By Aristofanis Papadatos
Just like the other major U.S. refining stocks, Valero Energy (VLO) has been beaten to the extreme by the market lately due to some headwinds. The stock has shed 17% since the end of April and 38% since it peaked in October. As a result, the refiner is now trading at just 6.7 times its next year’s earnings.
In addition, Valero's dividend yield spiked to an all-time high just above 5%. You can see our full list of 5%+ yielding dividend stocks here. Valero stock has recovered slightly in recent days, but the stock still offers a high yield of 4.8%.
As the stock has a major growth catalyst ahead, which will outweigh the recent headwinds, it is likely to offer excessive returns to its shareholders from its current price.
Valero has 15 refineries in the U.S., Canada and the U.K., with a total refining capacity of 3.1 million barrels per day. It used to be the largest refiner in the U.S. but that changed after the acquisition of Andeavor by Marathon Petroleum (MPC), which now has marginally higher refining capacity than Valero. The latter also has a midstream segment, Valero Energy Partners LP, but this segment has a small contribution to the total earnings and hence Valero should be viewed as a nearly pure refiner.
All the U.S. refiners posted impressive earnings in the fourth quarter but poor results in the first quarter. In the fourth quarter, their margins skyrocketed thanks to the markedly cheap input of refineries, as the Canadian crude supply glut led the discount of Heavy Canadian crude to WTI to $40 per barrel. However, Alberta enforced production cuts to alleviate the supply glut and thus caused the discount of Canadian crude to WTI to collapse in the first quarter, from $40 to $10 per barrel. Consequently, all the U.S. refiners posted lackluster results in the first quarter.
While the discount of Canadian crude to WTI has not risen significantly in recent months, investors should realize that the poor earnings in the first quarter mostly resulted from adverse seasonality, as refining margins are always weaker in the winter. Since the end of the first quarter, refining margins have expanded to healthy levels and are likely to remain around those levels or higher until the end of the year.
The stocks of refiners were also affected by a negative statement of President Trump, who threatened to impose a tariff on all the goods coming from Mexico last week. U.S. refiners import about 600,000-700,000 barrels per day of Mexican heavy crude grades in order to make up for the losses of the crude of Venezuela, which has similar properties. If these Mexican crude grades become more expensive, they will take their toll on the margins of the U.S. refiners.
Valero is considered one of the most vulnerable refiners to such a development, as almost half of its refineries are in the Gulf Coast and hence they will be significantly affected in such a scenario. However, investors should realize that, even if President Trump delivers his threat, the new tariff will not be permanent. If a new government comes into power next year, it may very well eliminate the tariff. Even more importantly, imports from Mexico comprise much less than 10% of Valero’s refinery throughput. Therefore, even if a tariff is imposed, it will not have a great impact on the earnings of the company. Overall, this seems to be another case in which the market hates uncertainty and punishes a stock to the extreme despite its promising growth prospects.
A Major Growth Catalyst
All the U.S. refiners are looking forward to the implementation of the new international marine standard, which will come into force in January. According to this standard, all the vessels that sail in international waters will be forced to burn low-sulfur diesel instead of heavy fuel oil. Consequently, the demand for diesel will surge whereas the demand for heavy fuel oil will plunge. As diesel is far more expensive than fuel oil, the new marine rules will greatly enhance the earnings of refiners.
Valero is ideally positioned to benefit from the new marine rules, as it has one of the highest distillate yields in its peer group. Source: Investor Presentation
Consultants expect the global demand for diesel to jump by more than 2.0 million barrels per day next year thanks to the new marine standard, in addition to the base annual demand growth of 300,000-500,000 barrels per day.
In regards to its other growth catalysts, Valero has a long pipeline of high-return projects, which aim to reduce operating expenses, improve margins and enhance market reach. The company approves only of projects that have an expected annual return of at least 25% and expects to spend approximately $1.0 billion per year on growth projects and generate $1.2-$1.5 billion in EBITDA from these projects. Given last year’s EBITDA of $7.6 billion, these projects are likely to result in 16%-20% EBITDA growth per year in the upcoming years.
Source: Investor Presentation
A great example is the delayed coker in Port Arthur refinery, which is expected to start-up in 2022. This project will cost $975 million but it will generate about $420 million in annual EBITDA, as it will essentially convert almost all the low-value products of the distillation units, such as fuel oil, into high-value products, such as diesel, jet fuel and gasoline.
Moreover, Valero has consistently enhanced its earnings per share via meaningful share repurchases. The company has reduced its share count at a 4% average annual rate in the last five years and management has repeatedly confirmed its intention to continue buying back shares at a similar rate. It is thus reasonable to expect share repurchases to remain a meaningful growth driver of the bottom line for the foreseeable future.
