Valero Energy: Focused Refinery Player Offers Both Value And Growth Prospects

Apr.30.14 | About: Valero Energy (VLO)

Summary

Valero has embarked on a focused and shareholder value creating strategy in recent years.

Structural changes in the US energy industry and shale boom create strong tailwinds.

There might be more upside, but be careful about the cyclical nature of the industry.

Investors in Valero Energy (NYSE:VLO) are cautiously optimistic after the largest US independent refining company saw a decent jump in its first-quarter earnings on the back of solid refining margins and a better performance at its ethanol business.

Despite a strong run-up in recent years, shares might still offer value, as the industry appears to have become structurally more attractive amidst the shale energy revolution.

First-Quarter Headlines

Valero generated first-quarter revenues of $33.66 billion, up just 0.6% compared to last year. Revenues for Valero can be quite volatile, depending on oil prices, and they don't necessarily reflect operating strength or weakness in the business.

Operating earnings rose by 27.2% to $1.35 billion, for operating margins of just 4.0% of total revenues. This operating earnings growth spurred net income growth, as earnings advanced to $828 million, with earnings per diluted share rising to $1.54.

Ethanol Drives Incremental Growth

Earnings were driven by the refining segment again, with operating earnings increasing modestly from $1.21 to $1.28 billion. Earnings growth was driven by throughput margins, which were up by thirty-one cents to $10.90 per barrel.

However, operating earnings per barrel rose by just a penny to $5.26 per barrel on higher costs. Higher processed volumes, which rose from 2.57 million barrels to 2.70 million barrels, drove the real earnings growth. Operating 16 refineries which have a total combined capacity of 2.9 million barrels per day makes Valero the largest independent US refinery.

Yet, it was the ethanol business which drove incremental earnings, as the unit reported operating earnings of $243 million, compared to just $14 million last year. Valero's 10 ethanol corn plants have the capacity to produce 1.2 billion gallons per year, or roughly 78,000 barrels per day.

With the retail segment no longer contributing to Valero after the company divested a majority stake in the newly-formed company, Valero lost $42 million in operating earnings as contributed last year.

Valuation

While Valero's results are inherently volatile due to changing oil prices and even more volatile refining margins, the company has committed itself to pleasing investors. To illustrate just how slim Valero's margins are, just check out last year's results. In 2013, Valero posted a $2.7 billion profit on $138.1 billion in revenues.

Recently, it hiked its dividend by 25% to $0.25 per quarter, which provides investors with a 1.8% dividend yield. This has been accompanied by a modest pace of share repurchases.

The company holds $3.65 billion in cash and equivalents on its balance sheet to maintain financial flexibility, although little over $750 million is held in the name of Valero Energy Partners LP. Total debt stands at $6.56 billion, resulting in a roughly $3.7 billion net debt position.

At $57 per share, the company is valued at just over $30 billion, or roughly 11 times 2013's earnings. While earnings are cyclical, it is not unthinkable to see earnings increase further in 2014 amidst structurally improved market fundamentals.

Valero Has Developed A Focused Strategy In Recent Years

Long-term investors have seen the full boom and bust cycle. Shares traded in their mid-seventies by 2007 to fall to lows in their mid-teens during the recession, after which shares have nearly quadrupled again to current levels in the high fifties.

The biggest drivers behind the recovery of its shares is the recovery of the US economy, and of course, the shale oil revolution, which is pushing up the spread between WTI and Brent oil, creating big tailwinds for Valero. Continued prospects for a strong US energy market, the focus on shareholder value and focus on its core operations are all driving results.

An example of its focused strategy, Valero has created a master limited partnership, including many logistics and transportation assets. Valero Energy Partners LP (NYSE:VLP) was incorporated in September of last year. At the moment, Valero still holds a nearly 69% stake in the business.

Last year has been busy for Valero, as it divested a majority stake in CST Brands (NYSE:CST) in May last year. All in all, Valero received roughly $1 billion in net proceeds. The company still holds a 20% stake in the business valued at roughly $500 million at the moment.

Final Conclusions

Valero is benefiting from two major trends. For starters, it is becoming increasingly focused, while many refinery businesses are just side-businesses for oil majors who close old refineries or divest them. Earlier, ConocoPhillips (NYSE:COP) has divested its downstream assets in a new highly successful company called Phillips 66 (NYSE:PSX). Other energy companies are contemplating or have made similar moves in recent times.

This focus and Valero's large scale is important, with the network effect of owning multiple refineries and transportation assets thereby allowing Valero to process crude in the most cost-effective way. Furthermore, the historically troubled ethanol business should be able to benefit from a much more solid export market going forward.

For now, the stock offers excellent value at 11 times last year's earnings and after showing solid earnings growth in the first quarter of this year. This puts the forward price-earnings ratio below 10. Combined with fair and increasing shareholder payouts, a solid growth strategy and superior execution, better days might be ahead.

Note that in the medium term, shares can undoubtedly remain very volatile. Despite improved prospects, Valero operates in a cyclical industry.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.