Delek US Holdings, Inc. (DK)
By Jeremy Butler, Editorial Analyst
Delek US Holdings (DK) is an oil and gas company that specializes in downstream operations. These include anything that occurs after crude oil or natural gas is extracted from the earth, through the point of sale, and involve refining, distribution, marketing, etc. Delek owns refineries and leases retail gas stations and their adjoining convenience stores. The company has two refining operations: Tyler in Texas, and El Dorado in Arkansas. In addition, the company has a 60% interest in Delek Logistics Partners, a publicly traded master limited partnership (MLP), formed in April, 2012. This MLP buys, stores, and distributes crude oil. Moreover, Delek recently announced its intention to acquire the shares it does not already own of Alon USA Energy Inc. (ALJ), a fellow petroleum company. The transaction is expected to close in the first half of 2017.
The Business Segments
The core refining segment consists of two refineries in Tyler, Texas, and El Dorado, Arkansas. Combined, these plants produce an average of 165,000 barrels of oil equivalent per day. They are in close proximity to the Permian Basin, where low-cost oil is extracted and readily available for Delek to use. Consequently, DK’s oil transportation costs are low. The company’s refined products consist of gasoline for trucks and automobiles, distillate and jet fuel, and small-engine fuel. Delek also manufactures the petrochemicals used to make asphalt, roofing, and other construction materials. Demand for its products is higher during the summer months when there is a rise in motor vehicle traffic, as well as increased road and home construction. In 2016, the refining business generated sales and operating income of $3.62 billion (75% of total sales), and $93.4 million, respectively.
The retail unit sells gasoline, diesel, and convenience-store merchandise via a network of 380 company-operated gas stations located in Tennessee (53% of stations), Alabama, Arkansas, Georgia, Kentucky, Mississippi, and Virginia. Most of these gas stations are operated under the MAPCO brand. The retail operation produced 2016 sales and operating income of $301 million and $108 million, respectively (20% of total sales). Delek is the lessee of the stations and earns income from the items it sells.
The logistics business is Delek’s smallest division and consists of Delek Logistics, a publicly traded master limited partnership. Delek has a 60% ownership of this operation. This entity buys, stores, and distributes crude oil to Delek’s refineries and to the refineries of other companies. This operation makes up about 5% of sales.
Shares of Delek have been on a nice run, of late, and we think that the momentum can continue for several reasons. First, increased deregulation in the petroleum industry is anticipated by most market watchers and is already underway. A less regulated oil and gas industry would aid Delek’s operations (as it would many others in the industry), by easing red tape and making it easier and less onerous to invest in new projects. Second, Delek is entrenched in the Permian Basin of West Texas, a region that has a prolific amount of low-cost oil and gas, which Delek uses as a major raw material in its flagship refining segment. Signs that production cuts by the Organization of the Petroleum Exporting Countries (OPEC) are sticking and resulting in higher prices have galvanized U.S oil producers into drilling for more oil and gas. Third, by acquiring Alon USA Energy, Delek would increase its refining segment output by 43%, to approximately 300,000 barrels per day (bpd). The purchase would also create a marketing apparatus of about 600,000 bpd. This would give Delek a great deal more access to the Permian Basin, the nation’s fastest growing oil field. Finally, with expectations for sustained GDP growth, helped by higher consumer confidence; low unemployment; increasing household incomes; and the potential for lower corporate and individual tax rates and infrastructure renewal initiatives, we believe demand for DK’s refined products will rise.
The Proposed Alon USA Acquisition
Delek currently owns 47% of Alon’s outstanding shares. On January 3rd, Delek announced a definitive agreement to purchase the remaining 53% of Alon shares in an all-stock deal worth $675 million (including the proportional assumption of $152 million in net debt). Specifically, Alon holders would receive a fixed exchange ratio of 0.5040 of a Delek US share for each share of Alon, for an implied price of $12.13. The acquisition is anticipated to be a catalyst in propelling Delek’s operations to a new level. It would result in the company being one of the largest buyers of Permian crude, giving it economies of scale in refining and logistics. There would also be an increase of about 310 retail gas stations. A larger asphalt and construction material presence is also expected to materialize as a result of the combination. Synergy savings of $110 million are anticipated in 2018, when the merger ought to be highly accretive to the bottom line. This should permit Delek to post share net of $0.50 in 2018, up from our estimate of breakeven in 2017.
As of December 30th, Delek had a long-term debt-to-total-capital ratio of only 40%, which is very healthy for a refiner, and would only rise to 45% following the Alon acquisition. The company reported a bottom-line loss of $2.49 in 2016, but cash flow remained positive. Capital spending needs are high, as is typical with a growing company in this industry. Delek is expected to continue paying a dividend of $0.15 a share per quarter.
Delek stock hit a multi-year low of $11.41 a share in the third quarter of 2016. Since then, however, it has been on an upward trajectory, in conjunction with the broader market averages. Moreover, we believe this upward trend will continue, thanks to the pending purchase of Alon, higher demand for refined products, easy access to a plentiful supply of low-cost oil, industry deregulation, and the potential for tax cuts and increased infrastructure spending. Consequently, risk-tolerant investors may want to take a closer look at these shares.
At the time of the above article’s writing, the author did not have positions in any of the companies mentioned.
