
    As per Morgan Stanley report dated September 26, 2007 (therefore partial data for Jun.-Nov. 2007).

     
    Aligned Incentives – Goldman Sachs and Kelso (private equity firm) remain the 2 largest shareholders in the Company, with a combined 77% ownership.  They did not sell a single share in the CVI IPO.  We believe that this is because they recognize the value that remains to be unlocked when the fertilizer segment begins to trade publicly in mid to late 2008.
     
    Experienced Management Team – Senior management team averages 28 years of experience each.  CEO has 35 years and has run a refinery nearly 5 times this size (at El Paso and Coastal) as well as a multi-plant fertilizer system.  COO has 33 years and was in charge of one of the largest fertilizer systems in the US.  CFO has 18 years and has been the CFO for 2 fertilizer manufacturers.
     
     
     
    NITROGEN FERTILIZER
     
    This is the real upside valuation driver here:
     
    Unique Lowest Cost Producer – Literally the ONLY operation in North America that utilizes a revolutionary coke gasification process to produce ammonia, making it the LOWEST cost producer of ammonia and UAN on the continent.  As a result of this technology (which utilizes a low-value petroleum coke byproduct from the refinery), CVI requires only 1% of the high cost natural gas that all other nitrogen fertilizer producers depend upon for the production of ammonia.  CVI estimates that its production cost advantage is sustainable at natural gas prices as low as $2.50/mmBtu equivalent (66% below current market levels based on today’s spot price of $7.45).  The plant is also the newest fertilizer plant in North America (built in 2000 and expanded during a full scheduled turnaround in 2006).
     
    INVERSE Exposure to Natural Gas Prices – Because natural gas is the primary cost component in manufacturing ammonia, fertilizer prices generally increase with natural gas prices.  As a result, CVI actually BENEFITS from higher natural gas prices not only because its cost structure is unaffected versus its competitors, but also because the price for its output increases right along with everyone else’s in the market, having a dramatic impact on margins in a tight supply/demand environment.  The current natural gas futures market runs through September 2011 and shows that current market expectations for natural gas during that time period fluctuate between $7.58 and $9.12 per mmBtu (2% to 22% above the current spot price), with an expected 4 year average price of $8.18 (10% high than current).  In other words, rising natural gas prices should be a significant benefit to CVI for years to come.
     
    Although we have not included the following upside scenario in our valuation, there is a strong argument to be made that natural gas prices are headed much higher than this forward curve would indicate, and/or that prices are vulnerable to short-term spikes (either of which would obviously be extremely lucrative for CVI’s fertilizer operations).  The drivers that may cause such a situation to play out include interruptions as a result of hurricanes or other severe weather, rapidly rising exploration and productions costs both domestically and abroad, declining production curves, continued delays in LNG gasification projects and a lack of LNG imports due to sustained increases in foreign demand.
     
    Strong Market Fundamentals – Nitrogen accounts for approximately 60% of worldwide fertilizer consumption and there are no substitutes for nitrogen fertilizers in the cultivation of high-yield crops such as corn.  A growing world population, increases in disposable income and associated improvements in diet (higher incomes = more beef = more feed corn) are all driving increasing high value food supply demands (particularly in India, Latin America and Russia) that are benefiting the nitrogen fertilizer industry.  The expanded use of corn for production of ethanol is also driving demand (2007 corn acreage exceeded 2006 levels by 19%).  As a result of these influences, over the past 45 years, growth in nitrogen fertilizer demand has outstripped growth in global fertilizer demand (by an annual rate of 4.8% vs. 3.7%).
     
    Current strong industry fundamentals include US producer UAN inventories that are lower than they were during the prior year, a tight US import market which contracted sharply in late 2006 and nitrogen fertilizer global capacity utilization which is projected to be near 85% through 2010.  These fundamentals have been driven, in part, by increased US corn plantings and increasing worldwide natural gas prices.
     
