Valero Still A Good Investment

| About: Valero Energy (VLO)

Summary

Valero still remains a good investment due to the strong fundamentals.

Eroding discount between the US oil and Brent might be a potential risk.

Valero should now be considered a dividend stock.

Cash flows and earnings are enough to sustain long term growth in dividends.

Stock price movement has been favorable for the refiners during the ongoing supply glut and these stocks have been a safe haven for investors in a troubled industry. Valero Energy (NYSE:VLO) was also one of the best performers in the sector as the stock price jumped more than% as the company benefited from falling oil prices. However, as the oil prices have started to go up, these stocks are not looking as attractive to investors as they were a year ago. I believe that Valero, at least, remains an interesting investment option in the sector due to its strong fundamental position.

If we look at the key metrics, the company has come a long way in the last five years. There has been substantial improvement in margins and the dividend growth has been extremely impressive.

2015

2014

2013

2012

2011

Gross Margin

16%

10%

5%

5%

4.6%

Operating Margin

13%

8%

3%

3%

3%

Net Margin

5%

3%

2%

1%

2%

Dividend Payout Ratio

21%

27%

13%

15%

10%

Total Capital Returned

92%

89%

30%

25%

31%

Click to enlarge

I have used the SEC filings ( mainly 10-Ks) to calculate these metrics for the company. The gross margin has been growing at an exceptional rate and it has almost quadrupled in the last five years. Major increase was seen in the last two years, which is understandable as the low oil prices resulted in lower feedstock costs and better margin. Operating margin and the net margin show the same trend.

Valero is one of the refiners that pay hefty dividend and have an attractive dividend yield. The yearly dividend for Valero shareholders is $2.4; this means that the dividend yield of the stock is over 4.6%. Payout ratio in the table is calculated using the free cash flows approach. At the moment, the company is paying out 21% of its free cash flows in dividends. Free cash flows here mean the cash left after the capital expenditures. The last line is a little unusual. This line shows the total capital returned to shareholders - in the shape of dividends and share repurchases. Share repurchases are adjusted for new shares issued. This is unusual because companies normally do not fund the whole share buyback by internally generated funds. I have used free cash flows here as well to see how strong the free cash flows are and whether it is sufficient to cover the future buybacks. The free cash flows are extremely strong and at least the dividends of the company look safe. In fact, the growth in dividends should continue regardless of the crude oil prices.

The effect of crude prices is usually short term as the prices for final consumers are adjusted accordingly, in most cases, when the oil prices fall. So, the advantage for refineries is usually short term. Dividends are a long term commitment and it will be foolish on the part of the management to commit to an increase in dividends which cannot be maintained in the long term. I am focusing more on dividends and the cash flows ability of the company because I am considering Valero as a dividend stock. The main reason behind this is that the oil prices are on the rise and there does not look to be an opportunity for the company in the short to medium term to have a wider crack spread. However, Valero will certainly benefit if the prices of the final products go up and the ethanol prices also get a boost. At the moment, ethanol segment is taking a small hit.

In the future, Valero will benefit from the growing domestic and export demand, which will enhance the margins further. Ethanol margins, however, will only rise if the prices for gasoline are increased. Ethanol is the smaller part of the overall business mix, so it should not have that big a negative impact for the company. One risk that refineries face is the inventory valuation. One would assume that the falling oil prices are all good news for the refiners. However, that is not the case. Gradual decline in oil prices can result in inventory losses for refiners as the inventories are now valued at lower cost. This was one of the largest charges in the first quarter and affected the profitability of the company. Oil prices went below $30 per barrel during the first quarter and the company had to revalue its inventory, which resulted in a loss. However, this was a purely accounting entry and it should be treated as such. It does not have any impact on the cash flows. In 2014, total inventory losses were over $1 billion as the company had purchased oil at a higher price and had to revalue when the prices started to fall. This is one of the key reasons the operating and net margin for 2014 did not show a robust increase in the table above.

Another potential risk for the company might come from the eroding discount between the US oil and the Brent. Falling domestic production as well as the export demand has reduced the oversupply and the discount between the two benchmarks will further diminish. As a result, US refineries will lose an advantage. However, despite these potential risks, the prospects look good as the demand is rising due to the summer affect and the prices at the pumps might also rise.

Valero is a good dividend stock as the cash flows are strong and the future pricing environment will also be in favor of the company. Rising oil prices should cause the gasoline prices to go up, which means the margins will get a boost from the demand side. On top of this, the heavy and medium sour discounts are still wide. This means that the crack spread from these feedstock will be on the higher side. Overall, Valero looks like a solid investment.

Disclosure: I/we 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.