INITIATING COVERAGE REPORT William C. Dunkelberg Owl Fund March 29, 2014 Michael Kollar: Lead Analyst [email protected]Maxime Berin: Associate Analyst [email protected]Shady Botros: Associate Analyst [email protected]COMPANY OVERVIEW VLO is the world‘s largest independent petroleum refiner and marketer, supplying transportation fuels (Diesel, gasoline, jet fuel, ethanol) and petrochemical products (propane, sulfur, asphalts, etc.), with 16 refineries and 11 ethanol plants. VLO is based in San Antonio, Texas and its geographic portfolio includes the United States (73% of revenue), Canada (7%), United Kingdom (8%) and the Caribbean (12%). VLO‘s revenue is driven by refining (96%) and ethanol production and (3.57%). Its refineries have a collective throughput capacity of 3.1 million barrels per day (mmbdp), while its ethanol plants have a capacity of 1.2 billion gallons a year. VLO also owns and operates a 50 mega-watt wind farm. INVESTMENT THESIS VLO is undervalued as it currently trades at a 16% discount to its implied EV/EBITDA multiple (5.44x vs. 6.31x) relative to its peer group. In the past, Gulf Coast (GC) refiners such as VLO have been at a cost disadvantage due to purchasing expensive Brent crude international feed stock while mid- continent competitors possessed the ability to source cheaper WTI feed stocks. The cost advantage has begun to transition to the GC region as synergies are realized between the GC‘s geographic export capabilities and the low-cost feed stocks abundantly flowing from E&Ps in Canada, the Bakken, and other higher margin crude basins around North America. VLO is the largest independent refiner in the Gulf Coast region and will see margin expansion between its imported feed stocks and exported refined products. Along with margin expansion, VLO has numerous growth investments which will increase volumes, fueling EBITDA growth in FY2014 and FY2015. With margins supported by microenvironment forces such as the US ban on exporting crude and the imminent Keystone XL pipeline completion, efficient logistics systems, and growing international demand for highly refined distillate products, VLO is positioned to capture this value creation more so than any of its peers. We rate the company a strong ―Buy.‖ Energy Oil & Gas Refining & Marketing Valero Energy Corporation Exchange: NYSE Ticker: VLO Target Price: $73.68 Current Price: $52.86 Sector Outperform Recommendation: BUY All prices current at end of previous trading sessions from date of report. Data is sourced from local exchanges via CapIQ, Bloomberg and other vendors. The William C. Dunkelberg Owl Fund does and seeks to do business with companies covered in its research reports. Key Statistics Price Projected $73.68 52 wk Low $33.00 Return 39% 52 wk High 55.96 $ Shares O/S (mm) 533 $ Yield 1.89% Market Cap (mm) 28,159 $ EV (mm) 30,917 $ P/E 12 Beta 2.49 Date EPS Δ NI YOY NI Surp Δ Price 1Q2013 $ 1.18 251% 24.6% -3.8% 2Q2013 $ 0.85 -44% -21.3% -2.1% 3Q2013 $ 0.57 -54% 14.9% 3.0% 4Q2013 $ 2.38 28% 74.5% 2.4% Earnings History $(2.00) $(1.00) $- $1.00 $2.00 $3.00 $4.00 $5.00 $6.00 $7.00 $8.00 2010 2011 2012 2013 E2014 E2015 Diluted EPS & Consensus 1Q 2Q 3Q 4Q Year Period 2010 2011 2012 2013 E2014 E2015 1Q $(0.20) $ 0.17 $(0.78) $ 1.18 $ 1.30 $ 1.55 2Q $ 1.03 $ 1.30 $ 1.50 $ 0.85 $ 1.65 $ 2.29 3Q $ 0.51 $ 2.11 $ 1.21 $ 0.57 $ 1.55 $ 1.76 4Q $(0.77) $ 0.08 $ 1.82 $ 2.38 $ 1.14 $ 1.32 Year $ 0.57 $ 3.69 $ 3.75 $ 4.97 $ 5.64 $ 6.92 Earnings Per Share ( $) for Fiscal Year Ending Dec.
fuel, ethanol) and petrochemical products (propane, sulfur,
asphalts, etc.), with 16 refineries and 11 ethanol plants. VLO is
based in San Antonio, Texas and its geographic portfolio
includes the United States (73% of revenue), Canada (7%),
United Kingdom (8%) and the Caribbean (12%). VLO‘s
revenue is driven by refining (96%) and ethanol production
and (3.57%). Its refineries have a collective throughput
capacity of 3.1 million barrels per day (mmbdp), while its
ethanol plants have a capacity of 1.2 billion gallons a year.
