- The coronavirus news is picking up in more geographies as incubation periods for the infected elapse, taking a massive toll on the stock market.
- Valero has been hit hard as demand for oil is forecast to fall, but some mitigating factors should be considered.
- Considering buybacks that the company might be conducting at these levels and the future dividend burden it reduces, return prospects are looking quite attractive.
The impact of the coronavirus is clear to anyone who is invested in the equity markets. Major indexes are falling as industrial and consumer activity is perceived to be coming to a standstill across geographies, where reporting is catching up to the virus' spread. Lack of demand for travel and freight means that there will be substantial demand destruction of oil, with forecast declines as high as 20%. As such, companies like Valero Energy Corporation (VLO), which rely on oil throughput, are likely to see lower utilisation rates and lower profits in a period where a recovery in profits was expected from high-sulfur crude discounts. Many might be considering selling at these levels, uncomfortable with the paper losses, but we want to present some points that may provoke reconsideration. We think that these levels actually present some upside and might be interesting to anyone who likes trying to catch falling knives.
First of all, demand destruction will at least mean that crude oil prices fall too, sustaining the crack spread. Even if throughput falls, this is a margin mitigant that we see in action both now (see chart) and have seen historically based on the correlation between refinery stock prices and the WTI or Brent, which over the last 10 years is seen to be linked by a beta of only 0.2 (according to Tiingo).
With regards to throughput, there are some mitigants there too. China is massive when it comes to its refinery capacity, globally contributing about 15%. It is a substantial contributor and its throughput could be down more than 50% since the Chinese new year. Teapot refineries in China are in really dire straits given their substantial indebtedness, not able to keep up throughput due to their lack of complexity and optionality. Although not a good thing for Chinese production, it does mean that Gulf Coast refiners' relative positioning will improve as they pick up some of the slack.
Finally, investors should consider precedent for predicting what might happen to the demand for oil in times like these. When the SARS epidemic hit, lock-down measures were put in place. Although there are clearly negative effects of a lock-down with respect to freight and flight demand, as well as public transport, people will opt for using personal vehicles if they really need to travel. The mitigating effect is that personal vehicles are relatively very fuel inefficient. During the SARS epidemic, oil consumption still rose, and actually rose more than the year prior, with GDP per barrel of oil consumed falling significantly. Although we may not see effects of the same magnitude now since the coronavirus spread has been much more rampant, there is comfort in the fact that these mitigants were strong enough in previous epidemics to entirely offset other forms of oil demand destruction.
There are more vectors to make an entry point here attractive. Valero has been pretty reliable when it comes to its shareholder remuneration policies. It takes the approach of paying out an at least growing dividend as a priority while remunerating the balance with shareholder buybacks. If we consider current levels and assume that the CAPEX projects continue, we can run a simple model that looks at the accretive effect that buybacks would have if conducted as in the past.
Let's focus on the next two years, where in 2020 FCF will decline from its seven-year historical average by 20%, the forecast decline in oil demand. In 2021, we assume this FCF will recover to the seven-year historical average. The reason we're using FCF is to account for the fact that Valero should be pursuing its growth projects in biofuels as planned.
As described by its shareholder remuneration policy, the dividend will be paid first, and we assume without growth in either 2020 or 2021. We will assume that the balance of the FCF can be used for conducting shareholder buybacks. We think this is sustainable given that it has almost $8 billion in available revolver borrowing capacity and liquidity. We assume that it will conduct these buybacks following revaluation of the shares by 10% in both periods, in line with its seven-year average of share price growth. By buying back shares, the company also reduces its dividend burden for the future. We consider the cash Valero saves on a smaller future dividend in perpetuity based on a 6% cost of capital.
Assuming that the company is valued on a FCF yield basis with a lower 2021 share count, we get the following:
(Source: Mare Research Database)
Assuming 10% revaluation in both periods and a return to a long-term average FCF in 2021, the forecast price appreciation based on a FCF-yield valuation tells us that there is a 22.76% price appreciation opportunity from buyback yield. If we consider our sum-of-parts valuation of Valero as shown in our last article, the parts being the refinery and renewable diesel segment, and include the estimated market cap of $43.5 billion in the model above, combined with the declining share-count and saved dividend cash, we get the following.
(Source: Mare Research Database)
This is not assuming any historical price appreciation, but the compounding rate the price would need to grow at to go from today's $68 to the forecast $111, meaning more expensive share repurchases. Nonetheless the high assumed rate means high buyback yields despite higher 2021 share count, resulting in a forecast price appreciation of 62.54%. Although this figure may be a little high, since the next quarter is going to produce less cash than priced in when we first did the analysis, there seems to be a margin of safety.
Risks and Conclusions
Naturally, oil is at risk with the coronavirus news. If the coronavirus outbreak extends across the US, both crude oil and gasoline prices will continue to drop, spurring reduced production and throughput for refiners including Valero. With regards to our model, even in spite of quite large liquidity reserves, debt is coming due for Valero as well, and buybacks will not be a priority when a liquidity margin becomes necessary. This would mean less buyback yield in a recovery and more tempered price appreciation forecasts.
Nonetheless, opportunity is found in sold-off companies, especially in an era where so many flows are mandated by nothing more than the need to rebalance and algorithmic rules. The crack spread is holding up, and throughputs will eventually recover. Valero is well managed and it has a nifty growth story too in renewable diesel and ethanol. It's a jewel in the crown of gulf-coast refiner stocks, and if you're comfortable seeing red for a while, now may be a good time to buy.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in VLO over 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.
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