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Independent refiner Tesoro Corporation (TSO - Analyst Report) came out with weak third quarter 2012 profits, as gross margin narrowed and its core California market suffered from disruptions and maintenance.

Earnings per share (excluding special items) came in at $2.05, missing the Zacks Consensus Estimate of $2.37 and also below the year-ago adjusted profit of $2.39.

The San Antonio, Texas-based firm reported revenue of $8,776.0 million for the three-month period. This was 18.1% above our projection and was also up 8.3% year over year on the back of higher throughput and solid operating performance.

Segmental Analysis

Refining: Tesoro’s Refining segment posted an operating income of $610 million versus $600 million in the year-earlier quarter. The improvement can be attributed to higher refinery throughput rates and significant crude sourcing advantage.

Retail: The Retail unit earned $18 million during the three-month period, down from $22 million in the third quarter of 2011, hurt by lower same-store fuel sales.

Throughput

Total refining throughput averaged 626 thousand barrels per day (MBbl/d), compared with 609 MBbl/d in the year-ago quarter.

Overall throughput volumes in California (consisting of the Golden Eagle and Los Angeles refineries), Mid-Pacific (Hawaii) and the Mid-Continent (North Dakota & Utah) increased 5.3%, 5.4% and 5.9% year over year to 260 MBbl/d, 78 MBbl/d and 126 MBbl/d, respectively. 

However, throughput in the company’s Pacific Northwest (Alaska and Washington) operations fell 4.1% from the third quarter of 2011 to 162 MBbl/d.

Refining Margins

Gross refining margin declined slightly (by 0.6%) year over year to $18.32 per barrel.

In terms of different regions, refining margin was down in California (by 18.7% year over year to $12.11 per barrel) and Mid-Pacific (by 34.3% to $8.92 per barrel), almost offset by increases in Pacific Northwest (by 16.0% to $17.39 per barrel) and Mid-Continent (by 13.7% to $38.11 per barrel).

Realized Costs & Prices

Manufacturing costs before depreciation and amortization fell 3.3% from the year-earlier level to $4.42 per barrel, in keeping with Tesoro’s stated objectives of reducing operating costs and increasing throughput rates.

Total refined product sales during the quarter averaged 740 MBbl/d, up 7.7% year over year. Average price realized on product sales increased 1.3% year over year to $124.40 per barrel, while average cost per barrel was essentially flat at $109.18 per barrel.

Capital Expenditure & Balance Sheet

Tesoro’s total capital spending during the quarter under review was $133 million (87% directed towards refining segment), while $11 million was exhausted on turnaround. The company informed that it expects capital spending for 2012 to be around $590 million ($80 million less than the prior guidance), together with turnaround spending of around $260 million.

As of September 30, 2012, Tesoro had $1,367.0 million cash on hand and total debt of $1,586.0 million, representing a debt-to-capitalization ratio of 25%.

Dividend Hiked

Tesoro announced a 25.0% increase in its quarterly dividend to 15 cents per share, or 60 cents per share annualized. The dividend is payable on December 14, 2012 to shareholders of record on November 30, 2012.

Rating & Recommendation

Notwithstanding the quarterly miss, our investment thesis on Tesoro remains positive.

Tesoro currently retains a Zacks #2 Rank (short-term Buy rating). We are also maintaining our long-term Outperform recommendation on the stock.

The company’s decision to resume dividend payout (and now increase it) and the announcement of a $500 million share buyback program make us optimistic about the independent refiner/marketer. Our positive stance also revolves around Tesoro’s proposed acquisition of BP Plc’s (BP - Analyst Report) Southern California refinery, which, apart from boosting refinery capacity, will also improve the company’s operational efficiency. An uptick in crack spreads and Tesoro’s scale and diversification benefits afforded by its portfolio of seven refineries add to the positive sentiment.

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