VLO Is Conservatively Valued

Summary

  • Valero (VLO) is conservatively valued on an absolute basis according to a Discounted Cash Flow Analysis.
  • VLO is conservatively valued on a relative valuation basis against its peers group.
  • Conservative valuation reflects expected margin contraction. Even though analysts’ 2015 earnings estimates are still biased high, ample margin of safety makes VLO a long-term HOLD.
  • If/when estimates do come down, VLO is a BUY on the dip.
  • Although good things are more likely to happen to conservatively valued stocks, a separate thesis is needed to indicate how management would unlock value.

Company Overview
Valero Energy Corporation (VLO) is the world’s largest independent refiner with 15 oil refineries, 11 corn ethanol plants, and a substantial portfolio of logistics assets. Its oil refining assets have throughput capacity to process 2.9 million barrels of oil per day. The company wholesales the majority of its rack volume through unbranded channels. The rest is sold through approximately 7,400 Valero-brand family sites which include Valero®, Beacon®, and Shamrock® brands in the U.S., the Ultramar® brand in Canada, and the Texaco® brand in the U.K. and Ireland. Its ethanol assets have production capacity of 1.3 billion gallons per year. CST Brands (CST), which was spun-off from VLO in May 2013, is now Valero’s largest wholesaler. Valero Energy Partners (VLP), a logistics-focused Master Limited Partnership, completed its IPO in July 2013; VLO retains significant ownership and a controlling interest in the partnership. In addition to the company’s portfolio of logistics assets, management expects to spend approximately $1.3 billion on additional logistics growth projects from 2014 through 2015 and expects that most of these asset will qualify for its MLP 1 2.

Figure (1): Valero Energy Corporation’s Operating ActivitiesVLO Operations July 2014
Source: VLO Investor Presentation, July 2014

Discounted Cash Flow Analysis
Discounted future cash flows analyses are an elegant way to sanity check other valuation methods. In fact, VLO’s accounting policies require the company to annually perform discounted cash flow analyses to test for asset impairment 3. Notable impairments include a $928 million impairment of the Aruba facility in 2012, and a $4.1 billion impairment in 2008 due to a reevaluation of market risk which increased the assumed discount rate4. Good accountancy means that, at just 1.3x book value, fair value estimates of the balance sheet should also hold up relatively well for the stock.

This analysis focuses on Owner’s Earning’s, a concept which was popularized through Warren Buffet’s 1986 letter to Berkshire shareholders. Owner’s Earnings are Operating Cash Flows less maintenance capital charges (i.e., expenses which are required to maintain the business’s current market share and general competitiveness). Owner’s Earnings differ from Free Cash Flows (FCF) only in that they differentiate between growth and maintenance capital expenditures. Owner’s Earnings estimate a business owner’s cash profit after accounting for all non-discretionary expenses; leftover cash can be used for various other financing and investing decisions. Since Owner’s Earnings are a cash flow metric, they are fairly straightforward to estimate and resilient to accounting distortions and manipulation. In order to discount into perpetuity, “Sustainable Free Cash Flows”, which are defined as “Cyclically Adjusted Operating Cash Flows” less “Maintenance Capital Expenditures”, are estimated. Cyclical adjustments, in this case, estimate mid-cycle cash flows (i.e., the mid-point of a 5 to 7 year commodities cycle).

Relatively anemic 2015 and 2016 cash flow estimates reflect that, over at least the next several months, margins are likely to be remain compressed. The Brent-WTI spread has been a strong tailwind for U.S.-based refiners since 2010. However, given that Brent and WTI do not differ materially with regard to density and sulfur-content, the wide spread is not sustainable over the long-term. It has already begun to collapse. For comparable FY 2015-16 free cash flow estimates, see Seeking Alpha contributor forecasts which are roughly in-line with my estimates5.

Looking forward past 2016, I estimate that VLO can sustainably generate approximately $4,000 million per year in Cyclically Adjusted Operating Cash Flows assuming long-term throughput margins of $8.75 per barrel of oil and $0.70 per gallon of ethanol. I further estimate Maintenance CapEx of between $1,500 to $2,000 per year, which is in line with 2015 management’s guidance and GAAP depreciation expenses 6. The more conservative case of $2,000 Maintenance CapEx implies that the company can sustainably generate approximately $2,000 million in free cash flows per year.

Plugging these inputs into a simple discounted cash flow formula, using a 7% discount rate, indicates that the stock is fairly at approximately $55.20 per share, or roughly the current market price. The equivalent annual Internal Rate of Return (IRR) is approximately 7.7%. Tables (1A) and (1B) and Formula (1) model the approach.

