VLO - Valero Energy: Taking To 'Hold' After Solid Run (Rating Downgrade)

2023-10-04 16:46:56 ET

Summary

• Valero Energy Corporation has continued to put up strong results on the back of wide crack spreads.
• Q3 should also be strong for the company, but more recently RBOB crack spreads have started to normalize.
• Based on more normalized earnings, Valero Energy Corporation stock looks fairly priced.

Back in June , I upgraded Valero Energy Corporation ( VLO ) to "Buy." I said that while the company had experienced peak earnings, it had been doing a great job buying back stock and increasing its dividend while also undertaking some nice growth projects that would help drive more normalized EBITDA growth once crack spreads returned to more historical levels. Since then, VLO stock has returned about 20% versus a -3% return for the S&P 500 (SP500).

Company Profile

As a refresher, VLO operates 15 refineries in the U.S., Canada, and the U.K. that process a variety of sweet and sour crude, as well as other feedstocks. In turn, it produces things such as gasoline and other transportation fuels, as well as low-sulfur fuel oil and heating oil. The company sells its refined products through unbranded channels, as well as a network of independent dealers and distributors that operate under the Valero name. VLO also owns other assets on the midstream side, such as product pipelines, crude pipelines, terminals, storage tanks, and marine docks. It also operates 12 ethanol plants.

Valero's Performance and Crack Spreads

As I've noted in past articles, the biggest profit driver for VLO and other refiners tends to be crack spreads, which in basic terms is the difference between crude prices and refined product prices. They are similar to refining margins but don't include revenue from other produced products or costs outside of crude.

Crack spreads blew out in 2022, leading to huge results for VLO and its peers. Not surprisingly, these ultra-high spreads did not last forever, but spreads continued to be well above historical norms in the first half of 2023. Today spreads have returned to more normalized levels, near their $10.50 historic average . There is some seasonality in the spreads around peak driving time, and they are expected to widen out again in March 2024.

Strong crack spreads led to solid Q2 results for VLO, with the company reporting net income attributable to Valero shareholders of $1.9 billion, or $5.40 per share. That was down from adjusted EPS of $11.36 a year ago.

For the quarter, VLO generated operating income of $2.76 billion, compared to $6.22 billion a year ago.

Refining segment adjusted operating income was $2.4 billion compared to $6.1 billion a year ago. In Q2 2021, the segment only reported adjusted operating income of $442 million. Refining throughput volumes averaged 3.0 million barrels per day for both Q2 2023 and 2022. Volumes were 127 thousand barrels per day lower in Q2 2021 for reference.

In the Renewable Diesel segment, VLO recorded $440 million in adjusted operating income, up from $152 million a year ago. Volumes doubled to 4.4 million gallons a day, due to the startup of the DGD Port Arthur plant in the fourth quarter of last year.

In its ethanol segment, adjusted operating income rose 61% to $127 million from $79 million a year ago. Volumes climbed by 15% to 4.4 million gallons a day.

The company generated $1.5 billion in operating cash flow, or $2.5 billion when excluding an unfavorable change in working capital.

Turning to the balance sheet , VLO ended the quarter with $9 billion in debt and $5.1 billion in cash and short-term investments. During the quarter, the company bought back $951 million in stock and paid out $367 million in dividends.

Looking at recent and future growth projects, the company's Port Arthur Coker project came online in April and is currently operating at full capacity. The company said the new coker has boosted the refinery's throughput capacity and has allowed it to process incremental volumes of heavy crudes and residual feedstocks.

Meanwhile, it said its Sustainable Aviation Fuel ("SAF") project at the DGD Port Arthur plant is progressing on schedule and is expected to be completed in 2025. VLO will pay half the $315 million cost of the project, which will allow it to upgrade 50% of the current 470 million gallons annual renewable diesel production capacity to SAF.

On its Q2 earnings call, COO Gary Simmons was bullish on the market and refining fundamentals, saying:

"We do believe that the DOE is understating gasoline demand. But even their data is showing on a 4-week average basis gasoline demand up about 3%. But if you look at our numbers, we had record volumes in both May and June of over 1 million barrels a day. We're seeing gasoline sales in our system up 14% year-over-year, up 22% from pre-pandemic levels. Gasoline inventory year-over-year is down 7.5 million barrels. So it's trending at the low end of the 5-year average range. Typically, this time of year, you have an open arb to ship barrels from Europe into the United States. But with inventory low in Europe, that arb is closed, which is hindering imports, and we see strong export demand from the U.S. Gulf Coast into South America. So the fundamentals around gasoline look very good. Diesel inventory is up 6 million barrels, but continues to trend below the 5-year average range. Diesel inventory is flat, where historically, this time of year, we start to see diesel building. Again, while the DOE reflects weaker diesel demand year-over-year, it looks like the weekly data is continually being revised up. … All the airlines are reporting very strong demand. Jet trading at a $0.10 per gallon premium in the U.S. Gulf Coast on a rent-adjusted basis today. So yes, the fundamentals look very, very good."

Overall, VLO put up a solid Q2, as crack spreads remained high, and it saw nice growth from its Renewable Diesel and Ethanol segments. With crack spreads starting to normalize, these two segments become more and more important for VLO.

While their contributions look small today, as noted above in Q2 2021 VLO's refining segment only had adjusted operating income of $442 million, and it was $1.0 billion in 2019 before the pandemic. Combined, the Renewable Diesel and Ethanol segments generated $567 million in adjusted operating income this quarter, so in a more normalized environment they are a much more sizable contributor.

Valuation

VLO trades at a 3.6x EV/EBITDA multiple based on the 2023 EBITDA consensus of $15.4 billion. Based off of the 2024 EBITDA consensus of $10.1 billion, it trades at around 5.5x.

It trades at about 5x forward EPS, with analysts forecasting 2023 EPS of $26.13.

It's projected to see revenue fall -13% in 2023 and 7% in 2024.

VLO's stock generally trades in line with other refiners.

As I noted in my past write-ups, VLO and other refiners look cheap because crack spreads have widened to well above historical norms. More normalized EBITDA after growth projects for VLO is likely closer to $6-7 billion. On that basis, it's trading around 8.5x normalized EBITDA.

Conclusion

Valero Energy Corporation should have a strong Q3, as summer crack spreads were strong due to some unexpected refinery outages at competitors. Meanwhile, diesel and jet fuel crack spreads blew out after Saudi Arabia cut its production of heavier crude, which is often produced into diesel. However, RBOB crack spreads have recently been plummeting, in part due to seasonality, but also on some concerns of gasoline demand.

Given the run-up in Valero Energy Corporation shares since my upgrade and the shift lower in RBOB crack spreads, I'm going to take my rating on VLO to "Hold," as once again the stock looks close to fairly valued.

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