Dropping It Like It’s (Not That) Hot: VLO’s MLP strategy in focus

Summary

  • Valero Energy Corporation’s (VLO) conservative valuation reflects a history of and expectations for cyclical margin pressures, secular regulatory pressures, and a management regime which does not create excess long-term shareholder value.
  • Management has singled out asset drop-downs to company sponsored MLP, Valero Energy Partners (VLP), as the most promising avenue for unlocking shareholder value.
  • Although the value gap between VLO and VLP is real, unless management radically accelerates VLP’s financing trajectory, the drop-down strategy will not significantly drive excess returns for VLO shareholders.
  • Disproportionate focus on arbitraging market value dislocations could detract from more enduring drivers of long-term value such as distressed asset acquisitions and continuous rationalization of core refining and logistics assets.
  • VLO’s core refining assets are among the best positioned and most complex in the world. If competently utilized, these assets are worth significantly more than the company’s market capitalization.

Valero Energy Corporation’s (VLO) stock is conservatively valued by most benchmarks for absolute and relative valuation. In my previous SA Article, Valero is Conservatively Valued, I assessed the company’s free cash flow potential as well as key operating and valuation multiple versus a carefully selected peer group. I rated the company a long-term hold due to an ample margin of safety between the price paid and the value received. I further attributed the stock’s cheapness to a history of and expectations for cyclical margin pressures and secular regulatory pressures.

This assessment reiterates the hold recommendation. VLO has the potential to produce asymmetric upside for shareholders due to the immense value of the company’s well-rationalized asset base in relation to its market valuation. However, near-term upside is handicapped due to a lack of meaningful catalysts.

VLO and VLP Company Overviews
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.

Figure (1): Valero Energy Corporation’s Operating Activities
VLO+IR+2015+Jan+FINAL+1-2-15
Source: VLO Investor Presentation, January 2015

In July 2013, Valero Energy Corporation (VLO) completed its IPO of Valero Energy Partnership (VLP), a master limited partnership (MLP). VLP enters service agreements “to own, operate, develop, and acquire crude oil and refined petroleum products pipelines, terminals, and other transportation and logistics assets… [in order to] increase access to cost-advantaged North American crude oil”. Service agreements feature fee-based revenues, 10 year minimum initial agreement terms, inflation escalators, and minimum quarterly throughput commitments. VLO maintains a 68.6% limited partner interest and a 2% general partner interest in VLP (the public owns a 29.4% limited partner interest).

Management has reiterated guidance that VLP is expected to grow distributions by 20% to 25% over at least the next 3 years. VLP used equity capital from the IPO to acquire logistics assets from VLO which produced approximately $65 MM in annual EBITDA. Any free cash flow generated in excess of distributions could be used to acquire assets from VLO through asset drop-downs. On 1 July, 2014, VLO completed its first asset “drop-down” to VLP for $154 million in cash. These dropped assets are expected to generate $15.4 million in annual EBITDA.

Figure (2): VLP’s Operations
VLP_All-Asset_Map_Revised_20141223
Source: VLP Partners, About

For more information on VLP, please refer to VLP’s SEC Form S-1(A), Amendment No. 3, December 2, 2013 and 2013 10-K, and VLO’s 2013 10-K.

A Brief Analysis of Valero’s Operating History
Since 1997, VLO has transformed itself from single refinery to now the largest North American refiner through a growth-by-acquisitions strategy that targeted distressed refining assets. Over time, the strategy transitioned to divesting cheaply acquired assets and smaller, less complex assets, and reinvest in larger, more sophisticated refining facilities. Until 2007, the market applauded the company’s direction. However, when oil prices spiked to over $140 per bbl in 2007, refining margins were crushed along with the company’s profits. A broad stock market rout coupled with contracting margins and expanding operating and compliance expenditures resulted in VLO’s stock plummeting 75% in 2008 from its July 2007 high-water mark.

Due to the lost value from 2007 and 2008, the stock has not meaningfully outperformed its peers, neither over the short nor long-run. Troubling is that before the stock tumbled, it had very reasonable valuation characteristics; at its all-time high of $77.71 on July 10, 2007, the stock was trading at 7.2x TTM earnings and 2.4x book value. The stock’s fall then was not on account of inflated valuations, but rather due to a deterioration in actual business conditions which implies that VLO’s stock has been a focused play on the refining industry vice a genuine value investment. Although VLO appears to be a bargain today with low P/E and P/B ratios, the apparent value can quickly turn into a value-trap if market conditions go sideways.