Just like the other refiners, Valero is a cyclical stock and thus tends to trade at lower price-to-earnings ratios than the broad market. To provide a perspective, Valero has traded at an average price-to-earnings ratio of 10.0 during the last decade.
However, the stock is exceptionally cheap right now. To be sure, thanks to the strong tailwind from the new marine rules, analysts expect the refiner to earn $11.18 per share next year. This means that the stock is now trading at just 6.7 times next year’s earnings. Whenever the stock reverts to its historical average valuation level, it will enjoy a 50% gain merely from the mean reversion of its valuation level. This is likely to occur in the upcoming months, when the market eventually focuses on the benefits from the new marine rules. It is thus evident that Valero has immense return potential merely from a valuation point of view.
Even if the market refuses to reward the stock with a more normal price-to-earnings ratio, the shareholders will greatly benefit from the cheap valuation of the stock. As Valero repurchases its shares at a significant rate, a cheap valuation is paramount, as it enables the company to reduce its share count at a faster pace with a given dollar amount of buybacks. Overall, Valero is likely to offer excellent returns from its current stock price thanks to the potential expansion of its price-to-earnings ratio and its share repurchases, which will greatly enhance shareholder value at the current suppressed price-to-earnings ratio.
Valero has an impressive dividend growth record in recent years. The refiner has more than doubled its annual dividend, from $1.70 in 2015 to $3.60 this year. Thanks to this dividend growth pace and the poor stock price performance in the last eight months, the stock is now offering an all-time high dividend yield of 4.8%.
Moreover, Valero has a healthy payout ratio of 50.5% and a strong balance sheet, as its interest expense consumes only 10% of its operating income and its net debt (as per Buffett, net debt = total liabilities – cash – receivables) of $19.8 billion is less than 7 times the annual earnings. Therefore, Valero is not likely to have any problem raising its dividend for the foreseeable future. To cut a long story short, investors can now purchase Valero at an all-time high dividend yield of 4.8% and rest assured that the company will keep raising its dividend for the foreseeable future.
Valero has some significant competitive advantages when compared to its peers. This is particularly important, as refining is a cyclical business and hence there is fierce competition whenever a downturn shows up.
First of all, Valero has the most complex refineries in the U.S. This means that its refineries have the greatest flexibility in processing a wide range of crude oil grades and producing refined products at various proportions, depending on their relative prices. In other words, thanks to the complexity of its refineries, Valero can take full advantage of the wild gyrations of the prices of the various crude oil types and refined products.
Valero also has one of the lowest operating costs in its peer group. This means that it operates its refineries with high efficiency. Both of these competitive advantages are critical in the event of a downturn, when the weakest refineries are forced to shut down and thus incur losses.
Behavior in downturns
Unlike most energy stocks, refiners greatly benefit when the price of oil falls. Lower oil prices reduce the input cost of refiners while they also improve the demand for refined products and thus enhance refining margins. This was evident in the fierce downturn of the energy sector, which began with the collapse of the oil price in mid-2014. In fact, Valero posted record earnings per share in 2015. Therefore, the shareholders of Valero should not be worried about the possibility of lower oil prices.
On the other hand, refiners are highly vulnerable to recessions. During such periods, demand for refined products slows down and exerts great pressure on refining margins. This was evident in the Great Recession, when the price of gasoline fell below the price of crude oil (!) for three months and refining margins remained suppressed for more than a year, thus causing Valero to post losses in 2008.
On the bright side, although the market panicked over a potential upcoming recession in December, this risk has materially decreased lately, as the Fed has adopted a much more flexible stance towards interest rates. While the Fed raised interest rates aggressively in the past two years, it has recently become more flexible and may even lower interest rates next month. Overall, the risk of a meaningful recession in the near future has decreased and this is an important factor for the vulnerable stocks of refiners.
Just like the other U.S. refiners, the stock price of Valero has remarkably underperformed in the last few months due to the poor results in the first quarter and the recent threat of the U.S. President, who stated that he may impose a tariff on all the goods imported from Mexico. However, even if the tariff is imposed, it will have a limited effect on Valero, which uses Mexican crude grades in much less than 10% of its refinery throughput.
Moreover, Valero has a major growth catalyst ahead, namely the new marine standard, which will come into effect in January. Thanks to this catalyst, the earnings per share of Valero are expected to surge 63% next year and the stock is trading at just 6.7 times those earnings. In addition, the stock is now offering an all-time high dividend yield of 4.8%, with ample room for future dividend hikes.
Given all these facts, investors should take advantage of the recent negative headlines and purchase Valero at a markedly cheap valuation level and an attractive dividend yield.
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.