VLO - Valero's A Dividend And Buyback Gem - If It Drops I'm Buying

2024-01-03 11:24:58 ET

Summary

• Valero Energy is a strong dividend growth stock in the energy sector, with a focus on refining and renewable energy production.
• The company has a history of maintaining a healthy payout ratio and has consistently increased its annual dividend since 2012.
• Valero employs share buybacks as a strategic tool for capital allocation, reducing the total number of outstanding shares and potentially boosting earnings per share.

Introduction

I would make the case that I'm not a great client for most brokers, as I have a very low transaction count. I barely trade stocks, and I almost never sell a long-term (dividend) investment.

However, last year, I sold my Valero Energy Corporation ( VLO ) investment, which I bought very cheaply during the pandemic.

On September 26, 2023, I wrote an article titled " Valero: Despite Massive Strength, I'm Considering Selling (Rating Downgrade) ."

Since then, shares are down 7.4%, including dividends, underperforming the S&P 500, which is up 11.6% since then, by a mile.

That said, I'm looking to get back in, as I believe that Valero Energy is one of the best (albeit volatile) dividend growth stocks in the energy space.

So, without further ado, let's get right to it!

Energy Income Growth

I have discussed Valero a lot in the past few years.

However, as this is the first article this year, let's take a step back to look at the bigger picture, especially for the people who are new to the VLO ticker.

Valero is a Fortune 500 company headquartered in San Antonio, Texas, and operates as a multinational manufacturer and marketer of petroleum-based and low-carbon liquid transportation fuels and petrochemical products.

Or, to put it differently, the company turns oil into value-added products like gasoline, diesel, and kerosene. It turns corn into ethanol and other bioproducts into renewable diesel.

While it is working to boost the production of renewables, as we will discuss in this article, its bread and butter is its refining business, as we can see in the table below.

Going back to its segments, the company manages 15 petroleum refineries with a combined throughput capacity of approximately 2.7 million barrels per day.

More than half of this capacity is located in the Gulf Coast, where it is the largest pure-play refiner.

Thanks to strategic locations and prudent management, the company is one of the most efficient producers in its industry.

The company also has a joint venture with Diamond Green Diesel Holdings, which owns two renewable diesel plants.

On top of that, it is one of America's largest ethanol producers, capable of producing 1.2 billion gallons per year and a number of typical by-products like dry distiller grains and corn oil.

One thing the company is very proud of (and rightfully so) is its shareholder distributions.

As we can see in the pyramid below, the company believes it is the best pick among large-cap corporations with investment-grade balance sheets and elevated EBITDA growth.

Although I have to say that the company was cherry-picking a lot in the pyramid above (it also has periods of negative EBITDA growth, and why filter out small companies?), I have to give Valero a lot of credit for being a great source of rising income for shareholders.

As we can see below, the company has maintained a healthy payout ratio in every year since 2012, except for the pandemic.

Since 2012, it has grown its annual dividend from $0.65 to $4.08.

Dividends play a crucial role in Valero's commitment to returning cash to shareholders.

Hence, the dividend policy is designed to provide shareholders with a reliable stream of income, making Valero an appealing choice for income-oriented investors.

The current dividend of $1.02 per share per quarter ($4.08 per year) translates to a yield of 3.2%.

On January 31, 2023, the dividend was hiked by 4.1%, which was the first dividend hike since the pandemic.

On a full-year basis in 2023, the company is expected to generate $8.7 billion in free cash flow. This translates to roughly 20% of its $44.3 billion market cap.

This shows that the dividend is extremely safe.

It is also protected by a balance sheet with a sub-0.5x leverage ratio and an investment-grade BBB credit rating.

Valero ended 3Q23 with $9.2 billion of total debt, $2.3 billion of finance lease obligations, and $5.8 billion of cash and cash equivalents. The debt-to-capitalization ratio, net of cash, was 17%.

On top of that, Valero employs share buybacks as a strategic tool for capital allocation.

The company repurchases its own shares from the open market, reducing the total number of outstanding shares.

This, in turn, can enhance shareholder value by boosting earnings per share and potentially signaling to the market that the company believes its stock is undervalued.

As the overview above shows, the company has bought back roughly 35% of its shares between 2012 and 2023.

Over the past 12 months alone, VLO bought back 8.5% of its shares.

In the third quarter earnings call , the company was asked about its cash deployment.