The stock’s lost value underscores the company’s susceptibility to external market conditions which affect refiners’ profits. In 2007, refining profits were crushed due to collapsing crack spreads and sagging consumer demand on the heels of the economic crises of 2007-08. Since no single entity can control demand for and prices of commodities, refiners’ profits are subject to sometimes wildly cyclical swings. Volatile earnings can, in turn, lead to volatile stock prices. The total return analysis presented in Figure (3), below, substantiates this assessment: VLO’s high degree of correlation against its peer index (coupled with a lack of excess return) is idiosyncratic of beta (i.e., pure risk). In other words, much of VLO’s short and long-term returns can be attributed to broader market trends (vice value creation).

Figure (3): Total Return Analysis: 1999 – Present
VLO TR Analysis, 1999 - Present
Source: Portfolio123
Note to Figure (3): Figure (3), above, compares total shareholder return of VLO versus a capitalization-weighted index of any refiners (GICS 10102030, excluding VLO) which were constituents of the S&P 1500 Index over the last 15 years. The methodology used to construct custom indices is based on S&P’s Indexing Methodology (with a few simplifying assumptions).

The current management regime which has been in place since roughly 2006, headed by Chairman and former CEO William R. Klesse, has been struggling to recapture lost value. Although crack spreads have since recovered, net profits are suppressed from 2007 highs due to increasingly onerous regulatory and compliance costs. VLO spends hundreds of millions of dollar per year to remain compliant with federal and state environmental laws. Expenditures related regulatory and compliance pressures have been growing rapidly in recent years with no end in sight. While compliance expenses have been partially offset by tax-credits and subsidies related to renewable energy sources, the regulatory balance tips heavily against refiners. Increasing regulatory burdens could result in unintended and unforeseeable consequences for refiners and thereby could derail shareholder value creation.

To management’s credit, VLO has made notable headway in controlling operating costs, increasing efficiencies, and building brand value. Combined operating expenses (i.e., SG&A and R&D) as a percentage of gross revenues have shrunk to less about .5% since reaching nearly 2.5% in 2009. Furthermore, the company has begun to successfully re-brand itself from being a discount gasoline brand to becoming a premium brandi. For years, VLO competed mainly on price which resulted in systemically low gross margins. Efforts to increase brand value have resulted in higher gross margins which are now in line with peers. The 2013 10-K corroborates that the company’s trademarks and tradenames are integral to the company’s wholesale marketing operations. In spite of the stock having lost a good portion of its value from 2007 to 2009, the company has emerged leaner and more competitive than before. Figure (4), below testifies to the company’s successes in normalizing margins.

Figure (4): VLO’s Gross Margins versus its Peer Group
VLO GrMgnQ vs GICS 10102030_20140123
Source: Portfolio123
Note to Figure (4): The peer group is the same as was used in Figure (3) to estimate VLO’s long-term total shareholder return. 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. Compustat’s methodology for computing Costs of Goods Sold differs from Valero’s financial reporting standards. Portfolio123’s Cost of Goods Sold includes refining segment operating costs, excludes Depreciation & Amortization, and excludes G&A.

Current Efforts
Despite management’s efforts, the reality is the stock has not produced excess long-term shareholder value. In response to the stock market’s prolonged tepid reception of refining assets, management has begun to identify and execute a series of efforts aimed at unlocking value trapped within the company’s diverse asset base. These efforts include the May 2013 spin-off of CST Brands and anticipated drop-downs to company sponsored master limited partnership (MLP), Valero Energy Partners (VLP). The common theme of these recent undertakings is the management has identified that the market values the individual parts more than the whole and executed a plan to unlock that value by carving off those more valuable pieces. Although management has an obligation to create shareholder value, a disproportionate emphasis on market arbitrage emphasizes short-term market gains often without respect to their long-term ramifications.

The spin-off of CST Brands traded short-term stock market traction for long-term structural advantages through direct retail operations. According to the July 2014 investor presentation, “the spinoff of CST Brands (CST) in May 2013 stockholder value equivalent to approximately $3.60 per share of VLO, or $1.9 billion in total” (representing about 10% of the stock’s value at time). Even though the retail segment represented only a fraction (<10%) of VLO’s operating income in 2012, in-house retail operations allow refining companies to effectively sell product at retail prices instead of at wholesale, thereby bolstering the whole company’s bottom-line. Hot dog and Slurpee® sales also provide an internal source of revenue diversification and can further increase brand awareness and value. The spin-off sacrificed a synergistic business unit for limited stock price appreciation. The retail segment offered the company structural advantages which, in my opinion, would have created significantly greater long-term value.

