Valero Keeps Gushing Profits And A 4%+ Dividend Yield

Summary

• Valero smashed through analyst estimates for the fourth quarter.
• The impressive performance resulted mostly from new pipelines, which enabled Valero to purchase grades of crude oil at deeply discounted prices.
• Valero has exceeded the analysts’ estimates on both lines for 11 consecutive quarters.

By Aristofanis Papadatos

Valero Energy (NYSE:VLO) reported its results for the fourth quarter last week. The company smashed the analysts’ estimates, as it achieved earnings per share that were essentially double the consensus ($2.12 vs. $1.07).

Valero is one of the 294 dividend-paying energy stocks. The big question is whether the stock is attractive at its current level.

Business Overview

Valero is an oil refiner. Now that Marathon Petroleum (MPC) has acquired Andeavor, Valero has become the second largest petroleum refiner in the U.S. It owns 15 refineries in the U.S., Canada and the U.K. and has a total capacity of 3.1 M barrels per day, which is almost equal to the capacity of Marathon. Valero also has a midstream segment, Valero Energy Partners LP, but its contribution to the total earnings is less than 10%. As a result, Valero should be viewed as an almost pure refining business.

The stock of Valero has incurred heavy losses since early October, as it has lost 30% during this period. The downtrend has absolutely coincided with the collapse of the oil price, from $75 in early October to $55 now. As low oil prices sometimes signal slow economic growth ahead, the collapse of the oil price may have affected the stock of Valero to some extent. However, refiners usually benefit from low oil prices, which increase the demand for refined products and thus enhance the refining margins. Therefore, the steep decline of Valero should be mostly attributed to other factors.

Indeed, a major reason behind the decline of Valero in recent months is the steep decline in refining margins during this winter. Since the summer, U.S. refining margins have plunged almost 50%, from about $14.49 per barrel in the summer to $7.93 per barrel now.

On the one hand, the decrease can be partly attributed to seasonal factors, as the demand for gasoline is much lower in the winter and thus refining margins are always lower in the winter than in the summer. On the other hand, the current refining margins are approximately half of what they were last winter and hence their steep decline, which has been caused by high product inventories, is concerning.

While margins will certainly recover in the summer, they are unlikely to return to their record levels of recent years and stay at those levels. In other words, refining margins seem to have peaked from a long-term point of view. This pattern has repeated in this cyclical business in the past; after years of excessive refining margins, refiners boost their production and thus lead refining margins to lower levels.

Moreover, Valero was negatively affected by a rumor that the U.S. government was trying to postpone the implementation of the new international marine rules in the U.S. According to the new rules, which will come in effect in January-2020, the vessels that will sail in international waters will be forced to burn low-sulfur diesel instead of heavy fuel oil. Consequently, demand for diesel will greatly increase. As diesel is much more expensive than fuel oil, the new rules will greatly boost the refining margins. Therefore, the market was somewhat justified to punish Valero due to the efforts of the U.S. government to postpone the implementation of the new rules.

However, it is doubtful whether the government will succeed in its efforts. Even if it does, it is likely to postpone the new rules by just one or two years. Thus, domestic refiners will eventually benefit from the new standard, albeit later than their international counterparts.

Last week, Valero reported its results for the fourth quarter. The company smashed the analysts’ estimates, as its earnings per share of $2.12 were essentially double the consensus of $1.07. The impressive performance resulted from a 66% decrease in biofuel blending costs, from $311 M to $105 M, but mostly from a $510 M increase in refining earnings, which came from purchases of crude oil at opportune prices. The cost advantage in crude oil purchases resulted from the completion of some pipelines projects, which provided access to the refiner to cost-advantaged grades. It is remarkable that Valero has exceeded the analysts’ estimates on both lines for 11 consecutive quarters.

Growth Prospects

The great flexibility of Valero in purchasing crude oil from various sources provides the company with a significant competitive advantage. The refiner posted impressive results in the fourth quarter despite the plunge of the refining margins during that period. In fact, its earnings per share in the fourth quarter were typical of the summer season, not the winter season. Moreover, Valero has another competitive advantage, namely the high complexity of its refineries.

Source: Investor Presentation

Thanks to this advantage, the company can change its product mix and its input mix to a great extent depending on the relative prices of the products and the various grades of crude oil and thus it can maximize its benefit from the fluctuations in the prices of crude oil and refined products.

Thanks to its increased flexibility, its sustained share repurchases and a possible benefit from the new international marine rules, we expect Valero to grow its earnings per share by approximately 12% this year, from $7.37 in 2018 to about $8.25 this year. It is worth noting that the company has reduced its share count by 4% per year on average in the last five years and is likely to continue reducing its share count at a similar pace for the foreseeable future.

Recession Performance

During recessions, the demand for refined products significantly decreases and thus causes the refining margins to plunge. This was evident in the Great Recession, when the price of gasoline fell even below the price of crude oil for almost three months. Valero could not remain immune and thus posted losses in 2008.

Investors should be aware that refining is a highly cyclical business and thus the results of refiners exhibit dramatic swings over cycles. In the last downcycle of refiners, in 2011-2013, about 20% of international refineries went out of business. U.S. refiners were shielded from that fierce downturn thanks to the ban on oil exports, which was in place back then. The ban resulted in U.S. oil supply glut and thus in a deep discount of WTI to Brent, which reached $30 per barrel at some point. As a result, U.S. refiners enjoyed much higher margins than their international peers and hence they navigated the downturn without any problem.

However, the ban on oil exports was eventually lifted by Obama administration. Consequently, whenever the next downturn in the refining sector occurs, U.S. refiners will not enjoy the protectionism they used to enjoy. This is an important risk factor to keep in mind. Nevertheless, as long as the U.S. oil production continues to boom, WTI is likely to remain at a discount to Brent and hence U.S. refiners will continue to have an edge over their international peers.

Valuation

Based on our above forecast for this year, Valero is currently trading at a forward price-to-earnings ratio of 10.3. While this earnings multiple may seem too low, particularly compared to the valuation of the broad market, investors should realize that refiners almost always trade at low price-to-earnings ratios due to their high cyclicality and the resultant elevated risk they carry. To provide a perspective, Valero has traded at an average price-to-earnings ratio of 10.0 during the last decade. Therefore, we prefer to be conservative and do not expect meaningful gains from the expansion of the price-to-earnings ratio of Valero in the upcoming years.

Final Thoughts

Valero is currently offering a 4.2% dividend yield. In addition, the refiner is likely to grow its earnings per share by approximately 4% per year beyond this year, mostly thanks to share repurchases. Therefore, we expect Valero to return approximately 8% per year on average in the upcoming years.

We find the stock quite attractive, mostly thanks to its competitive advantages, namely the high complexity of its refineries and its increased flexibility in purchasing discounted crude oil grades.

Nevertheless, given the markedly low prevailing refining margins right now, we prefer to wait for a somewhat lower entry point. That said, Valero is an attractive high-yield option for income investors.

Analyst’s 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.