VLO also owns and operates a 50 mega-watt wind farm.
INVESTMENT THESIS VLO is undervalued as it currently trades at a 16% discount to
its implied EV/EBITDA multiple (5.44x vs. 6.31x) relative to
its peer group. In the past, Gulf Coast (GC) refiners such as
VLO have been at a cost disadvantage due to purchasing
expensive Brent crude international feed stock while mid-
continent competitors possessed the ability to source cheaper
WTI feed stocks. The cost advantage has begun to transition
to the GC region as synergies are realized between the GC‘s
geographic export capabilities and the low-cost feed stocks
abundantly flowing from E&Ps in Canada, the Bakken, and
other higher margin crude basins around North America. VLO
is the largest independent refiner in the Gulf Coast region and
will see margin expansion between its imported feed stocks
and exported refined products. Along with margin expansion,
VLO has numerous growth investments which will increase
volumes, fueling EBITDA growth in FY2014 and FY2015.
With margins supported by microenvironment forces such as
the US ban on exporting crude and the imminent Keystone
XL pipeline completion, efficient logistics systems, and
growing international demand for highly refined distillate
products, VLO is positioned to capture this value creation
more so than any of its peers. We rate the company a strong
―Buy.‖
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Valero Energy Corporation Exchange: NYSE Ticker: VLO Target Price: $73.68 Current Price: $52.86
Sector Outperform Recommendation: BUY
All prices current at end of previous trading sessions from date of report. Data is sourced from local exchanges via CapIQ, Bloomberg and other vendors. The William C. Dunkelberg Owl Fund does and seeks to do business with companies covered in its research reports.
Key Statistics
Price Projected $73.68 52 wk Low $33.00
Return 39% 52 wk High 55.96$
Shares O/S (mm) 533$ Yield 1.89%
Market Cap (mm) 28,159$ EV (mm) 30,917$
P/E 12 Beta 2.49
Date EPS Δ NI YOY NI Surp Δ Price
1Q2013 $ 1.18 251% 24.6% -3.8%
2Q2013 $ 0.85 -44% -21.3% -2.1%
3Q2013 $ 0.57 -54% 14.9% 3.0%
4Q2013 $ 2.38 28% 74.5% 2.4%
Earnings History
$(2.00)
$(1.00)
$-
$1.00
$2.00
$3.00
$4.00
$5.00
$6.00
$7.00
$8.00
2010 2011 2012 2013 E2014 E2015
Diluted EPS & Consensus
1Q 2Q 3Q 4Q Year
Period 2010 2011 2012 2013 E2014 E2015
1Q $(0.20) $ 0.17 $(0.78) $ 1.18 $ 1.30 $ 1.55
2Q $ 1.03 $ 1.30 $ 1.50 $ 0.85 $ 1.65 $ 2.29
3Q $ 0.51 $ 2.11 $ 1.21 $ 0.57 $ 1.55 $ 1.76
4Q $(0.77) $ 0.08 $ 1.82 $ 2.38 $ 1.14 $ 1.32
Year $ 0.57 $ 3.69 $ 3.75 $ 4.97 $ 5.64 $ 6.92
Earnings Per Share ( $) for Fiscal Year Ending Dec.
in the Gulf, are at risk of disruption due to hurricanes.
Regulations: Fines and sanctions from federal, state,
and local environmental laws and regulations
regarding discharge of materials, pollution prevention,
waste management, and greenhouse gas emissions.
Projects: VLO has multiple ongoing and newly
beginning projects. There is potential that these may
turn into drag factors if they fail to meet analyst and
investor expectations as far as timing and returns.