    There is certainly a debate about whether the recent increases in ethanol production (and therefore corn plantings) are sustainable and a significant amount of froth has come out of some ethanol related equities over the last year or so.  We believe that the best metric to consider when determining future fertilizer pricing (aside from future natural gas prices) is to go straight to the primary driver – the price of corn.  Farmers don’t care whether their produce is going to feed cattle or to produce ethanol – they just care how much a bushel of corn can sell for and this drives their planting decision, which directly determines their use of nitrogen fertilizer (roughly 100-160 pounds of nitrogen for each acre of plantings).  Therefore, we believe the best indicator to determine the future health of the nitrogen fertilizer industry is to look at the futures market for corn.  The following table illustrates that the market expects corn prices to remain elevated and in fact to rise as much as 25% from current levels over the next 3 years.  This is also consistent with long-term USDA forecasts.

    Corn Futures Market
     
     
     
     
     
     % Change
     Contract
     
     Delivery
     
     $ / Bushel
     
     from Current Spot
    C Z7
     
     12/18/2007
     
     $3.75
     
    10%
    C H8
     
     3/18/2008
     
     $3.92
     
    15%
    C K8
     
     5/16/2008
     
     $4.02
     
    18%
    C N8
     
     7/16/2008
     
     $4.10
     
    21%
    C U8
     
     9/16/2008
     
     $4.15
     
    22%
    C Z8
     
     12/16/2008
     
     $4.21
     
    24%
    C H9
     
     3/17/2009
     
     $4.27
     
    26%
    C K9
     
     5/18/2009
     
     $4.31
     
    27%
    C N9
     
     7/16/2009
     
     $4.35
     
    28%
    C Z9
     
     12/16/2009
     
     $4.21
     
    24%
    C H0
     
     3/16/2010
     
     $4.26
     
    25%
    C N0
     
     7/16/2010
     
     $4.31
     
    27%
    C Z0
     
     12/16/2010
     
     $4.22
     
    24%
     
     
     
     
     
     
     
    Current spot price is for USDA Iowa North Central No. 2 Yellow Corn.
     
     

     
    Location is Key – Because shipping ammonia requires refrigerated or pressurized containers and UAN is more than 65% water, transportation cost is substantial for ammonia and UAN producers.  CVI’s fertilizer assets are located directly in the corn belt, creating a geographic advantage to supply products in this significant region without incurring intermediate transfer, storage, barge or pipeline freight charges.  This substantial cost benefit only further widens CVI’s structural competitive advantage over all other nitrogen fertilizer producers.
     
    Upcoming Expansion – CVI is now embarking on a $50m fertilizer plant expansion, which could increase the plant’s capacity to upgrade ammonia into higher margin UAN by 50% to more than 1 million tons per year.  We estimate that this project could generate an incremental $36 million in annual EBITDA at expected market prices (based on independent pricing estimates as per fertilizer experts Blue, Johnson).
     
    Secure Raw Material Source – Refinery byproducts provide 80% of the feedstock necessary for fertilizer production.  A recent 20 year inter-company supply agreement ensures that this will remain the case even after the separation.
     
    Upcoming MLP Spin-Out – CVI has already separated the nitrogen assets into a separate legal entity structured as a tax advantaged Master Limited Partnership (MLP) – this was done in conjunction with the CVI IPO.  We believe that this structure will attract yield focused investors and garner a higher valuation as a result – the MLP universe, on average, tends to trade in the range of 15x forward EBITDA.  Management has indicated that they expect to complete this transaction within the next 6-9 months.
     
     
     
    THE VALUATION
     
    The bottom line is that we think CVI is worth somewhere between $25 and $55 per share (as much as 155% upside) over the next 2 years.  The table below summarizes our valuation analysis and what follows is a more detailed look at some of our key assumptions: 

    CVI – Preliminary Valuation Analysis
     
     
     
     
     
     
     
    Low
     
    Medium
     
    High
    Refining Production Capacity (per Day)
     
        119,000
     
        119,000
     
        119,000
     
    Modified Solomon Complexity
     
           11.1x
     
           11.1x
     
           11.1x
    Production Equivalent Capacity (per Day)
     
     1,320,900
     
     1,320,900
     
     1,320,900
     
     
     
     
     
     
     
     
     
     
     
     
    EV / Equivalent Barrel
     
     
          $1,400
     
          $1,700
     
          $2,000
     
     
     
     
     
     
     
     
     
     
     