Following the July 2013 IPO of VLP, management has begun to single out future asset drop-downs as its preferred method of unlocking shareholder value. Although markets typically value refining assets at less than their replacement costs, related logistical assets are valued at significantly greater multiples. Investor appetite for fee-based, tax-advantaged, fee-based logistics assets has driven a wide valuation gap between VLO and VLP. This valuation disconnect has created an opportunity for management to drop assets and EBITDA at significantly higher multiples thereby raising cheap equity for further logistics growth projects and furthermore unlocking value for VLO shareholders. Table (1), below, compares several key valuations for VLO and VLP; the differences are quite significant.

Table (1): Key Valuation Metrics: VLO vs VLP

Price to Com. Equity (MRQ) Total Capitalization to EBITDA (TTM) EV to EBITDA (TTM) Forward PE Distrib/Divi Yield
Valero Energy Corp (VLO) 1.4 4.6 4.0 9.78 2.16%
Valero Energy Partners LP (VLP) 5.1 34.9 32.3 29.68 1.84%

Source: Portfolio123

On the surface, the drop-down story seems quite rosy. However, digging into the math reveals that the “no free lunch” principle is still mostly intact. Unless management radically accelerates the financing trajectory for the MLP, investor upside will be capped.

Currently, VLP’s assets produce $80 million in annual EBITDA. Management currently guides for 20-25% distribution growth over the next 2-3 years. Since distributions are paid directly out of distributable cash flow (DCF), EBITDA can be expected to grow at a similar clipii. Additionally, VLO retains an inventory of “MLP-able” logistics assets which produce approximately $800 million in annual EBITDA. VLO’s expects to grow its “MLP-able” EBITDA by $100 million by 2019 (this does not include VLO’s fuel distribution assets which are being evaluated as potential candidates for the MLP). July 2014’s asset drop for $15.4 million in EBITDA transacted at a 10x Cash-to-EBITDA multiple. Assuming that VLP can raise relatively cheap equity forever and that all future drop-downs occur at a 10x Equity-to-EBITDA multiple, the strategy could unlock a maximum of $9 billion for VLO shareholders (about 32% of the stock’s current market value).

There’s are several catches which blunt the potential upside of the above scenario:

  1. Assuming that EBITDA continues to grow at a 20% rate until VLO’s “MLP-able” assets are exhausted, it would take 13.5 years to perfect the drop-down strategy. $9 billion in total “unlockable” value has a net present value which is less than the face value.
  2. Value is unlocked only if/when VLP raises equity more cheaply that the cost of future asset drops. Currently, VLP can sell $35 in equity for every $1 in EBITDA and then turn-around and pay $10 for $1 in EBITDA (i.e., sell high and buy low). Only as long as VLP can sell $1 of equity capital more cheaply than it can buy $1 of growth will its management have an incentive to participate in future drops.
  3. VLP’s relatively cheap cost of equity is due to the market valuation gap between VLO and VLP. This gap is made possible only through investor appetite and may subside prematurely if something else comes into vogue before the perfection of the strategy.
  4. The amount of value that could be unlocked depends on the mix of financing methods which are available and used. Only outside equity capital is able unlock shareholder value. Debt and/or internal financing would not unlock value due to increases in non-controlling interests and/or other liabilities.
  5. Secondary stock offerings of VLP are necessary in order to meaningfully tap VLO’s inventory of “MLP-able” assets. Secondary offerings will dilute VLO’ controlling ownership. If/when VLO’s management loses its controlling interest, VLP’s owners are free to operate independently and may choose not to participate in future drops.

Given some simplifying assumptions, it is possible to model the net present value-add of  asset-drops totaling $916 million in “MPL-able” EBITDA over the next 14 years. Assuming a constant 10x EBITDA drop-down multiple, a 10% discount rate, that VLP can grow EBITDA by 20% annually until VLO’s inventory is depleted, and that VLP’s cost of growth remains below its cost of equity until the perfection of asset drops, the net present value of the all potential future drops is about $3,829 (~13.3% of VLO’s current market capitalization).

