Valero Energy: When Will The Semi-Annual Double-Digit Dividend Growth End?

Jun.26.14 | About: Valero Energy (VLO)

Summary

Free cash flow may grow by high single digit CAGR over the next few years.

Free cash flow and continued share buyback can continue to support the current dividend growth pace in near term.

As both free cash flow and earnings dividend payout ratios continue to rise, dividend growth has to slow down.

Given the current state, I estimate that a sustainable dividend per share growth would be around 8%.

Dividend yield on cost may rise to 4% in 5 years.

Dividend of Valero Energy (NYSE:VLO) has almost doubled since 2009. However, the growth trajectory shows a decelerating trend as the most recent hike of 11% in early this year is lower than the growth range of 12%-17% in the past 2 years. In this article, I will provide readers some perspectives on Valero's future cash flow and dividend trends.

To gauge the company's capacity for future dividend growth, I have performed free cash flow projections from 2014 to 2016. My analysis started with consensus revenue estimates which suggest the top line may grow by 5% CAGR from $126.0B in 2014 to $138.9B in 2016. The company's operating cash flow margin has expanded from 2.9% to 4.0% over the past 5 years. Given the current view that EBITDA margin will expand modestly in the next few years from 2013 level, I assumed the cash margin to be flat at 4.0% through 2016. It is noted that my cash margin assumption could be conservative if Valero is able to maintain a steady EBITDA to operating cash flow conversation over my forecast period. In this case, the cash margin will follow the potential EBITDA margin expansion compared to my flat assumption. For capex, I used management's guidance of $3.0B for 2014 and assumed the spending to grow by 3% per annum through 2016. Based on the somewhat conservative assumptions, free cash flow was projected to grow by about 8% CAGR from $2.0B in 2014 to $2.4B in 2016 (see chart below).

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Assuming Valero to continue grow its quarterly dividend semi-annually at a rate of 10% through fiscal 2016, I calculated total dividend spending to increase from $550M in 2014 to $754M in 2016 based on my average share count estimates which will be discussed later. In this case, free cash flow dividend payout ratio will increase largely from 13% in 2013 to 32% in 2016. As a result, Valero would have more than $1.0B excess free cash flow in each year (see chart above).

Given my excess free cash flow forecasts, I believe the company is able to spend more than $1.0B on share repurchase from 2014 to 2016. Hence, I modeled $1.0B share buyback for 2014 and assumed the figure to rise to $1.2B by 2016. Based on average buyback price assumption of $55 in 2014 and an annual price growth of 15%, I estimated that average share count will drop to 490M by 2016. As mentioned earlier, I have assumed a 10% semi-annually dividend growth from 2014 to 2016 in this analysis. On a fiscal year basis, this represents a 21% CAGR from $1.05 per share in 2014 to $1.54 per share in 2016. Compared with consensus EPS estimates, this dividend growth scenario implies that earnings dividend payout ratio will rise from 17% in 2013 to 24% in 2016 (see chart below).

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As both the free cash flow and earnings dividend payout ratio will climb up to a level that I believe Valero can still live with, the scenario of 10% semi-annual dividend growth through 2016 is still achievable (don't forget that my projections are based on some conservative assumptions). However, as the company's free cash flow is very unlikely to grow by 15%-20% CAGR over a medium to long run and consensus view only calls for a long-term EPS growth potential of 10.8%, that dividend growth scenario is most likely not sustainable.

The following charts shows a quarterly breakdown of my annual dividend per share forecasts from 2014 to 2016 as well as dividend per share forecasts from 2017 to 2016 which is based on an assumption of 8% annual growth rate. I believe the 8% annual dividend per share growth can likely be sustained over a long run given that it is modestly below Valero's consensus long-term EPS growth estimate of 10.8% and as long as the company's free cash flow can grow by at least 5% CAGR the continued share buyback will likely boost the dividend per share growth to 7%-8% level.

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As shown in the above chart, I expect 5 semi-annual dividend increases at 10% in Q3 2014, Q1 2015, Q3 2015, Q1 2016, and Q3 2016, respectively, following by 3 annual dividend hikes at 8% in Q3 2017, Q3 2018, and Q3 2019. In this scenario, quarterly dividend will reach $0.51 by Q3 2019, meaning that dividend yield on cost of ~$51 will rise to 4.0% by then.

In conclusion, Valero's current semi-annual double-digit dividend growth cannot be sustained over a long run. Depending on management's tolerance for free cash flow and earnings payout rate, the dividend growth will eventually drop to around 8% level. Nevertheless, as current dividend spending still represents a relatively small portion of the company's free cash flow and earnings, dividend growth in near to medium term can still be significant.

All charts are created by the author, and historical data used in the article and the charts is sourced from S&P Capital IQ, unless otherwise specified.

Disclosure: The author is long VLO. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.