     
    Implied Refinery Enterprise Value
     
          $1,849
     
          $2,246
     
          $2,642
     
     
     
     
     
     
     
     
     
     
     
     
    Nitrogen Fertilizer Pro Forma EBITDA
     
          $162.6
     
          $169.9
     
          $177.3
     
    EBITDA Valuation Multiple
     
     
             6.0x
     
           10.5x
     
           15.0x
    Implied Fertilizer Enterprise Value
            $975
     
          $1,784
     
          $2,659
     
     
     
     
     
     
     
     
     
     
     
     
    CVI Enterprise Value
     
     
          $2,825
     
          $4,030
     
          $5,301
     
    Pro Forma Total Debt
     
     
             (493)
     
             (493)
     
             (493)
     
    Economic Drag from CF Swap
     
             (190)
     
             (190)
     
             (190)
     
    Payments Deferred by J. Aron
     
             (124)
     
             (124)
     
             (124)
     
    Flood Rebuilding Costs
     
     
               (90)
     
               (90)
     
               (90)
     
    Crude Spill Remediation Costs
     
               (40)
     
               (36)
     
               (32)
     
    Minority Interest
     
     
     
               (11)
     
               (11)
     
               (11)
     
    Pro Forma Cash & Equivalents
     
                65
     
                65
     
                65
     
    Flood Insurance Receivable
     
     
                95
                95
                95
    Implied CVI Equity Value
     
     
          $2,037
     
          $3,246
     
          $4,521
     
     
     
     
     
     
     
     
     
     
     
     
     
    Pro Forma Shares Outstanding
     
             81.6
             81.6
             81.6
     
     
     
     
     
     
     
     
     
     
     
     
    Implied CVI Value per Share
     
          $24.94
          $39.75
          $55.37
     
    Premium to Current ($21.68)
    15%
    83%
    155%
     
     
     
     
     
     
     
     
     
     
     
     

    Refinery Assets:
    To avoid getting too much into the weeds here, it is worth referring you to a July 23, 2007, UBS research report initiating coverage on the US refiners that does an excellent job of providing an explanation of some of the various metrics by which to value refinery assets.  A good starting point (although it ignores profitability per barrel, which would likely favor CVI in this analysis) is to look at a refinery’s enterprise value per equivalent distillation capacity (a formula that effectively adjusts for varying complexities among refineries that impact their product mix).  The analyst provides the current market metrics for the key US refineries and shows that, at the time of the report, the most comparable assets (Valero, Tesoro, Sunoco and Frontier) were trading at a range of between $1,200 and $2,400 per equivalent barrel.  Because the CVI refinery assets are of fairly average complexity within this group (see the chart above), we have chosen a fairly conservative range in the bottom two-thirds of this spectrum for our valuation ($1,400 to $2,000 per equivalent barrel).  We ran our valuation on the demonstrated peak capacity after the improvements made in conjunction with the recent flood-related rebuilding (119,000 barrels per day).  The result is an implied enterprise value of $1.8 to $2.6 billion for the refinery assets alone.  Recall that we mentioned earlier that recent domestic expansion projects have been completing in the range of $15,000 to $25,000 per barrel (and even higher for newbuilds abroad).  For comparison purposes, our equivalent barrel valuation above translates into an implied value per barrel of roughly $15,000 (low case) to $22,000 (high case), entirely consistent (and perhaps conservative) with recent actual examples.
     
    Fertilizer Assets:
    We believe the real hidden value in CVI lies within the fertilizer assets, which in our estimation could actually be worth as much or even more than the refinery itself – especially considering the separate public MLP structure that Goldman and Kelso intend to pursue for these assets during the first half of 2008.  The table below shows our analysis of the potential earnings power of the fertilizer assets during 2006 (these pro forma figures were provided in the Company’s recent S-1); in their current form under prevailing market prices (2008 column); and once the anticipated gasification expansion is fully completed (2010 column).  All projections utilize current independent Blue, Johnson average corn belt pricing estimates for both ammonia and UAN.