Table (1A): Discounted Cash Flow Analysis, VLO
(millions USD, except throughput margins and per share metrics)

TTM 2014 (E) 2015 (E) 2016 (E) Horizon
Crude Throughput (MB/D) 2.75 2.75 2.75 2.8 2.9
Throughput Margin / bbl $10.95 $10.13 $8.31 $8.50 $8.75
Ethanol Throughput (MG/D) 3.37 3.37 3.40 3.4 3.5
Throughput Margin / ga. $1.14 $1.00 $0.97 $0.80 $0.70
Gross Profit 12417 11395 9559 9680 10156
OpEx 4340 4400 4500 4500 4500
G&A 680 700 700 725 750
Depreciation 1713 1725 1750 1775 2000
Operating Profit 5680 4570 2609 2680 2906
Interest Expense 467 409 400 400 400
Cash Tax (r ~ 20%) 1423 832 442 456 501
Other Comprehensive Income 55 57 59 61 63
Non-cash Charges 215 0 0 0 0
Operating Cash Flow 5773 5111 3576 3660 4068
Capital Expenditures 1884 2900 2650 2400 2000
Non-discretionary CapEx 1198 1700 1460 1385 2000
Growth CapEx 686 1200 1190 1015 0
Income to Non-controlling Interests 28 29 30 32 33
Owner’s Earnings 4547 3382 2086 2243 2035
Shares (millions) 523.10 520.00 510.00 500.00 500.00
Owner’s Earnings / Share $8.69 $6.50 $4.09 $4.49 $4.07
Present Value of Cash Flow (r = 7%) $0.00 $0.00 $3.82 $3.92 $47.46

Table (1B): Valuation Premium

Fair Value $55.20
Current Stock Price $50
Internal Rate of Return 7.70%

Formula (1) {V_0 = } \frac{C_1}{(1+r)} \, + \, \frac{C_2}{(1+r)^2} \, + \, \sum{_{t=1}^{T=infinity}} \frac{C_t}{(1+r)^t} \, = \, \frac{C_1}{(1+r)} \, + \, \frac{C_2}{(1+r)^2} \, + \, \frac{\frac{C_s}{(1+r)^3}}{r} Where:
{V_0 =} The value of an investment at time ‘{t}‘;
{C_t =} The future value of a cash flow to be received at time ‘{t}‘;
{C_s =} Sustainable cash flows to be received into perpetuity;
{r =} The discount rate which reflects a real (inflation adjusted) risk-free rate, opportunity costs, and risk premiums that compensate investors for bearing distinct types of risk 7; and,
{T =} The terminal time vector.

Relative Valuation
VLO compares favorably against a carefully selected peer group across key operational metrics, yet the company commands cheaper valuation multiples than it peers.

Table (1) compares VLO against peers across key operational metrics. Table (2) compares VLO against the same peer group across key valuation metrics. The peer group consists of publicly traded companies with tickers: PSX, VLO, MPC, TSO, HFC, WNR, CVRR, PBF, NTI, CLMT, DK, ALDW, ALJ, and BDCO. Peer group metrics are calculated as true aggregates (i.e., not averages and not medians).

Table (2): Key Operational Metrics

Gross Margin* (TTM) EBITDA Margin (TTM) NCI** (Complexity) Asset Turnover (TTM) EBITDA Return on Assets (TTM)
Valero Energy Corp (VLO) 5.9% 5.4% 12.01 2.90 15.6%
Phillips 66 (PSX) 3.5% 2.5% 10.86 3.08 7.6%
Marathon Petroleum Corp (MPC) 6.6% 5.2% 11.42 3.17 16.5%
Tesoro Corp (TSO) 5.4% 4.7% 11.29 3.02 14.2%
Industry Peer Group 5.5% 4.5% 11.29 2.98 10.3%

Sources: Oil & Journal’s 2015 Global Refining Survey; EIA’s 2014 Refinery Capacity Report; Portfolio123
* – Portfolio123 derives its financial data from S&P Capital IQ’s Compustat database. Compustat standardizes financial reporting to allow for easier comparisons across various stocks. The methodology used for computing costs of goods sold differs from Valero’s financial reporting standards (and, by association, most financial data sources). Portfolio123’s Cost of Goods Sold includes refining segment operating costs, excludes Depreciation/Amortization, and excludes G&A.
** – NCI: Nelson’s Complexity Index; for more information on the interpretation of NCI, please see my post, A Crash Course on Refining Fundamentals.

