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Shares of Valero Energy (VLO) traded with modest gains on Tuesday after the refiner reported a big drop in third quarter sales. While earnings fell sharply, they still beat versus consensus estimates in a more difficult refining environment.

Third Quarter Results

Valero Energy generated third quarter revenues of $36.14 billion, up 4.1% on the year before, coming in way ahead of consensus estimates at $29.76 billion.

Net earnings more than halved to $312 million as diluted earnings per share fell from $1.21 to $0.57 per share. Analysts were looking for third quarter earnings of $0.41 per share.

Note that the adjusted earnings declines are actually steeper. Last year, Valero reported large charges related to its Aruba refinery, among others. Adjusting for this earnings totaled $1.90 per share in the third quarter of last year.

CEO and Chairman Bill Klesse commented, "Third quarter refining margins were challenged, but our story remains intact. Fourth quarter 2013 gasoline margins have started out seasonally weak, but distillate margins continue to be strong."

Looking Into The Results

Third quarter refining throughput volumes averaged 2.8 million barrels per day, up 172,000 barrels from last year. Volumes rose on lower planned maintenance activity, as well as less weather-related downtime.

As noted the refining segment had a much more difficult time as operating income fell form $1.53 billion to just $600 million. Note that throughput margins were just $7.76 per barrel for the quarter, compared to $13.12 in the comparable period last year.

The weaker refining results was partially offset by a better performance of the ethanol segment which reported operating earnings of $113 million compared to an operating loss of $73 million last year.

Valuation

Valero ended its third quarter with $1.91 billion in cash and equivalents. The company operates with $6.56 billion in total debt, for a net debt position of $4.6 billion.

Revenues for the first nine months of the year came in at $103.6 billion, down 0.9% on the year before. Net earnings rose by nearly 35% to $1.44 billion, entirely on the back of lower income tax rates as operating earnings came in flat. At this pace, annual revenues of around $138 billion are achievable. Earnings could come in between $1.6 and $1.9 billion.

Factoring in gains of 2% on Tuesday, with shares exchanging hands at $40, the market values Valero at nearly $22 billion. This values Valero at 0.15 times annual revenues and 12-13 times annual earnings.

Valero currently pays a quarterly dividend $0.225, for an annual dividend yield of 2.2%.

Some Historical Perspective

Over the past decade, shareholders have seen decent but volatile returns. Shares rose from levels around $10 in 2004 to highs approaching $80 in 2007. The recession send shares tumbling again to their twenties after which shares recovered to highs of $48 earlier this year.

Between 2009 and 2012, Valero has more than doubled its annual revenues to $139.2 billion last year. After reporting a $2 billion loss in 2009, Valero posted earnings of a similar amount in 2011 and 2012.

Investment Thesis

Despite more difficult circumstances, shares of Valero have risen nearly 20% year to date. The company has been taking many steps to please shareholders. Earlier this year, Valero has spun-off its retail activities under the CST Brands (CST) name. Shareholders received an equivalent sum of $3.50 per share, while Valero still holds a 20% stake in the business.

Last month, Valero filed documents with the SEC to form a limited partnership for its logistics assets, to unleash more value. Besides these steps, Valero furthermore hiked its quarterly dividend by 2.5 cents to $0.225 per quarter, while it repurchased already 14.2 million shares this year, about 2.6% of the current share base. A such, investors receive combined dividend and share repurchase yield of about 6%.

Investors have seen a bit of a recovery in recent weeks after WTI and Brent prices were trading nearly at parity recently. Third quarter price differentials narrowed to just $3.86 per barrel compared to $17.30 in the third quarter last year. On top of the margin squeeze, Valero was also impacted by higher costs for Renewable Identification Numbers, to comply with new renewable fuel standards.

While third quarter margins were weak, year to date throughput margins are still at $9.16 per barrel, down just slightly from $10.51 per barrel last year.

Valero continues to see growth, setting a capital expenditures budget of $2.85 billion for this year, of which $1.30 billion reserved for growth investments. The abundant supply of natural gas and liquids in North America, attracts petrochemical manufacturer into the US and Canada, a reason why Valero remains upbeat about the long term growth prospects.

Three weeks ago, when analysts at Citigroup were issuing bullish research notes on Valero, I last took a look at the company's prospects. At the time, Citigroup argued earnings could bottom in the fourth quarter of this year.

So far this year Valero has successfully fenced off the more difficult market circumstances, mainly through its shareholder-friendly actions as outlined above.

I reiterate my stance although Valero has seen a lot of upside in just three weeks. At the time of writing shares traded at just $34 per share, now trading at $40 per share. I concluded that shares looked appealing around 9-10 times earnings despite real weakness in the external environment this year.

I concluded to be cautiously optimistic, liking the general prospects for refiners, including Valero. Yet I prefer Tesoro (TSO) given the prospects for synergies on the back of dealmaking in the past. I reiterate that stance as shares have only risen 10% in three week's time, trailing returns of Valero.

Source: Valero Energy - Solid Third Quarter Earnings After Solid Momentum In October