    Potential Fertilizer Segment EBITDA
     
     
     
     
    2006
     
    2008
     
    2010
    Total Ammonia Production
          369
     
          406
     
          406
     
    On-stream Factor
     
    89.3%
     
    96.7%
     
    96.7%
     
     
     
     
     
     
     
     
     
    Production Volume
     
         
     
     
     
     
     
    Ammonia
     
          123
     
          135
     
            -  
     
    UAN (upgrade)
     
          633
     
          660
     
          990
     
     
     
     
     
     
     
     
     
    Market Price
     
     
     
     
     
     
     
    Ammonia
     
        $379
     
        $485
     
        $450
     
    UAN (upgrade)
     
          183
     
          308
     
          293
     
     
     
     
     
     
     
     
     
    Revenues
     
     
     
     
     
     
     
    Ammonia
     
       $46.7
     
       $65.6
     
            -  
     
    UAN (upgrade)
     
       115.8
     
       203.3
     
       290.1
     
     
    Total Revenues
     
     $162.5
     
     $269.0
     
     $290.1
     
     
     
     
     
     
     
     
     
    COGS
     
       $22.4
     
       $26.1
     
       $27.7
     
    % of Sales
     
    14%
     
    10%
     
    10%
     
    $ per Ton of Ammonia Production
     $60.67
     
     $64.36
     
     $68.28
     
     
     
     
     
     
     
     
     
    Direct Operating Expenses
       $63.6
     
       $67.5
     
       $73.1
     
    % of Sales
     
    39%
     
    25%
     
    25%
     
     
     
     
     
     
     
     
     
    SG&A
     
       $12.0
     
       $12.8
     
       $13.5
     
    % of Sales
     
    7%
     
    5%
     
    5%
     
     
     
     
     
     
     
     
     
    Fertilizer Segment EBITDA
       $64.4
     
     $162.6
     
     $175.8
     
    % of Sales
     
    40%
     
    60%
     
    61%
     
     
     
     
     
     
     
     
     

      
    The ammonia capacity in 2006 was lower than true capacity (or historical reality) due to that year’s scheduled turnaround and a one-time hydrogen diversion.  For 2008 and beyond, it is management’s expectation that its on-stream factor should return to the nearly 97% utilization seen in 2005 (in addition to a further 6,500 tons as a result of spare gasifier improvements).  The end result is that CVI should be able to produce 660k tons of UAN next year by upgrading two-thirds of its ammonia production (just as it does now) and then nearly 1 million tons of UAN by the beginning of 2010 when the gasifier expansion project is completed.  Our cost assumptions increase by a 3% CAGR each year from the actual levels seen in 2006.  Due to the literally 99% fixed cost nature of the direct expense cost structure, the impact of anticipated fertilizer market pricing combined with the expected capacity improvements will result in a step-function increase in earnings power for the segment beginning as early as 2008 and improving going forward.
     
    As mentioned, the pricing assumptions are straight from an October 2007 report from the pre-eminent independent source for fertilizer and agricultural chemical pricing analysis (Blue, Johnson).  Their current long-term UAN forecast is as follows:

    UAN Price Projections
     
    2007
    2008
    2009
    2010
    2011
    2012
    2013
    2014
    2015
     Avg. Corn Belt Price
    $283
    $308
    $301
    $293
    $288
    $290
    $293
    $298
    $298
     % Change from 2006
    44%
    57%
    54%
    49%
    47%
    48%
    49%
    52%
    52%
     
     
     
     
     
     
     
     
     
     
    As per Blue, Johnson Associates as of October 2007.
     
     
     
     
     
     
     

     Finally, we apply a market multiple on the expected fertilizer segment EBITDA.  The pure play public fertilizer comps (POT, MOS, AGU, CF, TRA, TNH) currently trade at a wide forward EBITDA multiple range from about 5.5x to 16x.  We believe that the combination of factors described above (primarily the positive profitability correlation with natural gas prices) and the fact that the fertilizer segment will be spun out in a tax advantaged MLP structure (an analysis of public MLPs shows that they trade at an average implied forward EBITDA multiple of around 15x) gives us confidence that CVI’s fertilizer segment should command a market multiple at or above the high end of the current peer range.  However, we have capped the valuation range in our analysis at 15x and showed scenarios all the way down to what we feel is a very unrealistic 6x multiple to illustrate just how compelling the CVI valuation is at any of these levels.  The result is that we believe that the fertilizer segment alone is worth between $1.0 and $2.7 billion in enterprise value.
     
