Valero Energy: A Strong Refiner For The Long Term But Too Expensive Now

| About: Valero Energy (VLO)


Valero Energy is the largest independent U.S. refiner. It is a model when it comes to growth that benefits directly the company's shareholders.

Valero has a set of important projects that are likely to contribute significantly to its future EBITDA contribution by 2021.

It is hard to imagine that VLO can continue its uptrend much longer. The stock rallied over 25% already since September and is now overbought.

Courtesy: REUTERS/Mario Anzuoni/File Photo

Investment Thesis

Valero Energy Corp. (VLO) is the largest independent U.S. refiner. It is a model when it comes to growth that serves directly the company's shareholders. Profits and revenue have weakened in recent years when the company could no longer gain from the surplus of oil in the U.S.

However, thanks to Valero's business diversification, notably in renewable assets such as ethanol, the company can be considered as a solid investment in the oil and service sector. The caveat emptor is that the stock is showing an overbought situation at the moment.

Quick Presentation

From VLO presentation September 8, 2017.

The Company's segments include:

  1. Refining: This is the biggest part of the business. It represents the refining operations, logistics assets, and the associated marketing activities. logistics assets such as crude oil pipelines, refined petroleum product pipelines, terminals, tanks, marine docks, truck rack bays that support its refining operations.
  2. Ethanol: The ethanol segment includes its ethanol operations and the associated marketing activities, and logistics assets that support its ethanol operations located in the Northern part of the USA.
  3. Valero Energy Partners LP (VLP): Some of these assets are owned by VLP, which is a midstream master limited partnership owned by the company. Valero Energy was spun off VLP in December 2013. By placing pipeline, storage, and terminal assets into this partnership, It can circumvent taxes and collect generous distribution payments.

VLP's assets include crude oil and refined petroleum products pipeline and terminal systems in the United States Gulf Coast and the United States Mid-Continent regions. Its refineries produce conventional types of gasoline, premium gasoline, and lubricants, among others.

Chart VLO data by YCharts

The raw numbers: Third-quarter 2017 and 10-year history.

Valero Energy Corp. 2Q'15 3Q'15 4Q'15 1Q'16 2Q'16 3Q'16 4Q'16 1Q'17 2Q'17 3Q'17
Total Revenues in $ Billion 25.12 22.58 18.78 15.71 19.58 19.65 20.71 21.77 22.25 23.56
Net Income in $ Million 1351 1377 298 495 814 613 367 305 548 841
EBITDA $ Billion 2.51 2.62 1.15 1.32 1.72 1.37 1.11 1.05 1.39 1.85
Profit margin % (0 if loss) 5.4% 6.1% 1.6% 3.2% 4.2% 3.1% 1.8% 1.4% 2.5% 3.6%
EPS diluted in $/share 2.66 2.79 0.69 1.05 1.73 1.33 0.82 0.68 1.23 1.91
Cash from operations in $ Billion 2.33 1.36 0.49 0.64 2.32 0.86 1.00 0.99 1.80 1.04
Capital Expenditure in $ Million 370 867 -77 316 294 776 -108 279 293 341
Free Cash Flow in $ Million 1959 495 564 324 2025 87 1106 709 1504 696
Cash and cash equivalent $ Billion 5.76 5.30 4.11 3.78 4.93 5.95 4.82 4.46 5.21 5.18
Long term Debt in $ Billion 0.15 0.13 0.13 7.34 7.51 8.95 7.93 8.49 8.49 8.49
Dividend per share in $ 0.40 0.40 0.50 0.60 0.60 0.60 0.60 0.70 0.70 0.70
Shares outstanding (diluted) in Million 508 494 482 471 470 460 455 451 446 441
Oil, NG & Ethanol Production 2Q'15 3Q'15 4Q'15 1Q'16 2Q'16 3Q'16 4Q'16 1Q'17 2Q'17 3Q'17
Throughput volume in K Bop/d 2808 2823 2799 2879 2827 2860 2855 2839 3019 2893
Ethanol in K gallon p/d 3793 3853 3827 3740 3826 3815 3842 4041 3775 4032

Source: VLO filings and Morningstar.

Note: The debt to capital ratio, net of $2.0 billion in cash, was 24%.

Trends and Charts: Revenues, Earnings Details, Free Cash Flow and throughput volume and Ethanol production.

1 - Revenues.

The Company's segments include refining, ethanol and Valero Energy Partners LP (VLP).

The ethanol segment generated $82 million of operating income in the third quarter of 2017, compared to $106 million in the third quarter of 2016. The decrease from 2016 was primarily due to lower margins, resulting from higher corn and lower distillers grain prices.

The company minimized the effects of the two hurricanes Harvey and Irma. Joseph W. Gorder, the CEO, said in the conference call:

To think that the epicenter of the refining industry on the Gulf Coast could take a direct hit from a Category 4 hurricane and keep supply disruptions as short lived as they were was impressive... Now, despite the hurricane impacts, we're pleased to report another good quarter of results for the company.

One important element is that the company indicated that the margins were improving from last year due primarily to strong domestic and export product demand and large supplies of crude in spite of OPEC cuts on heavy sour discounts.

