VLO - Good Dividends And High Incentives In Valero Energy Stock

2023-04-12 16:07:15 ET

Summary

• Valero Energy has been a great stock market winner.
• The firm enjoys a status as a low-cost producer at a time of rising energy prices.
• However, its executive compensation plan rewards management for total returns to stockholders, and not capital allocation skill.
• The business appears to be a good bet to beat the market.

Valero Energy Corporation ( VLO ) has led the market in returns, thanks to being a low-cost producer at a time of an energy boom. Results have, however, been padded by an aggressive dividend policy, in my view driven by an executive compensation plan that rewards managers for returns to stockholders, and not capital allocation skill. Nevertheless, the company appears to be a good bet to beat the market.

Dividend Policy Fuels Stock Market Performance

In the last five years, Valero Energy's share price has gone up nearly 46%, compared to almost 56% for the S&P 500 (SPX). The Energy Select Sector SPDR ETF (XLE), which serves as a proxy for the performance of the energy sector, returned a TSR of more than 65%. However, thanks to the company's dividend policy which, since 2014, has aimed at a payout ratio of 40% to 50% every year, the firm's total shareholder return ((TSR)) was over 85%. Meanwhile, Valero Energy's peer group, including the Energy Select Sector SPDR ETF, returned a weighted average TSR of 69.43%. Valero Energy's peer group, aside from the Energy Select Sector SPDR ETF, consists of ConocoPhillips (COP), CVR Energy, Inc. (CVI), Delek US Holdings, Inc. (DK), Energy Select Sector SPDR ETF, EOG Resources, Inc. (EOG), HF Sinclair Corporation (DINO), Marathon Petroleum Corporation (MPC), Occidental Petroleum Corporation (OXY), PBF Energy Inc. (PBF), and Phillips 66 (PSX).

Management is Paid to Maximize Total Returns to Shareholders

The power of incentives is often underappreciated even by those who are very aware of how incentives shape behavior. Given the agent-principal problem, Valero Energy's executive compensation plan attempts to align management interests with those of its shareholders. It does so through the Performance Shares granted in 2020 are tied to two metrics: relative TSR versus the peer group, weighted at 75%, and 3-year average return on invested capital ((ROIC)) weighted at 25%. The firm aims for a 3-year ROIC of 9.5%. Since 2020, Valero Energy has been 5th out of 11 against its peer group, and it has achieved a 3-year ROIC of 15.32%. However, the Performance Shares granted in 2021 and 2022 include just one metric: TSR. This, I think, is a problem, because it rewards management for share price appreciation, which they have no control over, and encourages high dividend payouts, which may not always be the best use of capital. Valero Energy's Performance Share grants would better align interests if management was judged according to ROIC or ROCE, which would ensure that managers are paid for using capital efficiently.

Valero Energy has grown free cash flow ((FCF)) from $2.99 billion in 2018 to $8.25 billion in 2022, compounding at 22.51%. In that period, the firm had a cumulative FCF of $14.1 billion or 28% of the firm's market capitalization. Now, here we see what I think is the impact of the firm's incentive structure. Dividends have been paid throughout the period, growing from $1.37 billion in 2018 to $1.56 billion in 2022, compounding at 2.63% a year, even when, as in 2020, the company had a negative FCF. Cumulatively, the firm paid out $7.63 billion in dividends in that period. If managers are paid to distribute dividends, they will do so, but it may not be the optimal way to manage the firm's FCF. In addition, the company has repurchased its shares, with share repurchases growing from $1.71 billion in 2018 to $4.58 billion in 2022, although the intervening years were quite barren, and the 2022 rise is due to the great year the firm had. Cumulatively, the firm bought back $7.25 billion. Total returns to stockholders over the last five years amount to $14.88 billion, compared to the $14.1 billion it earned in FCF. This is a potentially very dangerous route to go, and certainly implies that management is possibly not making the best use of capital in my view, but is working to juice up TSR.

Profitable Growth

In the last five years, revenue has grown from $117.033 billion in 2018 to $176.38 billion in 2022, compounding at 8.55%. Let's place these results in context. According to "The Base Rate Book" , between 1950 and 2015, 24.2% of firms achieved a 5-year sales compound annual growth rate ((CAGR)) of between 5% and 10%. The mean and median 5-year sales CAGR in that period were 6.9% and 5.2% respectively. Its peers had a mean 5-year sales CAGR of 8.88%.

Gross profits rose from $5.6 billion in 2018 to $16.8 billion in 2022, compounding at 24.57%. In that time, gross profitability, which scales gross profits by total assets, rose from 0.11 to 0.28. Valero Energy's peer group earned a weighted average gross profitability of 0.22. Although Valero Energy's gross profitability is growing, research shows that 0.33 and above is an attractive level of profitability.

Operating income rose from $4.57 billion in 2018 to $15.69 billion in 2022, compounding at 27.98%. The firm's operating margin rose from 3.91% in 2018 to 8.9% in 2022. Valero Energy's peer group earned a weighted average operating margin of 18.48%. In our reference period, the energy sector had a mean operating margin of 11.6%, and a median operating margin of 12.1%. This reflects Valero Energy's cost leadership strategy, which implies low margins and high capital velocity. In fact, Valero Energy is the lowest cash operating cost producer among its peer group.

Valero Energy's net income rose from $3.53 billion in 2018 to $11.88 billion in 2022, compounding at 27.47%. In our reference period, 8.8% of firms achieved a 5-year earnings CAGR of between 20% and 30%. The mean and median 5-year earnings CAGR were 7.3% and 5.9% respectively. Its earnings in 2022 are greater than the weighted average peer group earnings of $8.16 billion.

Valero Energy's return on invested capital has grown from 14% in 2018 to 42.96% in 2022, through the nadir of 2020. In 2022, the peer group weighted average ROIC was 17.76%. Given the correlation between ROIC and company value, this is obviously a very good thing.

Valuation

Valero Energy has a price-earnings (P/E) ratio of 4.71, compared to a weighted average PE of its peers of 10.33, and an S&P 500 PE of 21.96 . In other words, on a relative basis, the firm appears cheaper than its peers and the market. With a gross profitability of 0.28 compared to a weighted average gross profitability of 0.22 of its peers, it is more attractive on a profit basis, than its peers. With an FCF yield of 6.28%, it has a superior yield to the average FCF yield of the 2000 largest firms in the United States, which was 2.7%, according to New Constructs . However, its FCF yield is lower than the peer group weighted average FCF yield, which is 10.88%.

Conclusion

I believe Valero Energy's management has succeeded in using its dividend policy to pad the excellent results the firm has enjoyed as a function of being a low cost producer in an era of rising energy prices. The incentive structure is, however, sub-optimal and does not reward managers for good capital allocation in my opinion. The company's financial results have been strong, and in terms of valuation, the company appears to be a good bet to beat the market.

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