Thursday, August 28, 2008

Screen Result No. 3: Valero

The third company that met my value screen -- down more than 10% year to date, excellent financial condition and earnings growth of 30% for the past five years -- is Valero.

Valero makes money by buying crude oil and turning it into gasoline and other products.

Let's look at how that works. A barrel of oil is 42 gallons. Say it costs $110 (see below). Per-barrel refining costs are $5.88, according to VLO's last earnings report, bringing the total per-barrel cost to $115.88. A barrel of oil yields about 19.6 gallons of gas, which, if Valero sells at retail for $3.60 a gallon, brings in $70.56. That same barrel of oil will also yield a little more than nine gallons of diesel. Diesel's selling for $4.25, so that's another $38.50, and Valero's pretty close to being in the black. Happily, it still has four gallons of jet fuel, a little "heavy fuel" and some other products to turn a profit with. All in all, its current "throughput margin" per barrel of oil is $10.82. (That's down from $18,14 a year ago.) Valero can process 3.1 million barrels a day.

Refining is a game of inches. Operating at capacity is unrealistic, and costs fluctuate. So it's a game of inches, and Valero's profit margin is only about 2.5%. Granted, that can add up rather nicely across $100 billion in revenue, and it usually does for this outfit.

Here are some other things to keep in mind about the company:

It uses cheap crude. The price you hear on the news each night is the front-month contract on light, sweet crude. Some crude is so light and nice it could go right into your crankcase. That's the good stuff, black gold. Heavy, sour crude -- so called because of higher sulphur content -- is cheaper.

Other refiners can't use sour crude, but Valero's 16 refineries are designed to use it, and that lowers the oil input cost. West Texas Sour goes for about 3.6% less than West Texas Intermediate. This seemingly small cost savings gives Valero a huge completive advantage. In fact, Valero is actually selling off its "basic" refineries -- the facilities that can only refine more expensive light, sweet crude -- so that it can focus on higher-margin sour refining.

Debt is low. Long-term obligations total $6.4 billion, about 34% of shareholder equity. Working capital was a healthy $2.8 billion in 2007. (If Valero wanted to raise more cash, it should sell or lease its chain of 5,800 gas stations. Its vision to build a high-quality premium gas brand is absolutely ludicrous. Gasoline is a commodity. Consumers are loyal only to location or, you know, price. Gas stations are difficult to manage and have very thin margins, which is already the problem in the refinery business)

Its steel looks like gold. Valero is sitting on extremely valuable assets: As we learned during Katrina, oil refineries are in short supply in these United States. Even so, these refineries can be purchased right now at a discount to rather than a multiple of their book value. You can buy Valero refineries for 93 cents on the dollar -- you sure as hell can't replace them for that, not with the cost of steel and concrete. Oh, and the business that generated a $3 billion profit last year while buying back shares and apying down debt? Investors get that for free.

It has a gun pointed at the CEO. Granted, it's probably the golden one from the James Bond movie of the same name. Nevertheless, Valero should be lauded for tying 82% of its chief's pay to his performance. It also requires the sumbitch to own Valero stock equal to 10 times his base salary. I like that. They paid the dude about $15 mil last year, about what his peers pull down. I'm OK with that if he hits his numbers. This is a company, after all, that turns a roughly $3 billion annual profit. $15 million is statistically insignificant.

Diesel, diesel, diesel. Let's hear this straight from the horse's mouth: "Despite the difficult environment for margins on gasoline and many secondary products, Valero continued to be profitable," Valero chief Bill Klesse said. "Wide differentials for the heavy and sour feedstocks that we can process in our refineries benefited us significantly in the second quarter."

Translation: We bought cheap oil and made it into pricey gas. We hate to be a greedy bastards, but we have an obligation to our shareholders.

"In our refining operations, we've made great progress in shifting production to take advantage of the strong market for distillates. From 2008's first quarter to the second quarter, we increased our distillate production by 110,000 barrels per day while maintaining steady gasoline production. In the same time frame, we increased our use of discounted feedstocks from 66% to 68%, partially due to improved operations at our heavy sour refineries" where we've done a bunch of repairs.

"Looking at market fundamentals, we expect distillate margins should be strong for the rest of the year and next. However, we expect gasoline margins to continue to be weak and industry utilization rates to decline. We expect secondary products to have a margin recovery, particularly if the price of crude oil stabilizes or falls, as the prices of these products lag changes in the price of crude oil."

This means: We're going to make shitload of money off diesel, where the margins are fat, instead of making gasoline, where the margins blow.

The screen establishes that Valero is worth looking at, and what we've heard so far sounds pretty good. Let's answer the questions posed in Monday's post to decide whether to add Valero to our portfolio:

How have earnings per share fared over time?
Valero's earnings grew 507.9% from 2003 to 2007. Revenue increased on 149.0% in the same period. The dividend came in in the middle, gaining 336.4% in the same period.

Is that likely to continue?
Probably. The profit margin in refining gas has always been low, and throughput is off. But Valero is still well positioned: It uses a cheaper input to create the same product, sells it for the same as its competitors and pockets the spread. It magnifies this happy profit algorithm when it cranks up diesel production.

Where does that put per-share results in two years? What do analysts forecast?
It's tough to say, as Valero's refinery roster is losing some players. Given the refinery sales, I'd peg earnings at about $5.75 to $6.25 a share this year and roughly $6.50 next. That's conservative and roughly in line with estimates.

What is the current earnings multiple?

How close is it to its historical average? To benchmarks?
Six isn't out of line for Valero. A rich estimate would be 7.

Where will the multiple be in two years?
I'll give them 7 for the target price. Anything more is wishful thinking. Even so, I think investors will like the refinery sales, the capital spending on its remaining assets and the effects of the share buybacks.

Given the earnings estimates and PE predictions, what will the fair market value of the stock be in two years?
$45.50. That's a gain of $10.30. from Valero's current $35.20 ashare price, or 29.3%.

Am I willing to accept the risk/reward this potential return represents?
No. That's not a rich enough gain. True, Valero will make money regardless of the price of oil, but that being said, owning these shares carry the risk of opportunity loss as the market regains its footing.

Though the shares are down -50% for the year and might be a good value based on the underlying assets, I don't see them beating the market for two years based on the fundamentals. Anything down 50% has to rise 100% to get back to where it started. I don't see a significant earnings catalyst to drive that.

1 comment:

Anonymous said...

How did you come to Valero's refinery assets worth 93 cents on the dollar?