Valero Energy Corporation (VLO) is a profitable company operating in the oil and gas industry and through substantial growth prospects provides a feasible investment opportunity. This analysis breaks down the fundamental composition of VLO's balance sheet, outlining the strategic advantages from VLO's key fundamentals such as capital structure, profitability, and liquidity that will ultimately add value. In addition, it will place a major emphasis on key attributes that impact VLO's valuation. Specifically, the valuation metrics that take into account pro forma financial statements, expected growth, and VLO's weighted average cost of capital. Modeling these valuation metrics will yield an intrinsic value for VLO as an entire firm as well as intrinsic value per share. To conclude, investors will be given a final consensus through a comparative analysis between the estimates of top-tier analysts and the valuation estimates that I have modeled. For a good primer, here is a broad overview of VLO's operations and most recent YTD performance.
Through its operations, VLO offers a wide array of different fuels and specialty products across three segments including Refinery, Ethanol and Retail.
- Refinery - The refining segment is segregated geographically into the U.S. Gulf Coast, U.S. Mid-Continent, North Atlantic, and U.S. West Coast regions. This segment includes refining operations, wholesale marketing, product supply and distribution. In addition, this segment is responsible for selling refined products in both the wholesale rack and bulk markets. These sales include refined products that are manufactured in VLO's refining operations as well as refined products purchased or received on exchange from third parties. VLO also sells a range of other products produced at its refineries, including: asphalt, lube oils, natural gas liquids, petroleum coke, petrochemicals and sulfur.
- Ethanol - This segment includes sales of internally produced ethanol and distillers grains. VLO's ethanol operations are geographically located in the central plains region of the U.S. VLO owns 10 ethanol plants with a combined ethanol nameplate production capacity of about 1.10 billion gallons per year. VLO sells its ethanol primarily to refiners and gasoline blenders under term and spot contracts, and in bulk markets such as New York, Chicago, Dallas, Florida, and the U.S. West Coast.
- Retail -VLO's retail segment operations include sales of transportation fuels at retail stores and unattended self-service card locks, sales of convenience store merchandise and services in retail stores, and sales of home heating oil to residential customers. VLO's retail operations are segregated geographically into two groups including Retail-U.S. and Retail-Canada.
In competing for contracts, VLO maintains a strong position lying in the upper quartile of its competitors. VLO is ranked second among the top firms to serve as major suppliers for the U.S Military. These top firms include Chevron (CVX), Royal Dutch Shell (RDS.A), World Fuel Services (INT), and BP Pl (BP). Unfortunately, as devastating as the repercussions following BP's oil spill may have been, VLO may be one of the few to benefit. As a result of BP's participation in what critics claim to be the largest and most devastating oil spill in U.S. history, BP has been temporarly stripped of its privilege to win new U.S. government contracts. According to analysts, BP has military deals set to expire in two years that are valued at nearly $2 billion. In September, the U.S. military made notable purchases of jet fuel and various refined products, both of which were purchased from BP. The estimated value on these were $1.37 billion. Given VLO is the number two supplier in defense contracts following BP, it is clear VLO is close to the top. The only metric holding VLO in second is the fact BP received approximately 49% more contracts in the previous year. Taking this into account, if you exclude BP from the picture and hold the demand for contracts constant, it is inevitably going to force additional suppliers to step up and fill the order. Figure 1 below outlines the current value of revenue (in billions) for both VLO and BP. Now a direct comparison between the two is not practical due to the variation size of each company, however considering a portion of one's revenue relative to their respective market capitalization illustrates a nice image.
Figure 1: BP & VLO Revenue Comparison
VLO's current market capitalization is approximately 17.35 billion. Based on the above figure, VLO's current level of sales is suggesting its sales are 7.3x its markets capitalization. In comparison, BP's sales clearly surpass those of VLO amounting to nearly by 386.46 billion. However, on the downside, this implies BP's sales are only 2.9458x its market capitalization. Excluding the relevance of BP and VLO's variation in profit margins as an implicit factor and holding all else constant, this simple comparison serves as a good indication of VLO's room for sales growth in the industry. This is an important factor to consider, because there is a strong relationship that exists between the increased magnitude of VLO's sales growth and a increase in the intrinsic value of equity, which I will clearly identify later in figure 8. Analysts covering VLO find this comparison intriguing because it identifies two key things. VLO's growth potential in terms of market share and a competitive advantage over peers in its ability to significantly augment profit margins.
YTD, VLO has provided investors with a high return of nearly 57%. To coincide with these returns, VLO provides a favorable dividend with a current yield of approximately 2.17%. At current price levels, VLO's P/E is approximately 16.13 and P/B is about 1.03.
Figure 2: VLO's Relative Performance
Above, you will see figure 2, illustrating five of VLO's competitors' YTD performance. Three of the competitors, which were previously mentioned, include BP, CVX and INT. The two that have not been discussed include HollyFrontier and Delek U.S. Holdings, which I feel serves as a better comparison based on the size of its respective market capitalizations. DK, the smallest of the five competitors with only a market capitalization of 1.55 billion, was capable of providing an impressive yield to investors of nearly 123%.
