Description

Executive Summary

Calumet Specialty Products (“Calumet” or “CLMT”) is an MLP and leading independent producer of high quality, specialty hydrocarbon products in North America. In its Specialty Products segment, Calumet processes crude oil and other feedstocks into customized lubricating oils, solvents and waxes used in consumer, industrial and automotive products. In its Fuel Products segment, Calumet owns four small refineries that process heavy Canadian crude oil into gasoline, diesel, and jet fuel. Calumet also owns a small oilfield services business that is just now breaking even at the EBITDA level.

We recommend buying CLMT’s unsecured bonds (either the 6.5s due 2021, 7.625s due 2022 or 7.75s due 2023) in the mid-80s as we believe the bonds are more than fully covered at face value and offer yields to maturity of 11-12%, far in excess of higher yielding midstream comparables.

Investment Thesis & Valuation

Calumet’s recent history largely creates today’s opportunity in the company’s unsecured bonds. For years Calumet’s Specialty Products business produced steady free cash flow (the Specialty business does ~$200-225mm of EBITDA per year with ~$40-50mm of capex) but in 2011, Calumet made a big push into refining and oilfield services while Calumet’s largest shareholder’s daughter, Jennifer Straumins, ran the company (more on this below).

Calumet spent $1.4bn on M&A from 2011-2015 largely on assets with volatile, cyclical earnings streams and heavy capital requirements. Calumet’s refining assets are subscale and geographically disadvantaged and losses in this business forced the company to suspend its distribution while it restores its balance sheet.

In January 2016, Calumet replaced Interim CEO Bill Hatch (who had replaced Ms. Straumins as CEO a year earlier) with Tim Go, a 25+ year energy industry veteran who was most recently VP of Operations of Flint Hills Resources, LP, a wholly-owned subsidiary of Koch Industries. In May, Calumet hired Bruce Fleming as EVP of Strategy and Growth. Mr. Fleming has more than 30 years of energy experience and spent the last 10 years as VP of M&A at Tesoro Corporation.

Go and Fleming’s actions and comments on Calumet earnings calls since taking the reins at Calumet suggest they intend to aggressively streamline the company’s operations and get the company out of refining and oilfield services, where Calumet has no competitive advantage, and to re-focus Calumet on its stable Specialty Products business.

At 8x, Calumet’s Specialty Products’ EBITDA of $225mm would be worth $1.8bn, which covers Calumet’s unsecured bonds at $0.88 on the dollar before taking into account any value from the company’s refining assets (on which the company spent $729mm) or oilfield services businesses (on which the company spent $250mm).

Early in 2016, Calumet announced a three-year operational excellence program under which the company expects incremental annual EBITDA of $150-200mm by 2018, including $60-75mm in 2016.

The Trump administration has signaled it intends to take significant action to lower RIN prices. Just last week Carl Icahn was named as a special adviser to Trump. Over the past few weeks Icahn has been particularly vocal about the need for renewable fuel standard (RFS) reform, and Icahn said he personally interviewed Scott Pruitt, Trump’s pick to head the EPA. Icahn owns a controlling stake in CVR Energy, an independent refiner that has suffered from a surge in RIN prices. Calumet’s gross RIN obligation is 120mm RINs per year, but internal blending reduces the company’s net obligation to around 60mm. If RIN prices were to fall to $0.40 from ~$1.00, Calumet would save $36mm per year.

Since Trump’s election, Mr. Go has purchased 28K shares (~$126K at Mr. Go’s average purchase price of ~$4.50) of Calumet equity and Mr. Fleming has purchased 58K shares (~$200K). This is especially notable as per the terms of Calumet’s 11.5% senior secured notes, Calumet cannot pay a distribution until its fixed charge coverage ratio reaches 2.25x, implying ~$375mm of annualized EBITDA.

Company Description

Calumet was formed as Calumet Refining Company Burnham, IL in 1919 to manufacture white oils and lubrication products. In 1953 it constructed a refinery in Princeton, LA that focused on naphthenic crude oil refining to produce specialty products including base and process oils, and asphalts, and the Bunrham facility became a distribution terminal. Calumet Refining was acquired by the Heritage Group in 1990 and renamed Calumet Lubricants after it moved its headquarters to Indianapolis, IN. After acquiring two refineries from major oil companies, Calumet Specialty Products Partners LP went public in 2006. The Heritage Group is Calumet’s GP and is the largest unit holder at ~20% (including family holdings).

