Two Red Flags for the Holly Corp./Frontier Oil Merger

The shareholders of Frontier Oil (FTO) are probably conflicted this morning. It was announced yesterday that the company is merging with Holly Corp. (HOC) and their stock is now worth about $27 per share.

On one hand, they're delighted that the stock has doubled since last October, taking advantage of the run-up in the rest of this group because of improved refining margins in the industry. But in a way they're sad that they never got back up to the $47 per share that this stock was trading at in 2008 during the height of the energy induced price spike.

For the rest of us there are a couple of really important pieces of information on this:

Here's a summary of the deal:

	HOC	FTO	Combined
Refining Capacity	255,000	187,000	442,000
EPS est	0.8	0.5	0.92
Shares Outstanding (M)	53.2	105.7	104.1
Earnings Est (M)	42.568	52.86	95.428
PE (historical ind Avg)			15
Market Cap			1431.42
Est Stock Price			13.8
Actual Stock Price			55.57
Effective PE			61

In a way, the deal makes sense for both parties: FTO's achilles heel was the fact that it was small and having some reliability issues with its system, per the analysis we did awhile back.

HOC also has some distribution terminals and pipelines that will make the combined business a lot bigger and hopefully make the company better.

But you can see that at the moment, with the value of HOC at 57, the current price is at nearly 60 times the combined earnings of the two companies per the current Yahoo Finance average analyst estimates. For an industry which historical PE was in the 10 range, and for which the PE during the absolute height of the 2007-2008 oil boom period was running at less than 15, this deal is entirely too expensive.

From Holly Corp.'s point of view, here is a summary of what it cost the company to get that refining capacity:

Transaction Cost	2,900,000,000
FTO's Capacity	187,000
Cost per BOD	15508

We did a lot of analysis awhile back on historical refinery deals. And the price of $15,000 per BOD capacity was what people were announcing back in 2008 for greenfield capacity, and is just below the exploitative prices that were seen back in that period during the greatest year of all time for a lot of these companies. This transaction could have taken place last fall for $6,000 per BOD and there are a couple of companies right now whose nominal refining capacity could have been bought for much less than that.

As we are quite fond of saying, every transaction is done by two parties with exactly the opposite visions of the future: If you are HOC you obviously are anticipating this deal being "worth it," and either the margins are going higher or the utilization is going to be high enough this summer to justify paying that much for another couple hundred thousand BPD of capacity ...

or ...

This entire sector is becoming overheated, the valuation of this deal was far in excess of its ability to generate earnings, and it is time to put a little money into your pocket and walk away with a smile on your face.

As we are also fond of saying, the world is chaotic, and there are no guarantees on anything.

But these two red flags should be enough to make you scratch your head.

Disclosure: I am long CLMT.