Natera Inc. (NTRA)
By Kevin Downing, Editorial Analyst
Natera (NTRA) is a healthcare diagnostics company that uses genetic, non-invasive prenatal testing (NIPT) technology to detect prenatal conditions. The company has launched seven molecular diagnostic tests since 2009 and intends to develop new products for prenatal and blood-based cancer testing in the future. It employs a direct sales force in the United States and has a global network of approximately 70 laboratory and distribution partners (some lab work is outsourced). Testing is available in the United States and Europe, with only 11% of third-quarter revenues coming from overseas. The company believes it has a dominant market position in the United States. The top line will likely rise from $55.2 million in 2013, to an expected $215 million-$220 million in 2016, but the company still operates at a loss, owing largely to R&D expenses and investments in new testing solutions.
Around two-thirds of revenue currently comes from Panorama, a non-invasive prenatal test that helps physicians identify various prenatal genetic abnormalities, including Down syndrome, Edwards syndrome, Patau syndrome, Turner syndrome, and triploidy, disorders that often result in intellectual disabilities, organ abnormalities, and even death. Panorama can also identify fetal gender. Too, Panorama can screen for five of the most common genetic diseases caused by microdeletions (missing pieces of DNA), which can have serious health implications and occur in 1 in 1,000 pregnancies, a higher rate than Down syndrome. Most of the company’s remaining revenues come from Horizon Carrier Screening, which “looks at your genes” to test for up to 274 genetic diseases. This information is valued by the current generation of fist-time parents, as many of them want to know how at-risk their children will be to genetic mutations. And, as the company claims, “most people are the carriers of at least one genetic disease,” a statement that could encourage people to get tested while family planning.
Most processes are performed at the company’s facilities using a maternal blood sample from as early as nine weeks into a pregnancy. This is significantly earlier than traditional testing methods. Panorama has been found to be over 99% accurate, and a paper published in the August, 2014 issue of Obstetrics & Gynecology reported that the test had a statistically significant lower false positive rate than competing methods. This allows physicians a greater degree of confidence when choosing to forgo invasive procedures. It also lowers the total cost to the healthcare system and limits the risk of spontaneous miscarriage, which is sometimes associated with invasive procedures.
One of the primary means of growth for the company is more insurance companies covering prenatal testing for people with average risk of having a child with birth defects, not just those with high risk. As points of reference, the high-risk base comprises about 800,000 births in the United States; the average-risk category represents about 3.3 million births per year; and Natera’s third-quarter annualized run rate for the Panorama test was 336,000. In mid-2015 there were very few people classified as average risk who had insurance that covered them to get a Panorama test. Now there is a potential market of 90 million average-risk patients that are covered in the United States. The number of covered individuals rose 60% over the past three quarters, and there is still more than half of the potential base to go.
Part of the progress can be credited to clinical studies that have concluded that average-risk patients should be tested. One such study, the DNAFirst trial, said “this is the first study providing evidence that primary obstetrical care providers can effectively offer non-invasive cell-free DNA screening to the general population as part of routine clinical practice.” Further, the National Society of Genetic Counselors (genetic counselors are professionals who often recommend the test to patients and physicians) issued an updated position statement on cell-free DNA screening (NIPT falls under this umbrella) endorsing non-invasive prenatal testing as a good option for all pregnant parties. These findings are important because they help Natera when appealing denied insurance claims and supporting changes in health insurance coverage policies. In fact, Cigna, one of the largest U.S. insurance outfits, did just that when it changed its coverage policy in August to include coverage for non-invasive prenatal testing for average-risk patients. Too, the company recently entered into an exclusive arrangement with a large hospital system to offer NIPT for all pregnancies, and is reportedly negotiating with several more.
Elsewhere, Natera sees significant opportunity to use its current technology in lung, ovarian, and breast cancer applications, such as therapy monitoring, recurrence monitoring, and early detection screening. Specifically, management believes it can detect recurrence four months to six months earlier than standard procedures. In the coming months, management expects to report details of testing that will demonstrate initial clinical validity of its platform to detect lung cancer recurrence.
The shares have been on a wild ride over the past six months, appreciating nearly 60% in value leading up to and following the release of third-quarter results, only to give some of that back in early January. The decline coincided with an announcement that a distribution agreement with Bioreference Laboratories (the third-largest full service clinical diagnostic laboratory in the United States) was terminated. Natera now intends to promote Panorama directly to clinicians, who previously ordered the test indirectly through Bioreference. By in-sourcing, the company believes it will significantly reduce channel conflict, or unintended competition between the distributor and Natera’s sales team. The internal sales force is capable of reaching most of the relevant physicians in the U.S., and the change should help efficiency in time, although near-term revenues may be moderately impacted. Nonetheless, we view this as a good move for the long term.
Meanwhile, as more patients can go “in network” to get Panorama tests, prices come down, which is expected to hinder revenue growth and gross margin expansion over the near term. Eventually, however, improved volume is expected to lead to revenue growth and be a net positive. To compensate for this near-term headwind, the company is looking to win more business from its most profitable accounts, especially those that opt for multiple tests (i.e., getting microdeletion tests and carrier screenings in addition to Panorama). All told, investors may want to wait until fourth-quarter earnings are released in early March to see the current impact of these near-term headwinds and hear the company’s 2017 outlook. Management’s 2016 guidance calls for revenue to be up 13%-16%, and annual cash burn of $75 million to $85 million, versus the $184 million of cash and equivalents on the books.
Like most small-cap companies in the healthcare arena, Natera shares carry significant risk, as evidenced by their high Beta and history of substantial price swings. That said, we believe in the fundamental long-term story here. Natera is well positioned to take advantage of more insurance companies accepting NIPT as standard practice in all pregnancies and should be able to eventually expand overseas, as well. Prospects for lateral applications of the technology in the oncology space also augur well for the long term.
At the time of the above article’s writing, the author did not have positions in any of the companies mentioned.