The company answered that it is likely to deploy more cash when opportunities present themselves. Given its balance sheet and recent free cash flow benefits, it is still in a great spot to buy back a lot of stock.

Doug Leggate [Question]

Okay. My follow-up is a quick one maybe for Jason. But another $1.8 billion of buybacks. You've now bought back, I think, about 15% of your shares in the last 1.5 years. You still got plenty of cash on the balance sheet, and we know this sector is notoriously seasonal. I'm just curious how we should think about your deployment or strategy of -- into seasonal periods when you get -- perhaps get more opportunistic ?

Jason Fraser [Answer]

[...] And then that brings us to buyback and you know our post to buybacks is to have the annual target of 40% to 50% of adjusted net cash from operations, and we view the buyback as a flywheel supplementing our dividend to hit whatever our target is for the year. In the third quarter, we had a 68% payout year-to-date through the third quarter, we're at 58%. So I would say, under these conditions, even given the softer seasonality in the fourth quarter, you should definitely expect us to pay out over 50% for the year .

With that said, let's take a closer look at its numbers.

The Attractiveness Of VLO

Despite all the good news so far, I sold VLO last year, which was mainly based on the macroeconomic environment.

This is what I wrote in my prior article:

Nonetheless, given the current risk/reward and other investment opportunities, I'm considering selling a bit of Valero Energy Corporation to potentially buy it back at lower prices if I get the chance.

As we can see in the chart below, the ISM Manufacturing Index has been in a longer-term decline, which is indicative of slower economic demand.

This decline has also pressured Valero.

For example, the refining segment achieved $3.4 billion in operating income for 3Q23, with refining throughput volumes averaging 3 million barrels per day at 95% capacity utilization.

Refining cash operating expenses were $4.91 per barrel, higher than the guidance of $4.70 per barrel, mainly due to elevated energy prices.

Total net income attributable to Valero stockholders for the third quarter of 2023 was $2.6 billion or $7.49 per share, slightly lower than the $2.8 billion or $7.19 per share for the same period in 2022.

Adjusted net income for 3Q23 was $2.8 billion or $7.14 per share.

Despite these cyclical setbacks, Valero remains focused on operational excellence, prioritizing strategic projects, and honoring shareholder returns.

For example, the DGD Sustainable Aviation Fuel project at Port Arthur is on schedule, expected to be complete in 2025, and is estimated to cost $315 million.

With this project, Diamond Green Diesel is anticipated to become one of the largest sustainable aviation fuel manufacturers in the world.

Valero also continues to evaluate opportunities in carbon capture and storage for reducing the carbon intensity of conventional ethanol.

Furthermore, despite cyclical headwinds, it benefits from very low distillate inventories in the United States.

On December 20, the Wall Street Journal reported the following:

Distillate stocks, mostly diesel fuel, increased by 1.5 million barrels, to 115 million barrels, and were 10% below the five-year average. Expectations were for a 700,000-barrel build.

I expect low inventories to turn into significant drivers of pricing benefits once economic demand improves.

So, what about the valuation?

Valuation

The valuation is interesting for a number of reasons.

• As we can see in the chart below, analysts expect a long-term normalization in earnings. They expect that the post-pandemic benefits from constrained industry supply and elevated margins will moderate, resulting in at least three years of double-digit EPS declines.
• Currently, VLO trades at a blended P/E ratio of just 5.3x, which is very cheap.
• The long-term normalized valuation multiple is 11.0x.
• However, because of the expected EPS contraction, the stock has a fair price target of roughly $139, which implies 6.4% annual returns through 2025. That is not very juicy.

When incorporating macroeconomic uncertainty and the recent stock price surge, I will remain on the sidelines.

However, as I am a huge fan of the company's focus on dividend growth, buybacks, and long-term growth investments, I am looking to buy the stock on a potential 1% to 20% stock price decline.

As we can see in the chart below, stock price declines of more than 10% are rather common.

Hence, I'm closely watching VLO in 2024 to deploy cash if I get the opportunity.

Takeaway

Valero Energy stands out with its robust refining business, shareholder-focused policies, and diverse product portfolio.

The company's commitment to consistent dividends and substantial share buybacks sets it apart in the market.

Despite a recent sell-off, Valero's fundamentals remain strong, backed by a secure financial position.

My cautious buying strategy sees a fair price target of $139 and aims for potential entry points during stock price declines of 1% to 20% in 2024.

After all, Valero's unique qualities make it not only a cyclical play but a strategic investment opportunity with long-term potential.

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