    Net Debt & Other:
    There are a number of adjustments to enterprise value other than the relatively straightforward calculations (pro forma debt, cash and minority interest).  These are broken out in the detailed valuation table above.  In short, we have endeavored to be as conservative as possible by essentially charging the equity with the full current value of the flood reconstruction costs, the crude spill remediation efforts, the back payments owed to J. Aron related to the cash flow swap agreement and most importantly, the current market value of completely eliminating the remainder of the dilutive swap agreement (something that management has indicated it does not believe makes economic sense at current levels).  We are treating the valuation as if these payments are all made today, even though no cash has left the Company for any of them yet (as of the last published pro forma balance sheet used herein).  More details on each of these issues is available in the Company’s S-1.  We believe that all of these items together represent a negative adjustment of approximately $780-$790 million.
     
    As the valuation table above shows, adding these pieces together yields an implied enterprise value for CVI of $2.8 to $5.3 billion and a fully adjusted equity value of $2.0 to $4.5b or roughly $25.00 to $55.00 per share (an extremely attractive payoff structure at current levels that implies for that 150% upside within the next two years).  Of course, any spike in natural gas prices or multiple re-rating in the currently undervalued refinery sector would create meaningful upside to these valuation targets.

    Catalyst

    1) The first earnings release as a public company will highlight the beginning of the dramatic step change in fertilizer earnings power that we have laid out here. We believe this segment will very quickly become impossible to ignore any longer.

    2) The Company’s timetable for the fertilizer MLP spin is within the next 6-9 months.

    3) CVI’s $50 million gasification expansion should increase higher margin UAN production by 50%, yielding significant earnings benefits by 2010.

    4) Refiners materially outperform from December to May (data above).

    5) The Company details a number of other accretive expansion and improvement projects in its S-1 that are either already currently underway or are planned over the near to medium term.

    Messages


    SubjectSpin-out Questions
    Entry11/19/2007 02:08 PM
    Memberdavid101
    Gatsby,

    Thanks for an interesting idea. Have some questions regarding the spin-out:

    1. With regard to spinning the fertilizer business off into an MLP, where will ownership of the general partner (GP) reside post spin? Is CVI going to retain an equity interest in the MLP post spin?

    2. Why buy now? A lot of things can happen between now and the spin date, but my guess is that the most owners of CVI are not natural holders of an MLP and would be likely to flip them.

    David

    SubjectThoughts
    Entry11/20/2007 03:36 PM
    Memberissambres839
    First off I completely agree with David.

    That said, if Gatsby doesn't want to respond to our questions, we can also post in his stead anything interesting that we have found out.

    My Goldman broker told me that a lot of really "smart" money participated in this IPO that almost never participate with in issuances. He told me that the book was super strong in the holders who participated.

    He expects Goldman to pick up coverage around 40 days after the offering, which would put coverage starting the week of December 3rd.

    At a minimum this could be an interesting trade when the brokers, especially Goldman (after all they are one of the big holders) start flogging this and put a value much higher than the current stock price.

    Subjectquestion
    Entry11/20/2007 07:25 PM
    Memberluke0903
    What do you think the refinery business will earn in 2008? Thanks for the writeup.

    Subjectre:your assumptions
    Entry11/21/2007 03:38 PM
    Memberissambres839
    I would disagree with your comments on fertilizer for multiple reasons.

    1)As an MLP, the fertilizer sub would not be doubly taxed, thus allowing the company to experience a much higher multiple.

    2)While we aren't at a bottom in agriculture, we aren't even close to a top. Historically, ag bull markets last 10-15 years, and this latest one started 12-18 months ago or so.

    3)Before you use such a low multiple as 6, I would have you compare it to other fertilizer company's whose multiples are much higher.

    4)Finally, I think you have to give the fertilizer sub a higher multiple due to the natural gas advantage.

    All of that adds up to a much higher multiple than 6, and if it gets an MLP EBITDA multiple, this stock will explode higher.


