Valero: Too Good to Be True?

I probably should have written about this earlier as I picked up a position in Valero Energy (VLO) a few weeks ago around the $18-$19 range. The valuations presented here are a bit crude (pardon the pun), but in my opinion, an equity investor ought to be more interested in being directionally correct than being exact when modeling. In the end, all we’re looking for is satisfactory margin of safety. On a final note, I have to give credit to Chad Brand at Peridot Capitalist for getting me interested in this one.

What is Valero?

Valero is one of the largest oil refiners in North America. It makes money processing oil and selling the resulting gasoline, distillates, and petrochemicals. While Valero operates in a commoditized industry, it operates the most technologically advanced refineries available and achieves cost advantages through the ability to process heavy sour crude. Heavy sour crude is cheaper than typical crude oil and allows Valero to extract higher margins than its competitors. For more a short primer on Valero, check out this Investopedia article on Valero.

Valuation Study

P/E Ratios

At $15-$20 per share, Valero trades between 3.5x and 4.0x TTM earnings. This is compared to an industry P/E at approximately 8.0x TTM earnings. Specific publicly traded comparable refiners including Holly Corp (HOC) (7.95x), Tesoro (TSO) (11.34x), and Sunoco (SUN) (8.54x) all trade at significantly higher price to earnings ratios.

Even if current earnings levels prove to be the run-rate level for the next few years, Valero’s low P/E ratio ought to trend upwards as it proves the stability of its earnings. Generally speaking, no-growth P/Es are in the 6-8x range which also happens to be the industry average P/E. Valero management’s friendliness towards distribution of its cash through share buybacks, and a hefty dividend (currently 3.5%-4.0%), will only support such multiple expansion as investors become more comfortable with its baseline cash/earnings generating strength.

Balance Sheet Analysis and Liquidation Value

Multiple analysis and subjective research only serve to establish the guidelines for our “bull” case. To establish that we have some margin of safety, we must look towards establishing a more conservative valuation of the business disregarding any long-term growth potential. (i.e. the “Ben Graham Valuation”)

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As you can see from the above charts, Ben Graham might not actually agree with my assertion that Valero is a great value. The company’s net-net working capital - the money the firm could return to investors if it shuttered its doors today - is negative. However, what we do know is that refineries and many of the properties that Valero owns are very valuable. Moreover, if we look at net tangible assets based on Valero’s own balance sheet, we find that the firm is worth $29/share. Its book value is an even more impressive $36/share. Basically, what we find is that the stock currently factors in a 20% haircut to its net PP&E.

Another thing we can look at is what the firm is worth based on recent asset sales and listings. The most recent listing price for Valero’s Aruba facility is less than inspiring as it implies a value for the firm around $11.50/share. The average selling price of the firm’s last two realized sales, on the other hand, paints a much more reassuring story.

Conclusion

Overall, we find that Valero is currently trading in line with rough liquidation valuation and at a significantly discounted multiple versus its peers. There are significant headwinds for the industry over the next year, but one can be sure that these are likely transient in the two plus year time frame. My opinion is that Valero’s current pricing is very compelling.

Full Disclosure: Long shares of VLO at the time of writing.

Comments

[macsmart:]

The key to Valero's success is that heavy sour crude is cheaper than typical crude oil and allows Valero to extract higher margins than its competitors.

When the price of oil comes back, and we know it will, Valero will outpace the comeback due to its larger margins.

2008 Dec 25 09:48 AM

[ArtfulDodger:]

Evidently to pay down debt, VLO was attempting to sell 3 refineries, but has taken two of them off the block due to having no buyers. It paid dearly for these back in 2005 and now wants to dump them.

VLO has also cut back production at all its plants, due to the drop in demand for both gas and diesel.

The stock is definitely out of favor, and that's the best time to buy in my view; but I fear the debt on its balance sheet, .32 debt to equity; .25 long term debt to total capital, will hinder the company's performance.

While these are not punitive ratios, they may be burdensome in the current economic arena.

So, why not consider a company not in the same field, but a similar one, such as Statoilhydro (STO) that has zero debt, sells at 3 times cash flow, 6 times earnings, is run like a Green Beret Unit, earns $360,000 per employee, and pays a 9% dividend?

I can't go with Valero, but I wish you well with your investment.

I own shares in STO.

2008 Dec 26 02:58 AM

[The Curious...:]

I was recently contacted by a Mr. Ashley Smith of Valero's Investor Relations and I think it's important for me to make a clarification. The "listing price" that I used for the Valero Aruba facility is based on estimates that I found on another blog post - epiphanyinvesting.com/.../. The $1.25 billion that I use in my analysis has not been corroborated by Valero which has never provided such information about the Aruba facility.

Let me reiterate that the analysis here is meant to be conservative and provide directional guidance. It is not an exacting valuation of the company and I provide it to share my thoughts and maybe help others to learn about the investing process.

My personal goal with these types analysis is simply to establish a baseline valuation with which to establish out MY buy and sell targets. Readers looking to make an investment should definitely do their own due diligence.

Jan 01 05:59 PM