Valero Energy: Citigroup's Bullish Notes Provide Energy To Refining Sector

| About: Valero Energy (VLO)
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Shares of Valero Energy (VLO) saw a nice little boost last week after analysts at Citigroup issued some bullish notes regarding the prospects for the refiner and the sector.

I agree with analysts at the bank, being optimistic about growth prospects for US refiners. Refiners have seen difficult times recently, driven by a narrowing WTI-Brent spread.

Citigroup's Upgrade

Last week Citigroup (NYSE:C) issued some bullish research notes on the protects for US refiners.

Refiners have seen weakness in recent months on the back of the fact that the difference between US WTI and European Brent prices has shrunk significantly. The premium of Brent over WTI has narrowed from levels above $20 at the start of the year, to essentially break-even in the summer.

According to analyst Khan and his colleagues, earnings for refiners have peaked in the third quarter of 2012, and are expected to bottom in the fourth quarter of this year.

Refiners which are overweight in the Midcontinent or the Midwest could see difficult earnings through the first quarter of next year, which could create some diverging performance within the sector.

On the back of this upgrade both Valero and Tesoro (TSO) were upgraded from "neutral" to "buy". Both firms trade at an estimated 25% discount to group mid-cycle earnings, according to Citi. As Valero will benefit from wider heavy-light price differentials in 2014, Tesoro stands to benefit from a tighter gasoline market in California.


Back in July, Valero reported its second quarter earnings. Note that Valero is scheduled to open its books for the third quarter at the end of this month.

The company operates with $2.40 billion in cash and equivalents. Total debt stood at $6.56 billion, for a net debt position of around $4.2 billion.

Revenues for the first six months of the year came in at $67.5 billion, down 3.3% on the year before. Net earnings rose from $399 million to $1.12 billion. At this pace annual revenues could come in anywhere between $130 and $140 billion, while consensus estimates for full year earnings stand at $2.0 billion, unchanged from last year.

Trading around $34 per share, the market values Valero at nearly $19 billion. This values the equity of the firm at 0.15 times annual revenues and 9-10 times annual earnings.

Valero pays a quarterly dividend of $0.22 per share, for an annual dividend yield of 2.6%.

Some Historical Perspective

Over the past decade shareholders in Valero have seen the full boom and bust cycle. Shares have risen from merely $10 in 2003, to peak around $75 in 2007. Shares have fallen all the way back to $15 in 2009 and 2010, to peak at $49 in March of this year. Ever since, shares have given up some 30% of their value.

Between the calendar year of 2009 and 2012, Valero has nearly doubled annual revenues from $64.6 billion to $139.2 billion. In the meantime the company has turned a $2.0 billion loss in 2009 into a similar profit in both 2011 and 2012.

Investment Thesis

Valero admits that it was caught by the recession about five years ago, causing its share price to tumble. The strong recovery in recent years ,and very favorable price differentials between Brent and WTI, allowed the company to report solid profits again.

Yet refiners have seen some weakness over the past half a year as the discount between WTI and Brent has essentially vanished. By using cheaper WTI oil as input for refining, US refiners were able to report steep earnings over the past year. This advantage has disappeared after both benchmark oil prices were almost trading on par this summer.

At the moment the spread between Brent and WTI has widened again to $5-$6 at the moment, while Valero expects a spread of $6-$8 per barrel in the second half of this year.

To create more value for shareholders in this difficult external environment, Valero is taking quite some action. This includes Valero's plans to spin-off its retail business. Earlier this year, Valero already distributed 80% of CST Brands (NYSE:CST) to its shareholders.

Shareholders received 1 share in CST in May for each 9 shares in Valero they held at the moment. With CST trading around $30 per share at the moment, the stake is worth approximately $3.33 to shareholders owning Valero stock before May. On top of this, Valero is also considering a master limited partnership for its logistical operations, like Phillips 66 (NYSE:PSX) has done recently.

So Valero is suffering from a more challenging environment, driven by unfavorable spread developments. Yet spread have seen stabilization in recent times, as Valero continues to make progress in distributing cash to shareholders and coming up with divestments, spin-offs and new legal formats, all meant to boost shareholder returns. In the midst of all of this, the valuation seems fair at just 9-10 times earnings despite the fact that Valero is seeing some real weakness this year.

So I agree with Citigroup and I am cautiously optimistic about the refining sector, after a difficult past six months. While I like the general prospects, including those of Valero, I have a slight preference for Tesoro given the large synergy possibilities on the back of past deal-making.

Disclosure: I am long TSO. 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.