VLO's current weighted average cost of capital (WACC) is 11.5%. Over the course of the past seven years VLO's WACC has deviated significantly from as low as 6% to nearly 12.5%. In descending order based on weighted allocations, the composition is primarily equity , Long Term-Debt (26.3%), and Short-Term Debt. There is currently no preferred stock outstanding on VLO's balance sheet, which I perceive to be a positive attribute indicating that VLO's management is not seeking alternatives for financial debt by issuing preferred stock. VLO debt has progressively decreased over the past few years. As a percentage of VLO's total capital structure, 26.3% and 2.4% can be attributed to long- and short-term debt respectively. The only concern if any regarding the relatively small amount of debt VLO has outstanding would be directed at long-term debt. I have provided the figure below to illustrate the decline in long-term debt over the past five years.
Figure 3: Changes in LT-Debt & ST-Investments
As previously mentioned, VLO has an identifiable advantage over peers for its potential to increase profit margins. In contrast to competitors, VLO has a strategic position as the number-two supplier of government defense contracting. This alone increases the probability of a favorable outcome of high sales growth. Regardless, an increase in profit margins is essential from the perspective of both VLO's growth as a firm and investors striving to add portfolio value through equity. However, historically VLO has revealed significant vulnerability in this area and it is crucial that it be addressed. For its industry, VLO has not produced the greatest return on assets. Asset utilization seems to be a core issue driving margins lower than competing firms in the industry. More interestingly, VLO's average fixed asset turnover is significantly higher than the industry average, however its ROA consistently lies below the industry's average. Figure 4 below illustrates VLO's steady growth in its ability to efficiently utilize assets.
Figure 4: VLO's Efficiency Measures
Taking into consideration VLO's excessively high throughput rate, it is critical to evaluate its ability to meet liquidity demands as well as analyze its cash cycle to see how long it actually takes VLO to complete the entire cycle. One of VLO's superior strengths in terms of profitability is its ability to generate high levels of free cash flow. VLO's free cash flow yield TTM ending 3Q12 is approximately 11.5%. As you will see outlined by the red line below in figure 5, VLO's cash cycle has been fairly steady over the past couple of years. It does not appear to have crossed 11 days during this time, which is a positive indication that VLO maintains an adequate level of liquidity.
Figure 5: Liquidity Measures
Below are a handful of profitability ratios I computed to help explain VLO's performance of the past few years. While a firm's past performance is not to be used as a sole guideline for projecting future growth, it can however provide us with a strong idea of the room an industry allows for growth. You will notice, that prior to the credit crisis in FY 2007, VLO provided a significantly high ROA and ROE to investors. As for margins, in FY 2007 VLO's gross margin was 8.78, where as now it is barely at 2.3.
Figure 6: Profitability Ratios
Earlier, I discussed the direct effect of added growth on the intrinsic value of equity. This next section on valuation will reveal the true value added through accelerated company growth, which proves to be highly favorable, yet realistic. Figure 7 below displays various condensed balance sheet and income statement items from FY 2007 to FY 2011 that I specifically used to compute forward growth ratios in order to forecast the appropriate numbers needed for the corporate valuation model.
Figure 7: Growth Ratios & Pro Forma Financial Statements
To evaluate the potential upside for investors, I used the corporate valuation model. The objective of this model is to calculate the intrinsic value of the firm based on the future value of operations by first projecting free cash flows forward. It then uses a modification of the constant growth model taking into account the firm's expected growth rate and weighted average cost of capital estimate. This allowed me to derive an intrinsic share value for the following years. Figure 8 below provides a two-case scenario modeling an intrinsic value that is precise, yet conservative. For clarity, the variation between the inputs used and the outputs derived are distinguished by red and orange text respectively.
Figure 8: Corporate Valuation Model
The primary difference between scenario one and two is the growth weights and the weighted average cost of capital. Scenario 1 is the more optimistic, yet realistic in terms of capital structure in my opinion. On the other hand scenario two provides investors with estimates projected with the assumptions of lower growth and a capital structure that is inherently riskier. For scenario two, the increase in risk is reflected through the change in weighted average cost of capital. As you see, FY 2012 estimates for intrinsic value per share are slightly above the current market value per share. The major variation between scenario one and two is not revealed until FY 2013, which based on my computations reveals an intrinsic value per share of $61.52 and $43.25 for FY scenario one and two, respectively.
To help investors come to a final decision, I extracted a sample of 15 different price targets initiated by various analysts at the firms listed below. In addition, I have provided the date each price target was initiated next to the corresponding firm and projection. With the exception of two estimates, all price targets listed below have been initiated within the last two moths and six within the last two weeks.
Figure 9: Analysts Price Targets
Based off the sample of 15 above, I computed an average price target of $37.
VLO is a strong company operating in a developed industry. Therefore aside from a strong business model and quantitative metrics supporting high levels of profitability it is crucial investors analyze the external risks that could potentially have a negative impact on returns. The increasingly difficult to deal with regulatory environment monitored by the Environmental Protection Agency could pose negative implications on VLO's operations. In addition, the dreaded, yet seemingly inevitable bear macro outlook may have a slight impact on VLO's market value per share. VLO consistently maintains an adequate level of liquidity, while still able to maintain high levels of profitability. Given, VLO's strategic placement in competing for defense contracts and BP's operations being heavily constrained, this may be a game-changing opportunity for VLO. Intrinsic valuation estimates are in support of a favorable upside and taking into account the most conservative estimate, investors are looking at nearly a 34% return by the end of FY 2013.
Sources: YCharts, Bloomberg Market Data, TD Ameritrade, and The Wall Street Journal, The Wall Street Pit, The Fiscal Times, The Street, CNBC, 99 Wall Street, and Street Insider.
Disclosure: I am long VLO.