Hold Valero For Long-Term Gains Or Buy Now

| About: Valero Energy (VLO)

One of the most appealing attributes for Valero (NYSE:VLO) derives from the difference between a refinery organization and the traditional E&P. While domestic E&Ps like Chesapeake (NYSE:CHK) are suffering from low natural gas prices, refineries like Valero are prospering. The crack spread resulting from the lowered input cost from declining natural gas prices and the increasing prices for gasoline are creating improved earnings for refineries like Valero. Natural gas remaining at record lows and gasoline remaining at record highs creates optimum earning potential for Valero. As long as this dynamic holds fast, it's reasonable for investors to expect upticks and increased activity on refinery stocks.

Occidental Petroleum (NYSE:OXY), Phillips 66 (NYSE:PSX), Murphy Oil (NYSE:MUR), and HollyFrontier (NYSE:HFC) are the firms most comparable to Valero Energy. Valero and Occidental's price are around 10.5 times earnings while HollyFrontier and Phillips 66 are around 5.5 times earnings. Valero's price is around 0.12 times sales and 0.98 times its book value - these are the lowest price ratios among these firms. Valero's $2.91 EPS is the lowest among these refinery firms; its EPS has increased 126% in 2012 and is projected to increase 6.2% in 2013. Valero's sales have increased 7.5% over the past 5 years. Both Valero and Phillips 66 current ratios are around 1.3 and their debt-to-equity ratios are around 0.42. Valero's annualized dividend is around $0.70 per share.

Valero's float short is around 1.9% and its 1.1 short ratio is the lowest among these firms. Valero's ROE is around 10.1%, its operating margin is around 2.3%, and its profit margin is around 2.8%. It has the lowest operating and profit margins by at least 120 bps, and only Murphy Oil's 8.9% ROE is lower than Valero Energy. Valero's beta is close to 1.5, and its average trade volume is close to 9.3 million; both are the highest among these firms. Its 0.47 relative volume is the lowest among the aforementioned. Valero's stock price has increased 42.7% YTD. It's down 7.8% in the past month but has increased around 7.9% since its last earnings release.

On Valero's second quarter earnings release, operating revenues totaled $31.62 billion, increasing slightly from $31.29 billion, YOY. The increase in operating income was mainly due to the Meraux and Pembroke Refineries that Valero acquired in the second half of 2011. Valero's second quarter costs and expenses totaled $33.3 billion, increasing from $30 billion, YOY. Operating income increased to $1.36 billion, increasing from $1.29 billion, YOY. Refining accounted for $1.36 billion of operating income, increasing from $1.25 billion, YOY. Second quarter net income totaled $830 million, increasing from $743 million, YOY. Valero finished the first half 2012 with $1.29 billion in cash and temporary cash investments, decreasing from $4.1 billion, YOY.

Valero has benefited from processing sweet crude oils from WTI crude oil due to the favorable price in comparison to benchmark sweet crude oils like Brent. The increasing domestic supply and increased deliveries of WTI crude from Canada have resulted in a significant discount compared to Brent crude oil. Valero does not expect these margins to sustain as more projects are completed and transported to the US Gulf Coast. The US Gulf Coast accounted for $637 million of Valero's operating income while the US Mid-Continental accounted for $444 million. Valero expects energy margins and markets to be volatile in the near to mid-term.

Valero recently began shutting down units at the McKee refinery in Texas as part of a planned work stoppage. The McKee refinery produces around 156 mbbls per day, Valero shut down a gasoline-making fluid catalytic cracking unit, a sulfur recovery unit, and a reformer as part of this planned stoppage. Out of its 16 US refineries, Valero is also looking to sell two California refineries producing over 200 mbbls per day in order to avoid hundreds of millions of dollars in regulatory upgrades that are to be implemented by 2020. Valero is also in the midst of reduction operations at its Aruba refinery in order to restructure the asset into a world-scale crude and refined products terminal. The reduction and reorganization is expected to complete by 2013.

Valero Energy is one the major corporations alongside Phillips 66, Occidental and HollyFrontier that accounted for 80% of California's 628 drilled wells in 2011, and could eventually be affected by recent efforts to ban fracking in the state. Vermont recently banned fracking earlier in the fall. Earthjustice, the Sierra Club, and three other organizations recently filed a lawsuit against California's Department of Conservation alleging the Division of Oil, Gas and Geothermal Resources did not conduct due diligence before approving fracking in the state. Accounting for around 13% GDP, a California fracking ban could set precedents for other states to follow suit. California accounts for around 1% of US natural gas production. This latest litigation is noteworthy but does not pose an immediate near term threat to any major refineries' earnings.

Valero also recently announced it will auction off 1,000 US locations and around 800 locations in Canada in order to divest its retail division from its core operations as a refinery; the locations are projected to sell for around $3.5 billion. This is a clear sign that Valero is confident in its refinery business and doesn't believe it needs the retail division for revenue. Retail only accounted for around 10% of Valero's total second quarter operating income.

Some analysts feel that selling the retail assets could make Valero an ideal candidate for a merger or acquisition by one of the larger integrated energy firms. Valero Energy has increased earnings 6.3% over the past 5 years and is making strides to reduce costs and increase its margins and prospects as a major global refinery. Current shareholders should hold long-term and interested investors should initiate a position in 2012 before Valero's various ventures come into fruition.

Disclosure: I 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.

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