Summary
- Valero has generated tremendous wealth for its shareholders since the bottom of 2020. Unfortunately, its dividend hasn't been hiked as a result of a steep surge in debt.
- In this article, I discuss why a dividend hike is imminent, as all COVID debt has been repaid, while free cash flow is expected to remain high.
- The company restarted its buybacks, and Valero shares continue to trade below fair value.
- I continue to believe that VLO is a great buy on weakness thanks to strong industry fundamentals.
- Hence, I will try to use bigger corrections this year to expand my position.
Introduction
I started my dividend growth portfolio in 2020 when I got serious about putting money to work on a long-term basis. I currently own two stocks that haven't hiked once since I bought them in 2020. One of them is Valero Energy ( VLO ) . This refinery giant was one of my worst investments until the vaccine news came out in November 2020. Now, it's one of my best investments.
As much as I love Valero, there's one major problem that is bothering a lot of investors - especially in light of industry tailwinds that have pushed Valero's stock up by 70% over the past 12 months. That problem is its yield. Valero currently yields 2.8%, which is way too low for a volatile energy stock.
That said, the good news is that we're getting very close to a dividend hike, which is the reason why I'm writing this article. The recently-released fourth-quarter earnings, which we will discuss in this article, revealed a lot about what we can expect in terms of dividend growth.
Industry tailwinds are persistent, and margins are high. Moreover, Valero's balance sheet health has reached a new high while buybacks are accelerating. There are no reasons for Valero to further delay dividend growth unless something very bad were to happen to demand in the short term.
Hence, management is hinting that dividend growth is coming back. I agree with that and believe we are just weeks away from a new hike.
Note that I wrote something similar in November . However, back then, management wasn't as sure about its dividend as it is now, net debt was higher, and people could only guess how strong the fourth quarter could be.
We now have way more data to work with.
With all of this said, allow me to elaborate.
Valero Protected Dividends With Its Balance Sheet
An A minus, an A, and a B plus. That's not a bad dividend scorecard. The problem is the C, indicating that VLO's yield isn't that attractive relative to the energy sector.
I agree as the energy sector has become a go-to place for investors looking for dividend income. Master limited partnerships are paying up to 10% dividends, while efficient oil drillers are paying even more. One doesn't need to be extremely skilled to find at least one decent stock with a very high yield.
Valero yields 2.8% based on a $0.98 per quarter per share dividend. This is the result of an 8.9% hike in January 2020, shortly before the world got some bad news from Wuhan.
The payout ratio is just 13.4%. Which is extremely low.
In December, I wrote an article covering the attractiveness of Valero's dividend. Back then, VLO was yielding 3.3%, which outperformed the energy median.
As the chart below shows, the pandemic ended a series of aggressive and consistent hikes after the Great Financial Crisis caused VLO to cut its dividend.
What's interesting is that VLO's dividend growth rates aren't even bad. Not even if we consider that VLO hasn't hiked its dividend since January 2020.
These are Valero's historical dividend growth rates:
- 10Y CAGR: 20.8%
- 5Y CAGR: 7.0%
- 3Y CAGR: 2.9%
As the graph above shows, dividend growth ended when free cash flow imploded. In 2020, the company did not even have enough cash to maintain its operations, let alone distribute cash to its shareholders.
Hence, net debt rose from $7.1 billion in 2019 to $11.4 billion in 2020.
The reason why the company did not cut its dividend is that it had a leverage ratio of just 1.2x EBITDA in 2019. It used its balance sheet to protect the dividend. While the company had guts, as nobody knew how bad COVID would get - let alone how long it would take - it used a low initial debt level to benefit its shareholders.
That's one of the many benefits of having a healthy balance sheet. It's not just bankruptcy protection. It's also a way to let shareholders benefit in certain circumstances.
In hindsight, the company did the right thing.
It's Time For A Hike (Management Agrees)
This sub-title isn't based on me being impatient (well, maybe a little) but on the company's ability to hike its dividend.
In 4Q22, the company generated $41.8 billion in revenue, which is $1.57 billion below estimates, yet 16.3% higher compared to the prior-year quarter. Adjusted earnings per share came in at $8.45, which is $1.23 higher than expected.
In its refining segment, the company reported $4.3 billion worth of operating income. In 4Q21, that number was $1.3 billion. Refining throughput averaged 3.0 million barrels per day.
According to the company :
Our refineries operated at a 97 percent capacity utilization rate in the fourth quarter, which is the highest utilization rate for our system since 2018," said Joe Gorder, Valero's Chairman, and Chief Executive Officer, "I am also proud to report that 2022 was Valero's best year ever for combined employee and contractor safety, which is a testament to our long-standing commitment to safe, reliable and environmentally responsible operations."
A mix of rebounding post-pandemic demand and global refinery shutdowns caused margins to remain high. Thanks to high throughput, the company was able to generate $9.8 billion in free cash flow. That is more than three times what the company did in 2019, a mind-blowing number.
