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Valero Energy Corporation (NYSE:VLO) is attractive due to its low valuations. It is trading at a forward P/E of 6.7x, at a discount when compared with the industry average of 8x. Its dividend yield is 2.2%, slightly higher than its peers' average yield of 1.8%. Valero's high growth prospects and improvement in refinery margins are depicted in its lucrative projects in pipeline. The expected completion of Port Arthur hydrocracker and St. Charles projects in the next few quarters will bring considerable growth for the company. We believe the start up of these projects, and the projected decrease in capital spending to $2 billion-$2.5 billion in the next year, would further increase its free cash flows. The company's raising throughput capacity, an improvement in on-stream reliability, increased plant processing capacity to feedstock, and up-gradation in product yields portrays its strong future prospects. Therefore, we recommend investors to take a long position in the stock.

Company Overview

Valero is the world's largest independent oil refining company. It has also engaged in the marketing of petrochemical products. The company's business operations are segregated into three different segments comprising of Ethanol, Retail and Refining. It possesses 10 ethanol plants with a production capacity of around 1.1 billion gallon per year in the U.S. Currently, the company has 16 refineries with 3 billion barrels per day of throughput capacity. Its refineries are involved in the production of CARB diesel fuel, distillates, jet fuel, petrochemicals, gasoline and other refined products. It is generating 88% of operating income from Refining, 12% from Retail and 0.3% from Ethanol.

Growth Prospects

Valero's high growth prospects are reflected in its current projects in the pipeline. The company's Port Arthur hydrocracker project is expected to be completed in Q3 and be operational by Q42012. Moreover, another important project, St. Charles, is expected to be operational by the second quarter of 2013.

Port Arthur hydrocracker project

The project's financial feasibility is reflected in the table given below; through this project, the company is expected to generate an EBITDA of $520M. The estimated incremental EBITDA comes out to be $634M by using 2011 prices. This project enables the company to refine 57,000 barrels per day and process high-acid of around 150,000 barrels per day. The unit will expand the company's capacity up to 30% and enable it to meet the growing demand of distillates.

Source: Company website

St. Charles Project

The profitability of the St. Charles Project is reflected in the table given below. This project will enable the company to add 60,000 barrels per day of hydrocrackers. It will produce high-value products by processing low value feedstock and inexpensive natural gas. This project's estimated EBITDA OF $380 million will increase the company's gross and operating margins.

Source: Company website

Separation of Retail Business

An important development was witnessed in the Q2 conference call; the company's Board of Directors authorized the management with regards to the separation of its Retail business from its Refining business. This separation will help both businesses focus on their core operational areas, and provide them with better operational flexibility. Investors usually treat Valero as a refinery and neglect the significance of its profitability from the Retail segment. The company's main Retail business is in the U.S. and generates higher margins from this area. The following map gives the positions of its retail network.

Source: Company website

Source: Company website

Financials

The company's improved performance is reflected in the increase in its operating income (quarterly) from $1.3 billion to $1.4 billion, through rising throughput margins. Its refinery capacity has increased by 342K barrels per day in the last quarter, primarily because of the addition of two refineries in Europe.

It has raised its capital spending guidance from $3.5 billion to $3.6 billion to bring growth through the development of new projects that are expected to be completed in the next year. However, in 2013, the company's CAPEX will decrease to $2 billion-$2.5 billion.

The company's selling, general and administration expense of $171 million was in line with its guidance of $170 million. Its interest and debt expense of $74 million in Q22012 declined from $107 million in Q22011. The company's depreciation, depletion, and administration expense of $386 million in the second quarter 2012 was in line with its guidance of $385 million.

Refining

Valero reported its refining gross margin of $10.63 per barrel, which increased by 38% QoQ and showed a downside of 7% YoY. Its throughput volume was increased to 2,658 thousand barrels per day. The Refinery segment's operating income was $3.59 per barrel, showing a decrease of 14% QoQ.

Retail

The contribution of the Retail sector significantly increased. Its operating income reached a new high of $172 million in Q22012, meaning an increase of 27% in the last one year. In the United States, fuel margins strongly rebounded to $0.3/gal in the second quarter from $0.05/gal in the first quarter of 2012. Canadian fuel margins also bounced back from $0.26/gal in the first quarter to 0.29/gal in the second quarter.

Ethanol

Its Ethanol business segment's operating income considerably declined to $5 million from $64 million in the last one year. In the same manner, its volumes decreased to 3,352 million gallons. Ethanol margins of $0.32 per gallon also decreased on a YoY and QoQ basis.

Comp Sheet

Valero Energy

Tesoro (NYSE:TSO)

Western Refining (NYSE:WNR)

Chevron (NYSE:CVX)

Alon USA Energy (NYSE:ALJ)

Market Cap:

17.47B

5.85B

2.36B

228.71B

770.27M

Qtrly Rev Growth (yoy):

11%

2%

-4%

-10%

20%

Revenue (NYSE:TTM):

137.29B

31.34B

9.03B

230.56B

7.58B

Gross Margin :

4%

6%

13%

30%

6%

EBITDA :

5.46B

1.52B

1.03B

50.98B

274.61M

Operating Margin :

3%

4%

10%

16%

2%

Net Income :

1.65B

664.00M

203.04M

26.63B

29.43M

The company's gross and operating margins of 4% and 3% are comparatively lower when compared with the margins of Tesoro Corporation , Western Refining , Chevron Corporation and Alon USA Energy . Going forward, Tesoro believes its margins will improve after the acquisition of a BP refinery in Caron City near Tesoro's Wilmington refinery. Chevron has been enjoying strong operating and gross margins due to its good crack spread and high utilization rate. In our opinion, after the startup of the hydrocracker projects and the expected improvement in throughput, VLO's margins will expand as well.

Valuations

Comp Sheet

Valero Energy Corporation

Tesoro Corporation

Western Refining

Chevron Corporation

Alon USA Energy

PEG (5 yr expected):

1.16

0.86

-1.31

30.13

0.29

P/S :

0.1

0.2

0.26

1

0.1

Forward P/E (Dec 2013)

6.71

7.95

6.8

9.31

8.9

EV/Revenue

0.17

0.2

0.28

0.94

0.21

EV/EBITDA

4.26

4.08

2.43

4.27

5.79

Dividend Yield

2.20%

1.10%

1.20%

3.10%

1.20%

The stock is trading at 6.7x to its forward earnings, at a discount when compared with the forward P/E of 7.9x, 6.8x, 9.3x and 8.9x of Tesoro Corporation, Western Refining, Chevron Corporation and Alon USA Energy, respectively. The stock's EV/Revenue is 0.17x and EV/EBITDA is 4.26x. It is trading at a P/S multiple of 0.1x, in comparison to the industry average of 0.3x. The company is paying a dividend yield of 2.2%, higher than the dividend yields of 1.1%, 1.2% and 1.2% of Tesoro Corporation, Western Refining, Inc. and Alon USA Energy, respectively. However, it has a low dividend payout ratio of 16.8%, in comparison to the industry average of 38.7%. Looking forward, its CAPEX is expected to decrease, which will eventually increase its cash flow. We expect its dividend payout ratio to improve as well..

Source: Valero Is A Refinery To Buy On Cheap Valuations, Decent Dividends And Growth Prospects