VLO - Valero Energy: A Good Bet In Downstream

2023-03-09 10:57:03 ET

Summary

• Valero Energy is one of the leading refiners of petroleum products in the United thanks to its size, scale, and diversified portfolio of refineries across North America.
• I believe that the industry conditions for Valero Energy are favorable and the company's strong financial performance in 2022 proves that the company is well-positioned to absorb industry tailwinds.
• My valuation calculations indicate that the stock is fairly valued with modest single-digit upside potential.

Investment thesis

Valero Energy (VLO) is well-positioned to absorb the current supply-demand imbalance for petroleum-based products which rose due to increasing demand for fuels in post-Covid reality. The company is also benefiting from additional tailwinds caused by the war in Ukraine. VLO's stellar performance in 2022 demonstrates that management was very efficient in utilizing favorable market conditions which are expected to remain in place for the foreseeable future.

Company information

Valero Energy, incorporated in 1981, is a Fortune 500 company based in Texas. The company is a multinational manufacturer and marketer of petroleum-based and low-carbon liquid transportation fuels and petrochemical products. VLO owns 15 petroleum refineries located in the United States [U.S.], Canada, and the United Kingdom [U.K.] with a combined capacity of approximately 3.2 million barrels per day [BPD].

The company disaggregates its revenue into three segments which include Refining, Renewable Diesel, and Ethanol. Refining is by far the largest segment for the company, representing about 95% of the company's total revenue and close to 100% of the total operating profit.

From Seeking Alpha Quant Ratings perspective, the company looks very well balanced with all grades above B- or equal.

Financials

The company reported its latest financial quarter on January 26, 2023. There was a negative surprise from the topline side with a $1.57 billion miss, though delivering a solid EPS beat. Despite missing revenue consensus estimates, the YoY growth was a strong 16.27% gain. Net income increased threefold from $1 billion to over $3 billion on a YoY basis. From segment perspective, revenue dynamics were mixed during the quarter.

The company's major segment, Refining, demonstrated a robust 18% YoY growth with the operating margin expanding significantly from 3.7% to 10.9%. This improvement reflected higher refineries throughput and higher prices. The company's refineries operated at 97% throughput capacity in 4Q2022 compared to 96% in 4Q2021.

Lower revenue and shrinking Ethanol segment operating profit from $474 million to $7 million were attributable to an asset impairment that adversely affected production volumes. The daily volume of ethanol production declined 8% from the same quarter year earlier.

In January 2019, the company established its Renewable Diesel Segment . It includes operations from a joint venture called Diamond Green Diesel [DGD]. This line of business emphasizes the growing importance of renewable fuels for the company. The segment is growing rapidly with a 56% YoY increase in revenue as well as operating margin widening from 21.9% to 24.5%

For the full year, the company delivered a 55% increase in revenue with operating income growing more than sevenfold from about $2.1 billion to $15.7 billion. VLO's levered free cash flow more than doubled, from $4.3 billion to almost $9 billion. Having a very strong year enabled the company to return $6.1 billion to stockholders both in form of share repurchases and dividends and reduce debt by approximately $2.7 billion. Overall, the company's performance in 2022 was favorably impacted by the ongoing worldwide demand recovery for petroleum-based transportation fuels, while the supply was constrained.

According to the company's latest 10-K , management is looking forward to 2023 positively mainly due to improving jet fuel demand, which is still below pre-pandemic levels and below historical levels of light product inventories in the U.S. and Europe.

The company's balance sheet is solid with good liquidity ratios and modest leverage levels. Valero Energy's debt is considered to be investment grade with a BBB rating from Fitch and a stable outlook.

Overall, based on the company's very strong financial performance in the last year, I can conclude that it is very well-positioned to capture benefits from the supply-demand imbalances which are still in place. As OPEC's General Secretary stated recently , the energy sector, including downstream, needs "significant investment" for supply to keep up with the rising demand for oil products.

Valuation

For valuation, I use the dividend discount model [DDM], because VLO has been very consistent in paying and increasing dividends. For the required rate of return, I use the company's WACC which Gurufocus currently estimates at 10.89%, to be conservative I round it up to 11%. For current dividend I use FY 2024 dividend estimate, which is at $4.27. The dividend growth rate for VLO is tricky due to very mixed recent historical data due to various shocks disrupting the downstream industry with a sharp decline in demand due to the Covid-19 pandemic followed by global supply shortage due to the start of war in Ukraine. So, here I use my professional judgment and estimate a dividend growth rate at 8%, given continued demand growth for fuels together with still constrained supply.

Incorporating all the assumptions together into DDM formula, I arrived at the conclusion that the stock is fairly valued with a modest upside potential of 7% from the current price level of about $133 per share.

Usually, to cross-check my calculations, I conduct multiples analysis to make sure that valuation ratios are close to the company's historicals. If we refer to Seeking Alpha Quant Valuation Grades of VLO , we can see that current valuation multiples are well below 5-year averages as well as sector median metrics.

To conclude valuation, based on DDM and multiples analysis, I have high conviction that VLO stock is fairly valued with single-digit upside potential.

Risks to consider

There are risks that investors need to consider before purchasing VLO.

First of all, given the fact that VLO business success depends on the difference between crude oil and refined products, the company's profits can be adversely affected in case of unfavorable fluctuations in prices of crude oil and refined oil products. The potential economic slowdown will lead to softening demand for petroleum-based fuels, which will push down refined product prices. The company has almost no ability to set prices for gasoline and other products it sells, heavily depending on the supply-demand equation.

Second, the Energy sector is heavily regulated by various government bodies and unfavorable changes in regulations may lift a company's operating costs thus negatively impacting earnings.

The third risk that I would like to emphasize is an ecological risk because possible product spills or emissions above regulated thresholds will lead to litigations and fines, which will also adversely impact the company's financial performance.

Bottom line

In summary, VLO represents a good investment opportunity in the current market, which is favorable for downstream players. The company's strong financial position together with its diverse portfolio of refineries and investments in renewable fuels will highly likely enable VLO to continue efficiently using industry tailwinds.

I see VLO stock as a buy with good potential to deliver returns both via dividends and share price appreciation in the next years.

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