Calumet’s Specialty Products business is a steady, niche producer of popular consumer lubricants and greases that consistently produces $200-225mm of annual EBITDA. This segment produces the following popular consumer brands:

* Bel-Ray: High performance lubricants and greases used in aerospace, food, industrial, marine, mining, and power sport applications

* ORCHEX: Optimally balanced pesticide approved for use on tree crops, nuts, row crops, vegetables, and shade trees

* Penreco: Unique line of petrolatums, waxes, white mineral oils and gelled hydrocarbons used in cosmetics, pharmaceuticals and personal care products

* Quantum Lubricants: One of the fastest growing branded automotive and heavy duty lubricants

* Royal Purple: High performance synthetic motor oils that optimize engine performance

* TruFuel: High performance, ethanol free engineered fuels that are pre-blended for use with outdoor power equipment

Calumet’s lubricants and greases have passionate and loyal customers, as a quick glance at Amazon reviews for the company’s products attests:

https://www.amazon.com/Bel-Ray-Waterproof-Grease-16oz-99540-TB16W/dp/B0045L75M6/ref=sr_1_1?ie=UTF8&qid=1482937264&sr=8-1&keywords=bel-ray+waterproof+grease

https://www.amazon.com/Royal-Purple-API-Licensed-Performance-Synthetic/dp/B005SEJTUA/ref=sr_1_1?ie=UTF8&qid=1482937348&sr=8-1&keywords=royal+purple

https://www.amazon.com/TruFuel-2-Cycle-50-Pre-Blended-Equipment/dp/B00F2ZH9UW/ref=sr_1_2?ie=UTF8&qid=1482937463&sr=8-2&keywords=trufuel+50+1

Apart from Calumet’s consumer facing businesses, the Specialty Products group produces 5,000 different solvents, esters and other products that are nicely profitable and have real switching costs (i.e., Calumet produces a formulation that has been used in WD-40 for decades), but have small enough markets that they won’t attract the attention of Valero and other large refiners. There hasn’t been much in the way of new specialty capacity being built recently and most of the majors got out of the business in the last decade. Calumet’s prices in this segment tend to move with crude prices with some lag in both directions, though the lag is somewhat sticker (and margins more resilient) in a falling oil price environment.

Starting in 2011, Calumet made a push into refining and over the next two years spent $729mm on Murphy Oil’s Superior, WI refinery ($413mm, ~45kbpd throughput capacity), Montana Refining’s refinery in Great Falls, MT ($192mm, ~25kbpd throughput capacity) and NuStar Energy’s San Antonio, TX refinery ($118mm, 21kbpd throughput capacity). Calumet was also a joint venture partner with MDU Resources on a refinery in Dickinson, ND that struggled to make a profit before Calumet and MDU sold to Tesoro in June 2016.

Calumet’s refining business was very successful out of the gate and generated $121mm in Adj. EBITDA in 2012 when wide crude differentials and crack spreads prevailed. Despite its scale disadvantages, Calumet’s refineries benefited from local market product premiums and from the ability to source Mid-Continent and heavy Canadian crude feedstocks at significant discounts to WTI. When drilling activity in the Mid-Continent slowed down, local distillate demand followed. Making matters worse, Gulf Coast refiners started shipping product into the Mid-Continent in response to decreased export demand. Ultimately Calumet’s benchmark crack spreads (weighted to Calumet’s crude mix of 35% Western Canadian Select, 30% Bakken and 35% WTI and product mix of 40% Gulf Coast, 60% Mid-Continent) declined from $38/bbl in 2012 to $18/bb in the twelve months ended September 30, 2016. Excluding inventory adjustments, Calumet’s refining segment lost $38mm in EBITDA on an LTM basis.

Finally, Ms. Straumins oversaw the acquisitions of Anchor Drilling Fluids USA ($224mm in March 2014) and Specialty Oilfield Solutions ($30mm in August 2014). These businesses contributed $30mm in EBITDA in 2014 but have since lost a cumulative $29mm, although the business was nearly breakeven in Q3 2016.

Shortly after Tim Go took over as CEO, Calumet suspended its distribution, saving the company ~$230mm annually, including IDR payments. In April, Calumet layered its unsecured bonds with $400mm of new 11.5% first lien bonds due 2021. Calumet’s unsecured bonds dropped more than ten points to the low 60s in the following weeks, but the new issue coupled with the distribution suspension cemented Calumet’s liquidity profile (current cash plus revolver availability of $388mm) for the next 4-5 years and provides a runway for Mr. Go and Mr. Fleming (hired as an M&A specialist) to divest underperforming refineries and bring Calumet’s leverage metrics in line with peers.

Conclusion

We believe that Calumet’s Specialty Products business TEV more than covers the unsecured bonds at current market prices in the mid-80s, and that Calumet’s Superior, WI and Great Falls, MT refineries are collectively worth $350-400mm (58%-66% of Calumet’s cost) after accounting for ongoing cost reductions and likely RIN relief. Messrs. Go’s and Fleming’s recent equity purchases reflect confidence in this thesis, as they have collectively purchased $326K worth of stock in the last two months. As mentioned above, this is especially noteworthy as Calumet will not be able to pay a distribution to the equity until annualized EBITDA reaches ~$375mm (2016 consensus estimates are for $186mm of EBITDA as of this write-up), at which point the company would be levered ~5x through the bonds.

Risks

* Calumet is running a crude slate of increasingly heavy Western Canadian crude oil. This lowers Calumet’s feedstock costs but forces the company to produce more asphalt, which has been marginally profitable and been a working capital cash drag early in the year

* RIN reform may not come to pass

* OPEC may curtail production, leading to escalating crude prices and pressuring underlying crack spreads with no change in product demand

Catalyst

* Trump EPA moves on RIN reform

* Further progress/clarity on cost savings initiatives