    SubjectFertilizer multiples
    Entry11/21/2007 03:52 PM
    Memberjohn771
    My impression is that analyst valuations average 5X EBITDA for nitrogen assets, 8X EBITDA for phosphate, and 15X EBITDA for potash.

    TNH is an outlier with a high valuation for nitrogen fertilizer production. It's either a somewhat rational premium for the LP structure, or the market has made a big mistake (some discussion on the TRA idea posted earlier this year).

    I think 5X fertilizer EBITDA is a good "base case" for use in valuing CVI and 10X would be a "best case."

    SubjectMLP questions
    Entry11/23/2007 12:17 PM
    Memberissambres839
    Does anyone know a reason why a fertilizer company couldn't or wouldn't want to become an MLP? Why wouldn't other companies try to become MLPs? Would it give CVI a competitive advantage by having a lower cost of capital?

    Thoughts?

    SubjectAnswers (Part 1)...
    Entry11/29/2007 12:50 AM
    Membergatsby892
    Apologies for the delayed responses. Hopefully the following will be somewhat helpful.

    1. Where will ownership of the fertilizer GP reside post spin?
    Goldman Sachs, Kelso and the CVI management team have purchased the GP interests from the Company for $10.6 million. While we view this as somewhat of a negative given the substantial value that we believe should accrue to these units over time, this arrangement aligns incentives in an extremely beneficial way for CVI shareholders – the GP interests are essentially completely worthless unless the distribution obligations to the LP units are met in full over an extended period of time (details disclosed in the S-1). In other words, no one stands to gain more from increasing the LP distributions than those that have the best ability to make that happen (management and those shareholders that control the Board).

    2. Is CVI going to retain an equity interest in the fertilizer MLP post spin?
    The Company plans to sell approximately 20% of the MLP to new shareholders in an offering expected to occur by the third quarter of 2008. CVI will retain the remaining 80%. The purpose of the offering is to highlight the value of an overlooked segment that is being underappreciated by energy investors, not to dispose of a non-core asset or to raise capital for the refinery business. Management understands the value of what they own and they have chosen to highlight this asset through the public markets and then hold on to the remainder.

    3. Why buy now? Isn’t it true that most owners of CVI are not natural holders of an MLP and would be likely to flip them?
    The MLP interests are not being spun to existing CVI shareholders, but rather a stake (probably 20%) will be sold by the Company directly to new shareholders, ensuring that the securities end up in the hands of those that value them the most (yield seeking MLP investors). As a result, there is no overhang issue here. It is our view that the closer that we get to the MLP offering, the more the overlooked value of the fertilizer segment will be highlighted and finally reflected in CVI’s share price.

    4. Why pay more than 6x EBITDA for a fertilizer business?
    Issambres839 has already done an excellent job of answering this, but we’ll quickly highlight our thoughts. MLPs typically trade at significantly higher multiples than C-corps largely due to their advantageous treatment for federal income tax purposes (a broad sampling of publicly traded MLPs traded at an average enterprise value to LTM EBITDA of 13.8x, 13.1x and 12.9x at year-end 2004, 2005 and 2006). The only publicly traded nitrogen fertilizer MLP (TNH) also trades at a mid-teens EBITDA multiple. Moreover, we believe that CVI’s fertilizer assets actually deserve a premium to TNH – although the operations are smaller than Terra’s, they are not subject to the volatile negative effects of rising natural gas prices (a critical factor considering the typical dividend yield valuation approach taken by MLP investors). However, if you disagree with the market’s valuation of publicly traded MLPs or with the value currently ascribed to TNH, then short them as hedges against your upside optionality in CVI.

    5. Why wouldn't other fertilizer companies try to become MLPs?
    Income from fertilizer manufacturing of all types (nitrogen, phosphate and potash) does in fact qualify for MLP treatment. However, what likely has prevented many of CVI’s peers from making this election is the commitment to minimum quarterly distributions to the LP unit holders. The fact that the largest component of a nitrogen fertilizer manufacturer’s cost structure is natural gas makes for highly volatile cost of goods sold and therefore profits and therefore cash available for distribution. CVI’s fertilizer segment is unique thanks to the coke gasification process that allows it to take natural gas out of the equation, maintain a virtually entirely fixed cost structure and therefore reduce the downside volatility of cash available for distribution. This is an advantage that cannot be claimed by any other fertilizer manufacturer in North America. Furthermore, CVI is trying to highlight the value of an overlooked segment that belongs in the hands of an entirely different shareholder base than its refinery assets. No other fertilizer manufacturer faces such a compelling rationale for separating its nitrogen assets into an MLP structure.

