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by R. Brian Tracz

Valero Energy (NYSE:VLO) is the largest independent downstream refiner and distributor of oil in the world, with a capacity of around 2.8 million barrels per day. Valero has made significant strides in its overall managerial strategy, helping it to improve margins in an industry where the refined product is sold very close to capital expense.

I believe that Valero Energy is trading at a deep discount to its fair value. At around $22, Valero Energy is at an excellent buying price. Despite the recent downslope of its share price, the company has made significant steps towards greater profitability. Valero has a strong stake in refining operations, wholesale marketing, supply and distribution, and transportation infrastructure. With this asset base and value, Valero makes a strong buy for both 12-month and 3-year investors.

Valuation

Over the past 52 weeks, the price range for Valero Energy has been between $16.40 and $28.68. The price/book ratio is 0.1, which is at the lower end of its 0.1-0.5 range over the past five years. The current fiscal year price/earnings ratio for Valero is 6.94, one of the lowest among its peers. Additionally, shares are presently trading below their 10-week moving average. I believe that we will see shares meet a price target of greater than $30 over 12 months, with a potential upside of around $35. Valero shares are trading at a discount, as investors are yet to realize the growth potential of the company.

Performance

Valero Energy had an increase in throughput volume year-over-year in the fourth quarter 2011 by 24%. Total operating income was up 116% in 2011 from 2010, and revenues jumped to $126 billion in 2011, a 53% increase from 2010. While there have been sluggish margins in gasoline-a 185% decrease year-over-year from 2010 to 2011-nevertheless Valero's current bottom-out will be followed by significant growth supported by retail sales and ethanol markets.

In 2011, the company's retail business was up to $83 billion year-over-year, a $22 billion increase. The company stands to do better than its competitors in the coming year. For instance, Sunoco (NYSE:SUN) will be experiencing a fair amount of uncertainty as it is acquired by Energy Transfer Partners (NYSE:ETP). Sunoco is another refining, marketing, and distribution company, but I think that Valero shares are a better investment given their clear discount price and the surer likelihood that Valero shares will trade at their fair value above $30.

The company's ethanol business is booming. In the fourth quarter 2011, Valero Energy's ethanol business netted $180 billion in operating income, up from only $70 billion in the fourth quarter 2010. It averaged 3.5 million gallons per day during the fourth quarter 2011. With all of this success, however, comes a silver lining. It is true that ethanol fortification of gasoline has saved Americans somewhere around $1.00 over the past year. The long-term value of ethanol use has yet, however, has yet to be seen as a proven, sustainable energy option. It is unclear whether it is comprehensive energy efficient option. Thus, Valero Energy will need to remain versatile in the future despite ethanol's current profitability.

Value

The refinery business is a volatile business that operates with relatively narrow margins. So it is important to invest in downstream specialists that are focused on value, and an approach that also requires a fair amount of patience on the part of the investor.

Valero Energy is well-positioned to take advantage of its holdings in the Canadian oil sands. Additionally, Valero Energy is the largest Gulf-Coast refiner, and the company will benefit from higher output from the Gulf Coast, leading to lower cost basis and a competitive advantage. In all, there will be greater demand in the coming year for refined goods and oil derivatives, leading to a positive outlook for Valero Energy; additionally, lower natural gas prices are working in Valero's benefit.

Valero Energy's management is also adding investment strategies to its cost-reduction approach. The company intends to increase its EBITDA by $1.3-$2.1 billion after the completion of its economic growth projects, leading to a earnings of about $2 per share by the end of 2013. With this, plus its growing business, will likely contribute to a 6% 5-year growth rate, higher than we could expect from Sunoco, Magellan Midstream Partners (NYSE:MMP), or HollyFrontier (NYSE:HFC), all of which are likely to hover nearer to 5%.

Acquisitions and Expenses

Valero Energy recently took part in a flurry of acquisitions. It acquired the Meraux Refinery from Murphy Oil (NYSE:MUR). Additionally, the company brokered a deal to acquire Chevron Limited from Chevron (NYSE:CVX), the entity that holds Pembroke Refinery, to increase its refining capacity by 220,000 barrels per day.

Valero Energy's capital expenditures for 2012 are expected to be around $3.5 billion, whereas they were around $3.0 billion for 2011. In the fourth quarter 2011, the company repurchased 3.5 million shares that management considered rather undervalued. The dividend for 2012 is expected to be $0.70, and the dividend for 2013 around $1.00. In a volatile business like refining, it is important to make investments that return a fair amount of cash to investors.

Valero's debt/capital ratio is 35%, rather high for its subsector. One might think that this comes at a risk, particularly given market technical (Valero's beta is 1.52). Despite this, Valero Energy's S&P debt credit rating is BBB. In all, despite its high debt structure, I believe that high confidence in Valero's debt reflects its broad refining base and rather stable production history.

Conclusion

The oil exploration, production, and refining business is inherently risky given economic fluctuations in commodity prices and the finicky production schedule of refineries and wells. Refining businesses further augments this risk. However, Valero Energy maintains a broad base of refineries via acquisitions and has taken meaningful steps to improving its profitability. This makes it one of the strongest buys among refining companies.

Source: Valero: Don't Miss $22 Entry Point