Table (2): Net Present Value-Add of Future Asset Drop-downs to VLP

Year EBITDA Drop-Down VLP EBITDA Remaining “MLP-able” EBITDA Equity Financing Required for Future Drops PV of Drop-down for VLO Shareholders
2014 $15.40 $86 $815.00
2015 $17.20 $103.20 $800 $172.00 $156.36
2016 $20.64 $123.84 $778.96 $206.40 $170.58
2017 $24.77 $148.61 $754.19 $247.68 $186.09
2018 $29.72 $178.33 $724.47 $297.22 $203.00
2019 $35.67 $214.00 $788.80 $356.66 $221.46
2020 $42.80 $256.79 $746.01 $427.99 $241.59
2021 $51.36 $308.15 $694.65 $513.59 $263.55
2022 $61.63 $369.78 $633.02 $616.31 $287.51
2023 $73.96 $443.74 $559.06 $739.57 $313.65
2024 $88.75 $532.49 $470.31 $887.48 $342.16
2025 $106.50 $638.99 $363.81 $1,064.98 $373.27
2026 $127.80 $766.78 $236.02 $1,277.97 $407.20
2027 $153.36 $920.14 $82.66 $1,533.57 $444.22
2028 $82.66 $1,002.80 $0.00 $826.58 $217.67
Total $932.20 $9,168.00 $3,828.31

Source(s): multiple

Plugging in the potential market value add of future drop-downs into an Economic Book Value Analysis (i.e., a modified balance sheet which allows for certain types of assets and liabilities to reflect market valuations while ignoring other non-operating items) indicates that VLO’s stock is roughly trading near fair value.

Table (3): Economic Book Value of VLO in 2015 (Pro-forma)
(millions USD, except percentages)

Assets
Current Assets
Cash & Equivalents $4,191
Inventories (Avg) $6,779
Non-current Assets
PP&E
Crude oil processing facilities $27,260
Pipeline and terminal facilities $2,813
Other $4,032
Accumulated Depreciation -$8,226
Total Assets $36,849
Liabilities & Shareholder’s Equity
Current Liabilities
Trade Account Deficit $3,190
Short-term Debt (Book Value) $400
Non-current Liabilities
Long-term Debt (Market Value) $6,485
Capital Lease Obligations $702
Operating Lease Obligations $1,224
Other Long-Term Liabilities $325
Total Liabilities $12,327
Total Equity $24,522
Non-redeemable Non-controlling Interests
Non-controlling Interest in VLP $374
Non-controlling Interest in DGD $116
Shareholder’s Equity $24,032
Economic Value Reconciliations
Market Value of VLP $2,988
Non-Controlling Interest in VLP (%) 29.4%
Market Value of Non-controlling Interest in VLP $878
Net Present Value of Future Asset Drops $3,828
Net Effect of Asset Drops on PP&E -$827
Economic Book Value $29,143
Approximate Market Value of VLO $28,700
Discount to Economic Book Value 1.5%

Source(s): multiple

In spite of whatever level of precision a model imposes, it is impossible to know to what extent future drop-downs will unlock shareholder value because their potential value-add is rooted in market conditions which are beyond management’s control.

Commentary
VLO remains a hold due to a lack of meaningful near-term catalysts. Although drop-downs should unlock some shareholder value, the potential value locked up within the company’s logistics assets is not sufficient to propel the stock much higher.

Morgan Stanley analysts analyze similar data and conclude that VLO could unlock nearly $20 per share (40% of its current price) over the next 3 years through aggressive drop-downs. While I welcome opposing views, I also believe that the Morgan Stanley thesis ignores the inevitability of VLP’s contracting multiples and rising cost of equity.

The only real long-term operational advantage to the MLP strategy is tax-preference. If management were to focus more on the tax angle and give less weight to the value-unlocking potential of future drop-downs, I probably would have glossed over the value aspect.

Barring a 20% downside correction (~$44), the only event I foresee which could make the stock a buy is a fundamental shift in management’s vision to create long-term shareholder value. Recent corporate actions, including the spin-off of Corner Store Brands (CST) and dropping critical logistic assets to VLP, underscore management’s strategy to appease shareholders by maximizing current market price in lieu of building lasting value. The stock would immediately become a bargain if management were reconsider its disproportionate focus on market arbitrage, and instead, zero in on long-term value creation through tried-and-true operating excellence, increasing brand value, disciplined capital management (i.e., smart and timely acquisitions/divestitures), and continuous rationalization of core refining, logistics, and marketing assets.

The Long View
In spite of maintaining a hold recommendation, I remain a VLO shareholder due to the immense value and quality of the company’s core refining assets which I believe the market grossly undervalues.

VLO’s refining assets are highly rationalized with respective to their access to cost-advantaged throughputs and value-added yields. SA Contributor Callum Turcan’s article, Valero Energy is Ready to Refine Light Sweet Oil, makes a compelling case that the company’s diverse asset base will provide a long-standing competitive advantage against more marginal competitors. VLO is also one of the few refiners able to locally refine heavily-discounted heavy-sour Canadian crude.