    SubjectAnswers (Part 2)...
    Entry11/29/2007 12:51 AM
    Membergatsby892
    6. What do you think the refinery business will earn in 2008?
    Rather than just give you our projections, it might be most helpful to walk you through how best to approximate CVI’s refinery earnings under various crude oil assumptions. Unfortunately, I cannot post a table here, so the math may get a little messy in paragraph format, but I’ll give it a shot.

    Let’s start with the current futures market price for WTI crude for 2008 (12 month average based on today’s closing prices) of $87.69 per barrel – use whatever assumption you want here, but we’ll stick with the futures market for the best approximation of reality for our calculations. Over the past 20 years, the NYMEX 2-1-1 crack spread has averaged 17% of WTI, implying $14.91 per barrel for 2008 in our example ($87.69 * 17%). CVI has the ability to purchase heavier sour crudes at a discount to WTI that has averaged between $4 and $5 per barrel over the past few years. Additionally, CVI benefits from a regional basis differential whereby its products are typically sold at an average premium of $3.60 to NYMEX. Adding these two benefits to the NYMEX crack spread yields a gross profit per barrel of liquid production of $23.01 in our analysis ($14.91 + $4.50 + $3.60). However, CVI’s liquid production yield is currently only 91%. The remaining 9% is lost to slurry, petroleum coke, propane, etc. and essentially generates a loss that partially offsets the high profitability of the higher value fuel production. This loss can be calculated by assuming that CVI purchases its crude for $83.19 (WTI of $87.69 less CVI’s crude differential of roughly $4.50) and is only able to generate revenue per barrel of about $10.00 on average (based on conversations with management), implying a total loss per barrel of $73.19. Weighting the $23.01 gross profit per barrel at 91% of production and the $73.19 loss at 9% yields a total blended gross profit per barrel of $14.35. Finally, subtracting about $3.90 per barrel in fixed operating expenses (excluding D&A) yields a cash refining margin of $10.45 per barrel. Applying this to the conservative production estimate of 115,000 barrels of production per day (well below the 119,000 per day demonstrated recently) implies a total cash refining margin of roughly $440 million annually based on current crude futures.

    SubjectRestricted
    Entry12/14/2007 12:42 PM
    Memberissambres839
    Thanks for this wonderful idea, my research has supported your analysis and I really like the prospects of this company.

    As a side note, Goldman Sachs is completely restricted from trading this stock. This is a new restriction, and you can't buy or sell this through Goldman.

    Me thinks Goldman is advising them on some kind of transaction.

    SubjectRe: Restricted...
    Entry12/17/2007 11:20 AM
    Membergatsby892
    It is our understanding that Goldman has been restricted since initiating coverage of the name on December 2nd. This is likely just a temporary aspect of an overly cautious compliance plan given Goldman's significant economic interest (and obvious potential conflicts of interest).

    That being said, we do believe that the Company (and likely Goldman) are hard at work on the potential fertilizer MLP transaction. There has also been recent speculation of consolidation within the sector that could drive numerous potential restricted outcomes. Typically, the Chinese wall concept is enough of a safe harbor to allow client trading activities to continue, but it seems that Goldman is being very cautious here.

