Will Valero Energy Surprise Again?

| About: Valero Energy (VLO)

Summary

Valero is scheduled to report its fourth-quarter 2015 financial results on Thursday, January 28, before market open.

According to 19 analysts' average estimate, Valero is expected to post a profit of $1.39 a share, 24% decline from its actual earnings for the same quarter a year ago.

While the Brent-WTI crude spread has disappeared, the U.S. crack spread remains high.

Considering its compelling valuation metrics and its high earnings growth prospects, VLO's stock, in my opinion, is extremely undervalued.

Valero generates strong free cash flows and returns substantial capital to its shareholders by stock buyback and increasing dividend payments.

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Oil prices have continued to fall sharply, and no sign of recovery has been seen yet. The table below shows the price changes of crude oil, natural gas and gasoline from July 01, 2014, and in the last 52 weeks.

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However, some energy companies have benefited from the low oil prices and have showed a significant return in the last 52 weeks. The table below shows the top twenty S&P 500 energy stocks according to their 52-week return including the dividend.

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It is not surprising that the top performers in the last 52 weeks have been refiners. U.S. refining companies have benefited from a high Brent-WTI crude spread, high refining margins and strong demand for refined products. As a result, their profit has soared, and their shares have surged. However, the large Brent-WTI crude spread has vanished because of the U.S. Congress decision on December 18 to repeal the 40-year ban on exporting U.S. crude oil, and shares of refiners have retreated in the last few weeks as a consequence. In recent years, North American refiners have been able to increase margins by using cheap North American crude oil as feedstock.

Valero Energy (NYSE:VLO), the world's largest independent petroleum refiner and marketer, has shown the highest return among all 40 S&P 500 energy stocks in the last 52 weeks. Since the beginning of 2015, VLO's stock is up 32.3% while the S&P 500 Index has decreased 9.7%, and the NASDAQ Composite Index has lost 5.6%. Moreover, since the beginning of 2012, VLO has gained an impressive 211%. In this period, the S&P 500 Index has increased 47.8%, and the Nasdaq Composite Index has risen 71.6%. Nevertheless, considering Valero's compelling valuation and high growth prospects, the recent drop in its price creates an excellent opportunity to buy the stock at an attractive price.

VLO Daily Chart

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VLO Weekly Chart

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Charts: TradeStation Group, Inc.

Valero is scheduled to report its fourth-quarter 2015 financial results on Thursday, January 28, before market open. According to 19 analysts' average estimate, Valero is expected to post a profit of $1.39 a share, a 24% decline from its actual earnings for the same quarter a year ago. The highest estimate is for a profit of $1.62 a share while the lowest is for a profit of $0.88 a share. Revenue for the fourth quarter is expected to decline 38.2% year-over-year to $17.23 billion, according to 6 analysts' average estimate. There was one EPS up revisions during the last seven days and five up revisions and two down revisions during the last thirty days. Since Valero has shown earnings per share surprise in its last eight quarters, as shown in the table below, we can expect that the company will beat estimates also in the current quarter.

Data: Yahoo Finance

Crack Spread

While the Brent-WTI crude spread has disappeared, the U.S. crack spread remains high. In fact, last Brent crude price of $27.67 a barrel is lower than the WTI crude last price of $28.13. The Brent-WTI crude spread was about $8.0 a barrel in February 2015. That might decrease U.S. refiners advantage over European refiners. However, since U.S. gasoline crack spread has continued to be high, its last value was at $15.10 a barrel, as shown in the chart below, I expect continued strong profits for the company.

RBOB Gasoline Crack Spread Futures February Contract

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Chart: TradeStation Group, Inc.

In my opinion, there should not be any incentive for U.S. oil producers to increase crude oil production for export. After all, the breakeven price for most U.S. oil producers is between $40 and $50 a barrel, while the last WTI crude price was at $28.13 a barrel and the Brent crude price was at $27.67. The firm demand for refined products will continue as long as crude prices remain low. Due to cheap gasoline, more people are driving, and new passenger vehicle sales are at the highest in a decade. What's more, U.S. refiners in general and VLO, in particular, have a sustained export advantage including access to lower-cost feedstocks, low-cost natural gas, large complex refineries, high utilization rates and a sophisticated workforce.

U.S. Natural gas price has continued to drop in the last few months, as shown in the chart below. That should have contributed to the improvement in Valero's earnings in the fourth quarter. Refiners use natural gas as an energy source for the process; cheap natural gas helps to lower production cost.

Natural Gas, February 2016 Leading Contract

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Chart: TradeStation Group, Inc.

Valuation

Considering its compelling valuation metrics and its high earnings growth prospects, VLO's stock, in my opinion, is extremely undervalued. The trailing P/E is extremely low at 6.89, its forward P/E is also very low at 8.54, and its price-to-sales ratio is exceptionally low at 0.33. Furthermore, its price-to-free-cash-flow ratio is very low at 9.28, the second lowest among all 40 S&P 500 energy stocks, and the Enterprise Value/EBITDA ratio is also very low at 3.68. Also, the PEG ratio is extremely low at 0.60, the second lowest among all 40 S&P 500 energy stocks. The PEG Ratio - price/earnings to growth ratio is a widely used indicator of a stock's potential value. It is favored by many investors over the P/E ratio because it also accounts for growth. A lower PEG means that the stock is more undervalued.

The 10 S&P 500 energy stocks with the lowest price-to-free-cash-flow ratio

The 10 S&P 500 energy stocks with the lowest PEG ratio

Source: Portfolio123

In the third quarter, the company raised its dividend by 25% and significantly increase shares buyback. Valero returned a total of $1.3 billion in cash to stockholders in the third quarter of 2015, of which $199 million was paid in dividends, and $1.1 billion was used to purchase 17.2 million shares of Valero common stock. Year to date, dividends, and stock buybacks totaled $2.7 billion. In the second quarter report, the company said that it increased its targeted of total payout ratio to approximately 75% of 2015 net income from the previous target of 50%, and the third quarter report showed that Valero is fulfilling this target. According to its latest price and the new dividend rate, the forward annual dividend yield is at 3.05% and the payout ratio only 15.4%. The annual rate of dividend growth over the past three years was very high at 51.8%, over the past five years was at 11.8%, and over the past ten years was very high at 21.9%.

VLO Dividend Chart

VLO Dividend data by YCharts

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Source: Investor Presentation January 2016

Summary

Valero is scheduled to report its fourth-quarter 2015 financial results on Thursday, January 28, before market open. According to 19 analysts' average estimate, Valero is expected to post a profit of $1.39 a share, a 24% decline from its actual earnings for the same quarter a year ago. Since Valero has shown earnings per share surprise in its last eight quarters, I believe that the company beat also estimates in the fourth quarter. While the Brent-WTI crude spread has disappeared, the U.S. crack spread remains high. Since U.S. gasoline crack spread has continued to be high at $15.10 a barrel, I expect continued strong profits for the company. Also, U.S. Natural gas price has continued to drop in the last few months; that should have contributed to the improvement in Valero's earnings in the fourth quarter. Considering its compelling valuation metrics and its high earnings growth prospects, VLO's stock, in my opinion, is extremely undervalued. The price-to-free-cash-flow ratio is very low at 9.28, the second lowest among all 40 S&P 500 energy stocks, and the PEG ratio is extremely low at 0.60, also the second lowest among all 40 S&P 500 energy stocks. Moreover, the company generates strong free cash flows and returns substantial capital to its shareholders by stock buyback and increasing dividend payments. All these factors bring me to the conclusion that VLO is a smart long-term investment.

Disclosure: I am/we are long VLO.

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.