Moreover, VLO’s refining assets are among the world’s most sophisticated. Depending on the data source utilized, VLO’s refining assets have a Nelson Complexity Index (NCI) rating of between 12.0 and 12.4. By comparison, I consider NCIs of 10 or more to be globally superior. Refiners with complex refining assets will typically have more stable refining margins due to their ability to optimize product slates and mixes depending on market conditions. High complexity assets also reach deeper into the hydrocarbon/petrochemical value-chain which provides some level of insulation against commodity price shocks. For more information on how to analyze refiners, please see my article, A Crash Course in Refining Fundamentals.

In spite of VLO’s deep reach into petrochemical value chain, the market treats these high cost assets as commodities. By contrast, similar assets within companies which brand themselves as specialty chemical manufacturers receive far richer market valuations. If/when the market begins to re-admire the irreplaceable role of petrochemicals in everyday life and, more importantly, the sheer cash-flow generating power of well-rationalized refiners, I believe the stock will be trading much higher.

Table (4), below, summarizes the key metrics used in this assessment. Although VLO has the among the most sophisticated assets of any large independent U.S.-based refiner, it is also apparently the least expensive barrel-for-barrel dollar-for-dollar.

Table (4): Key Valuation Metrics for the Largest U.S.-based Independent Refiners

EV* EDC** (MB/CD) EV to EDC (USD/MBD) NCI*** (Complexity)
Valero Energy Corp (VLO) $29,253 29413.24 0.99 12.01
Phillips 66 (PSX) $41,948 20564.93 2.04 10.86
Marathon Petroleum Corp (MPC) $30,845 19841.19 1.55 11.42
Tesoro Corp (TSO) $13,076 9455.06 1.38 11.27
Industry Peer Group**** NA NA 1.45 11.20

Sources: Oil & Journal’s 2015 Global Refining Survey; EIA’s 2014 Refinery Capacity Report; Portfolio123
Notes to Table (4):
* – EV: Enterprise Value
** – 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.
*** – NCI: Nelson’s Complexity Index; for more information on the interpretation of NCI, please see my post, A Crash Course on Refining Fundamentals.
**** – 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).

Concluding Remarks
Valero Energy Corporation (VLO) is conservatively valued by most metrics, including a discounted cash flows, a relative value analysis, and an Economic Book Value analysis of the balance sheet. Although asset drop-downs could result in some upside for VLO shareholders, the potential for long-term value creation still resides within VLO’s core refining assets. If VLO’s management is not abidingly seduced by short-term fads and, instead, resumes its focus on long-term fundamentals, the stock could trade much higher over the next several years (i.e., commodities cycle). Aggressive pursuit of distressed asset acquisitions and continuous rationalization of its existing refining and logistics assets has and will continue to be cornerstone of long-term value creation in the refining business.

In conclusion…

Does the value-gap present an opportunity to raise cheap equity for further logistics growth projects? Sure. Is this value gap sustainable long-term? Who knows?

Can the drop-down strategy unlock some shareholder value over the next decade or so? Probably. But, at the current rate of execution, is the potential upside anything to get that excited about? Probably not.

Should management continue to pursue drop-downs as one method to unlock value? Maybe. Should drop-downs receive preference over other drivers of long-term value? Absolutely not!

Is Valero’s stock a value at current prices? I believe it is. But is it a value due to the drop-down catalysts that management currently touts? I believe it is not.

Footnotes
i. ^ Gasoline and diesel fuels at the pump originate from intermingled pipelines. There is no indication that a branded station gets its fuel from a company refinery. Gasoline is a fungible commodity; the only differences between gasoline brands are patented detergents which are added at the rack. However, the perception of brand value allows some companies to charge more per gallon. ExxonMobil (XOM), Chevron (CVX), Shell (RDS.A), and other premium brands can charge more per gallon due to the perception of brand value which is driven mainly by patented detergents (i.e. Chevron with Techron®) which are injected into the gasoline after the refining process. While brand may have once mattered in terms of product differentiation, regulations now mandate that detergents be included at the pump. Now, more than ever, gasoline is just a fungible commodity.

ii. ^ MLPs like VLP work by raising cash-equity in the marketplace, using that cash to purchase logistics assets, and then using cash flows thrown off by those assets to pay out distributions to unitholders. Most MLPs peg distributions to an estimate of operating income less maintenance capital expenditures (often called “distributable cash flow”). Income tax is generally not assessed to the company; unitholders themselves are taxed on distributions at their individual tax-rates, vis-a-vis the “pass-through” method of an LLC or S-Corp.