    SubjectQuestions
    Entry12/17/2007 05:09 PM
    Memberstyx1003
    Thanks for this very interesting idea. My questions are as follows:


    1) Valuation of Fertilizer MLP: MLPs tend to trade on yield not EBITDA; yields range from 7% to 10%. Most of them are low-risk “toll-road” type businesses such as pipelines and do not have the cyclicality of fertilizer. Thus, it would seem appropriate to use the higher 10% yield to value the expected distribution for CVR’s MLP. Based on your projections I get approximately $4.50 per share of potential total distribution. The minimum distribution to the non-Managing General Partner interests is $1.73, the remaining is split with the Mng Gen Ptr at rates as high as 48% to the MGP (most MLPs are 20% to MGP when minimum # is covered, which would argue for a lower potential valuation for our MLP all else being equal). After giving the MGP its share, the MLP shareholders would receive approximately $3.33 a share, at a 10% yield = $33.33 price x 33.33M shares = about $1.1B valuation (using 7% would be $1.6B). That is if they hit your numbers which have onstream factor going up 7% and UAN prices up. It seems to me that your Medium and High cases valuation for the Fertilizer MLP are very high and do not take into account cyclicality or the very large split with the MGP – am I missing something here? Can you share with us your MLP distribution analysis?

    2) Refinery Valuation: It seems more likely that CVR’s refinery will trade on EBITDA (about 5x for comps right now) than replacement cost. Can we take your $440M estimated cash refining margin and deduct $60M of G&A and some number for the EBITDA lost because of the swap to get actual reported EBITDA for 2008 and 2009? Or does the $440 already deduct these items? What was this number for 2006?

    3) CF Swap: How did you calculate the $190M liability from the CF Swap? Do you have an estimated cash flow impact from the swap for 2008 and 2009 based on your assumptions for crack spread?

    4) Potential Legal Liability from Flood Oil Spill: How do you think about this risk? Doesn’t seem like you have provisioned for it?



    SubjectGoldman report
    Entry01/04/2008 12:18 PM
    Memberissambres839
    Goldman upgraded CVI today and added it to their "Americas Conviction" list as the number 1 refiner to buy. They also upped their estimates and their price target to $37 per share.

    SubjectRefining margins vs. nat gas
    Entry03/03/2008 05:04 PM
    Membertyler939
    Gatsby, given the cross currents in this name (declining refining margins and positive natural gas prices), I was wondering if you might update your thoughts on valuation. Thanks.

    SubjectAny updates on this name?
    Entry03/11/2008 06:00 PM
    Membertyler939
    Thoughts on earnings / confernece call would be appreciated.

    Subjectgatsby, thoughts on restatemen
    Entry04/30/2008 12:40 PM
    Membertyler939
    Any thoughts on the restatement? Are you still long? Any updates, thoughts on the refinery operations or the fertilizer mlp would be appreciated.

    SubjectIMHO
    Entry05/11/2008 09:17 PM
    Memberissambres839
    This stock is very cheap just on the basis of its fertilizer sub. The fertilizer sub should be a monster IPO and the market appears to be offering an incredible opportunity at current prices. We only have to wait until Thursday to hear about how good biz is at the fertilizer sub.

    Subjectcancelled MLP offering
    Entry06/16/2008 08:53 PM
    Membertyler939
    Well, CVR postponed the fertilizer MLP on Friday. I suppose it's not a huge surprise, given their statements in the quarterly conference call. They said the decision was "based on MLP market conditions" rather than "the fundamentals and outlook for the fertilizer business," but I don't see how the market for MLPs is especially bad. The Citigroup MLP total return index is 2.5% off it's high for the year, and is up nearly 7% since that earnings call. Between that and the market's enthusiasm for fertilizer stocks (see, e.g., IPI's IPO), it's hard for me to believe that market conditions were not favorable for the MLP. Does anyone else have a view on this?

    SubjectThesis still in tact?
    Entry07/17/2008 04:01 PM
    Memberjay912
    Despite the absence of the main catalyst, and potential share sale by the sponsors, the intrinsic value of the company should not be changed. What's the valuation now, given how crack spreads have been under pressure and the refinery hedges rolling off? This stock seems to trade like whichever is worse in a particular day, of the refiners or fertilizers. Meanwhile, we're getting closer to the point where we'll get one of the businesses for free!

    SubjectRE: RE: Thesis still in tact?
    Entry10/24/2008 12:38 PM
    Membersurf1680
    Anybody looking at this now that it's trading at nearly 1/2 book value?

    Subjectgoldman relationship
    Entry11/11/2008 12:05 PM
    Membersurf1680
    It seems like this selloff might have something to do with their goldman sach's relations. If goldman has to liquidate, would they have to register or at least file form 4s? Or could it already be happening? market anticipating?
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