Moreover, high natural gas prices in Europe incentivized refiners overseas to process sweet crude oils instead of sour crude oils. This added further pressure on sour crude oils. Valero's Port Arthur Coker project is expected to be completed in the second quarter of 2023 and will increase refinery throughput capacity and the ability to process incremental volumes of sour crude oils and residual feedstock.
In its renewable diesel segment, operations continue to expand with the successful commissioning and start-up of the new DGD Port Arthur renewable diesel plant in November. The project, which came in under budget and ahead of schedule, will bring DGD's annual production capacity to roughly 1.2 billion gallons of renewable diesel and 50 million gallons of renewable naphtha.
The good news is that while margins are expected to ease a bit (the market isn't staying this tight forever), Valero remains very upbeat about its future:
Looking ahead, we expect low product inventories and continued increase in product demand to support margins, particularly for US coastal refiners that have crude oil supply and natural gas advantages relative to global refineries. And we continue to see large discounts for heavy sour crude oils and fuel oils that we can process in our system.
Now, back to the dividend.
The company has repaid all the incremental debt it incurred as a result of the implosion of free cash flow during the pandemic. Its net debt-to-capitalization ratio is back at 21%.
In 4Q22, VLO returned $2.2 billion to its shareholders, bringing the full-year total to $6.1 billion. This puts the payout ratio at 45% of the adjusted net operating cash flow.
In light of these numbers and everything we just discussed, Bank of America's ( BAC ) Doug Leggate asked the question on everyone's mind during the 4Q22 earnings call:
[...] I hate to do this, but I got to ask the cash return question. Your balance sheet, you've managed it or Jason, maybe, back to below COVID levels. Your dividend still hasn't moved and your share count is now down, I guess, about 7%. So, all things considered, it seems you've got a lot of capacity for dividend to restart dividend growth. How can you walk us through what you're thinking on cash returns?
Here is the answer CFO Jason Fraser gave:
[...] one of our main objectives as the financial situations improve post-COVID was the payback this incremental debt, which we've been aggressively working on. And we've messaged that while we're working on this competing goal of deleveraging, we would stay at the lower end of our 40% to 50% payout range, which is what we've been doing.
[...] during the quarter, we increased our stock purchases to $1.8 billion and we're able to end the year at a 45% payout ratio. So, we're able to work our way back to the midpoint of our target range for the full year.
Moreover, the company has now reached its targets and is looking to return to growing the dividend.
[...] we continue to aim for a dividend as sustainable and competitive versus our peers. We would also like to show growth.
And then we're rebuilding cash and working our debt down. So, now, as I've said, we've kind of met those goals so we would like to return to a pattern of growth as we move forward.
So, to summarize the situation:
- Valero has repaid every penny of COVID-related debt.
- It is now expected to have a leverage ratio of less than 0.2x EBITDA in 2023 and 2024.
- In 2025, the company could have more than $4 billion in net cash (negative net debt), unless it engages in large buybacks down the road.
- Management started to distribute excess cash through buybacks last year.
- Management aims to maintain a competitive dividend and it acknowledges that it's time to hike.
This situation is perfect for a dividend hike. Hence, I'm willing to make the call that the next dividend announcement could very well be a hike.
Valuation
Valero is trading at 4.3x 2023E EBITDA of $13.4 billion. That's based on its $58.0 billion enterprise value. This number consists of its $54.2 billion market cap, $1.4 billion in 2023E net debt, $1.8 billion in minority interest, and minor pension liabilities.
The implied free cash flow yield is 11%. However, I'm using 2024 free cash flow estimates. Using 2023 estimates, that number would be 15.0%. This shows how much potential VLO has to distribute cash.
I believe that a fair price is close to $160 per share.
However, I wouldn't recommend anyone to rush in at current prices - despite its valuation, positive outlook, and high likelihood of the return of dividend growth.
Economic growth is going down south quickly, and I believe that the market is way too dovish when it comes to estimating what the Fed is up to in 2023 and 2024.
Hence, I believe the best way to play VLO is to buy after 20% drawdowns. That's how I usually deal with cyclical and volatile stocks in my portfolio.
This also explains my neutral rating.
20% may seem like a lot, but VLO has regularly sold off more than 20% in the past ten years, often outside of official recessions.
Takeaway
In this article, I focussed on Valero's dividend. While VLO owners have benefited from the tremendous growth in its stock price, the yield is now below 3%. That is not attractive and a big turnoff for most investors in the sector.
The good news is that VLO is back on track. Its pandemic-related debt has been erased, free cash flow and EBITDA are expected to remain high, and buybacks have been restarted last year.
Management knows it's time to hike the dividend, and it acknowledges the importance of paying a competitive dividend.
In 2020, it protected the dividend by issuing new debt. Now, it can use free cash flow and balance sheet health to raise that dividend.
While I cannot promise anything, I think the next dividend announcement is going to be a hike. Even if I'm wrong, I think a hike in 2023 is almost a total certainty.
(Dis)agree? Let me know in the comments!
For further details see:
The Valero Dividend: Time For Takeoff