2 - Free cash flow.

Free cash flow is an important clue that should be always evaluated carefully when looking at a long-term investment. Basically, FCF should be adequate and positive if the business model can be regarded as healthy.

Accordingly, it must be sufficient enough to compensate for the distribution, reduce debt and pay for eventual shares buyback. VLO has passed the VLO test with FCF of $4.015 Billion annually. This is an impressive achievement.

As a reminder, VLO has approximately $1.6 billion of share repurchase authorization remaining as of September 30, 2017. Distribution is now $1.234 billion annually.

Conclusion: VLO passed the FCF test.

We can also conclude that the dividend seems secure at the present level which is $2.80 per share (yearly) or 3.4% annually.

3 - Net debt.

Net debt is about $3.31 billion as of September 30, 2017.

Note: $116 million in cash is held by VLP.

The Net Debt-to-EBITDA (NYSE:TTM) stands at x0.61 which is very satisfactory and much lower than the average ratio for the Industry. Let's compare to Marathon Petroleum (MPC) or Phillips 66 (PSX).

4 - Throughput and Ethanol Production.

John Locke said in the conference call:

Refining throughput volumes averaged 2.9 million barrels per day, which was 33,000 barrels per day higher than the third quarter of 2016, despite Hurricane Harvey related impacts. Throughput capacity utilization was 92% for the third quarter of 2017.

Refining cash operating expenses was $3.71 per barrel up 4.8% from third quarter of 2016, mostly due to higher energy costs in the third quarter of 2017.

1 - The company expects throughput volumes to fall slightly in the fourth quarter from about 2,893K Boep/d to 2,845K Boep/d (mid-point).

  • U.S. Gulf Coast at 1.65 million to 1.7 million barrels per day.
  • U.S. Mid-Continent at 410,000 to 430,000 barrels per day.
  • U.S. West Coast at 265,000 to 285,000 barrels per day
  • North Atlantic at 465,000 to 485,000 barrels per day.
  • Refining cash operating expenses in the fourth quarter to be approximately $3.90 per barrel from $3.71 per barrel in Q3.

2 - Ethanol production: The company expects to produce a total of 4 million gallons per day in the fourth quarter, with operating expenses averaging $0.37 per gallon, which includes $0.05 per gallon for non-cash costs such as depreciation and amortization.

3 - Projects.

Valero has a set of ongoing projects that are likely to contribute $350 million (mid-point) to its incremental annual EBITDA target by 2021.

These projects are:

  1. Wilmington cogeneration project, the Houston alkylation project. The project costs $110 million with startup expected now.
  2. Diamond pipeline project,
  3. Diamond Green Diesel expansion project
  4. Central Texas pipeline (build an approximately 135-mile, 16-inch products pipeline from Houston to Hearne, Texas) and Pasadena marine terminal project in collaboration with Magellan Midstream Partners, L.P. (NYSE: MMP) in a 50/50 JV. Cost approximately $730 million.

These projects are intended to improve feedstock flexibility, supporting steady growth, and developing logistics capabilities.

The Wilmington cogeneration plant is expected to cut energy costs and provide a steady supply of power.

The Houston alkylation project is expected to upgrade low-value isobutane to high value alkylate. The project costs around $300 million and is expected to be completed by first half of 2019.

The Diamond Pipeline project requires the construction of 440 miles of pipeline, which would transport crude oil from Cushing to Memphis with pipeline capacity of 200K bp/d. Cost $460 million for the company 50% stake, with completion expected soon.

The Diamond Green Diesel project is aimed at developing VLO’s capacity to produce renewable diesel. The project is expected to cost $200 million and likely to be completed by mid-2018.

The CEO Joseph Gorder said:

we're eager to see the incremental earnings contribution from these projects beginning in 2018.

Technical analysis

VLO is forming a classic ascending broadening triangle pattern with a strong support around $68 and resistance at $85. The ascending broadening wedge/triangle is a chart pattern that can be traded in several ways: either as a bullish/bearish breakout or with a swing trading strategy. I am recommending the latter at the moment. Given that It is hard to imagine VLO continuing this hot momentum much longer. The stock rallied over 25% since September and can be considered as technically overbought.

I believe the first support is the 50MA around $79.25 and I recommend to take some profit off the table between $84-$86 if possible and wait for a healthy consolidation in the mid-$70s.

Final wrap up

Valero Energy will continue to be a strong candidate for a long-term investment due to its solid fundamentals and clear potential for future growth. It is certainly a good choice for value-oriented investors despite an evident overbought situation at the moment. Free cash flow generation is very impressive and supports a good dividend payout "as far as the eyes can see".

Nonetheless, investors will have to be vigilant about the refining margins which are crucial for operating cash flow and will probably be the subject of pressure as oil continues to climb. Nothing comes with no risk in this market especially when it comes to oil.

My recommendation is to wait for a healthy retracement that will re-test the supports to initiate a new position in VLO.

Important note: Do not forget to follow me on the oil industry. Thank you for your support; it is appreciated.

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.

Additional disclosure: I trade the stock often right now.

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