Table (3): Key Valuation Metrics

EV to EDC (USD/MBD)*** Price to Com. Equity (MRQ) EV to EBITDA (TTM) Price to Forward Sales**** Forward PE****
Valero Energy Corp (VLO) 0.98 1.18 3.66 0.23 8.30
Phillips 66 (PSX) 2.02 1.62 10.11 0.26 9.94
Marathon Petroleum Corp (MPC) 1.48 2.08 5.62 0.28 10.50
Tesoro Corp (TSO) 1.35 1.99 6.05 0.27 10.93
Industry Peer Group 1.42 1.56 5.66 0.26 9.22

Sources: Oil & Journal’s 2015 Global Refining Survey; EIA’s 2014 Refinery Capacity Report; Portfolio123; Yahoo! Finance, Analysts’ Estimates
*** – EDC – Equivalent Distillation Capacity, also known as complexity-barrels; for more information on the interpretation of EDC, please see my post, A Crash Course on Refining Fundamentals.
**** – Forward data uses the weighted average of analysts’ FY’14 and FY’15 estimates.

Commentary on Valuation
Conservatively, robust operating cash flows support VLO’s current valuation. Purchasing the company’s stock at $50 yields a sustainable 7.7% cash-on-cash annualized internal rate of return. This is on par with most benchmarks for a required cash return on equity and therefore supports the stock’s current valuation. VLO’s conservative valuation against its peer group further supports this notion. As long as operations continue to generate significant cash, and the company remains competitive in its market, I see a solid floor of support within the stock’s 52-week trading range. Even so, cheap valuation does not equate to a value thesis. According to the Efficient Market Hypothesis (EMH), cheap stocks are often cheap for a reason.

VLO’s conservative valuation for the most part reflects expectations of an extended period of compressed refining margins. I believe that analyst’s 2015 earnings estimates for VLO are still too high based on persistent weakness in the Gulf Coast and Mid-Continent refining margins. According to Yahoo! Finance, analysts expect VLO to earn $5.11/share in 2015. Unless margins snap back, I believe that 2015 EPS of $3.00 may be more likely. My 2014Q4 revenue and EPS estimates are available on Estimize under username “Primus”. Indeed, on December 13th, Deutsche Bank downgraded shares of VLO to “hold” based persistent weakness in refining margins and a narrow WTI-Brent spread 8 9. On the other hand, Morgan Stanley analysts posited that “Valero Energy will be operating at a meaningful higher utilization rate and is best positioned to capture any wide range Gulf Coast differentials resulting from turnaround activity” 10.

While higher utilization rates may slightly offset weak margins in the short-run, 2015 EPS estimates are still biased high; the stock could dip if/when earnings forecasts are cut. Even though refining assets are long-lived, refiners tend to trade with the three-month crack spread (i.e., the average per barrel price differential between crude oil throughputs and valued-added yields). I believe that over the long-run, the replacement costs of refining assets must dictate normalized crack spreads. The fact that markets tend to value refining assets near to or below their replacement costs discourages new refinery construction. Unless demand decreases or a glut of new capacity is brought online, margins must eventually normalize to their long-term averages. My previous post, A Crash Course in Refining Fundamentals, provides the context of this assessment. For better or for worse, cyclically volatile margins are just the price of admission in the refining business. In spite of cyclical margin woes, VLO’s already conservative valuation provides long-term investors with an ample margin of safety. For these reasons, I rate VLO a HOLD. If/when estimates for FY 2015 come down, the stock is a BUY on the dip.

Conclusion
Generally, when stocks are cheap, there are many ways for investors to win since it is much easier to beat expectations when those expectations are set low. If VLO’s management could somehow figure out how to unlock value, the stock could enjoy very significant upside (in excess of crack spread perturbations). The value creation story seems to unfolding at the present time through asset drop-downs to the company’s sponsored master limited partnership (MLP), Valero Energy Partners (VLP). I expect to publish a premium article on this topic soon. Please continue check in to my Seeking Alpha homepage for updates.

Footnotes   [ + ]

1. VLP SEC Form S-1(A), Amendment No. 3, December 2, 2013
2. VLO Investor Presentation, July 2014
3. VLO 2013 10-K
4. VLO, 2008 10-K
5. Valero Energy: 20% Annual Dividend Growth Remains Very Possible
6. VLO Conference Call, Q3 2014
7. CFA Institute
8. UPDATE: Deutsche Bank Downgrades Valero Energy
9. In spite of a “hold” recommendation, Deutsche Bank analyst Ryan Todd sees approximately 20% upside from current levels, setting a price target of $59/share.
10. Valero Energy ‘Best Positioned,’ Morgan Stanley Says