There have been a considerable number of stories on Seeking Alpha discussing how Valero Energy Corp. (VLO) is undervalued (for those interested, see here, here and here, for some recent articles). I agree with the broad conclusion that VLO is a cheap stock by most conventional metrics, trading at 2.885x 2012 on an EV/EBITDA basis. Companies with problems trade at a sub-4.0x multiple (reflecting a deep market skepticism in forward estimates), and VLO is not a company with real problems (for a discussion about the business in greater depth, refer to my blog).
VLO is, however, the largest independent refiner in the world. For those unfamiliar with the refining industry, in simple terms, a refiner takes crude oil and turns it into usable products like motor gasoline, heating oil and jet fuel. The refining business, not to mix words, kind of stinks, so far most business variables go. Margins are lousy, there is little control over the cost of the feedstock (oil) and the realized price of the products leading to considerable volatility around the earnings and there are constant environmental issues and operational problems to manage. However, the refining business is an essential business to the global economy (without refiners, crude oil is a useless slick black liquid), and not going anywhere, despite being a crummy business. In this article, I am going to present the valuation case that I use for VLO, incorporating the challenging underlying fundamentals of refining, the essential nature of the business and the specific condition of VLO, the company.
Normalized EBITDA is the right look through for the long-term investor. Refining goes through boom and bust years. During the recent golden years of 2006 and 2007, VLO generated EBITDA of north of $8.0 billion. In 2009, coming out of the 2008 recession, VLO generated EBITDA of $1.8 billion. The company is expected to do $6.2 billion of EBITDA in 2011, falling to $5.5 billion in 2012 (consensus). Taking a normalized look at VLO, and looking through anomalies in margins and the economic cycle, it would appear reasonable to conclude that VLO is a business that is capable of doing $5.0 billion of EBITDA (average) every three-years (which could prove light behind the company's ethanol expansion and recent capital expenditure drive to improve operations, and assuming no prolonged recession cycle in the US).
Using a 4.5x multiple, to reflect the cyclicality of the business (consistent with other commodity driven businesses), the enterprise is worth $22.5 billion. Subtracting out the debt ($7.7 billion) and minority interests ($16.0 mm) and adding in cash ($2.8 billion), the long-term value left for shareholders is $17.6 billion, or $31.50 per share. Note: I am trying to value the business on a run-rate EBITDA, and not talking about book value, as these are long-term, depreciated assets, and valuing the break-up book value of assets does not seem to make sense, relative to a look through on the cash flow generative capacity of the assets themselves.
Further supporting the $31.50 long-term value are three variables:
- There is a dividend. VLO pays an annual dividend of $0.60 per share, yielding 2.84%, in excess of the S&P 500 dividend of 2.10%. Using the Dividend Discount Model, at $0.60 per share, assuming a 2.0% discount rate (the risk-free UST 10-year), the stock is worth $30.00 per share (and that implies no growth to the dividend). The DDM is rather simplistic, and the discount rate will ultimately move up, but for now, the stock is priced cheap relative to the cash flow to the investor from the dividend.
- There is a lot of cash. VLO has a track record of buying back stock. The company has a lot of cash ($5.00 per share). There is the potential for management to undertake a strategic action, supporting the stock in 2012.
- Capital expenditures decline post 2012, creating more financial flexibility. For more on this, and the implications, check out my blog discussion of VLO.
The long-term investor should look at right now as an attractive entry point into VLO. Absent catalysts, the stock is trading at a 50% discount to a reasonable long-term value for the business, regardless of how lousy the underlying business is. With catalysts factoring in, there is more upside. And, when looking past the struggle the sell-side community has in coming up with an accurate forecast 12-months out, it is easy to see that regardless, downside to the fair value is being priced in, to reflect the uncertain economic conditions headed into 2012.
Disclosure: I am long VLO.