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INDEPENDENT REFINING INDUSTRY ANALYSIS Overview Refinery revenue is dependent on domestic and international demand for their products, while profits are dependent on
the Crack Spread, or the differential between the cost of crude to a refinery and the price it can charge for refined
products after ―cracking‖ the crude. While major integrated oil companies hedge themselves against market price
movements naturally by controlling their supply chains, independent refiners use the futures markets to lock in future
prices for fuels and other petroleum products depending on their optimal product mix. Futures prices are determined by
the New York Mercantile Exchange (NYMEX) which was founded in 1882. Refineries run many types of crudes at
various differentials, but as a proxy, their feed stocks prices follow West Texas Intermediate crude (WTI) while their
refined products fetch prices closer to, and above Brent crude.
The Year Ahead
We believe that FY2014 will prove to be an excellent year for the refining industry, as robust investments in
infrastructure solidify the Unites States‘ position as a net energy exporter. Crude oil now flows from the mid-Continent
US to refineries on the East, West and Gulf Coasts via interstate pipeline networks, railways, ships and river barges. It
should be noted that there has not been a large refinery (>100,000bpd capacity) built in the US since 1976 (See
Appendices: Newest US Refineries). The lack of new refinery construction insulates Valero from losing market share going
forward.
Location Advantage The Gulf Coast (GC) is the largest refining center on the planet and companies with refineries in the region, such as
VLO, have a large competitive advantage on feed stock costs and export capability compared to those who do not.
Logistics infrastructure has been built out from the GC across the continent which affords refiners in this region with
the lowest feed stock cost, currently $0 to $5 below the price of Brent, versus +$2 on the East Coast and +$1 to -$2 on
the West Coast. VLO has over 50% of total refining
capacity on the GC with a total operating capacity of
14.3 mmbpd, represented on the graph to the right,
second only to XOM, the largest oil company in the
United States. VLO towers above PSX and MPC, the
only other refineries in VLO‘s peer group (other
refiners are major integrated and private LLCs and
LPs). VLO also benefits from being in the US as it
pays about $4/mmbtu for its natural gas it uses for
processing, compared to $16/mmbtu in Europe and
$17/mmbtu in Asia.
US Export Ban on Crude Not Lifting Anytime Soon
A key tailwind to the refining industry and VLO is the US ban on crude exports. The ban will remain over the medium-
term as any change would require an act of Congress and the US Secretary of Energy has stated that those in favor of its
lifting have failed to make a convincing argument. Further, requiring domestic crude to be refined prior to exportation
effectively subsidizes gasoline prices for Americans because E&Ps cannot export their product directly to the
international markets. If E&Ps could sell crude internationally, domestic prices would rise to equilibrium with
international gasoline prices. Although there is immense lobbying done by the major integrated oil companies (such as
XOM), Congress is unlikely to favor any legislation detrimental to American consumers and the overall economy.
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$131,940
$3,896$5,242
Revenue Segments
Refining: 93.5%
Retail: 2.8%
Ethanol: 3.7%
Effects of Ukraine & Russia Conflict
Europe views the conflict in Ukraine as a potential threat to its economy because it imports 30% of its oil from Russia.
Further, most of Europe‘s natural gas travels through pipelines spanning Ukraine. Geopolitical unrest in the region
creates volatility in the global energy markets, particularly the Brent crude index. While higher Brent prices historically
amount to improved pricing for VLO‘s refined products, violence and war can inflate all crude indices, resulting in
margin compression.
WTI – Brent Spread
Crude oil in North America is priced as West Texas Intermediate (WTI) at a central hub in Cushing, Oklahoma. Without
getting into explicit detail, WTI is ―sweeter‖ than internationally benchmarked Brent crude because its lower sulfur
content makes it easier to refine into diesel, gasoline, and other distillates. In theory, WTI would be priced at a premium
to Brent because lower refining cost leads to higher margins, and price should reflect this cost advantage. However,
structural difficulties in getting WTI to international market and rampant supply results in its discount to Brent. These
structural difficulties include the United States ban on crude oil exports and government restrictions on pipeline
development. This disconnect is more evident as the correlation between the benchmarks has also broken down since
US production has increased since 2011. The U.S. Energy Information Association noted in its latest ―Short Term
Energy Outlook‖ report that it expects the spread between WTI and Brent to average $11.46 per barrel through 2014,
and $11.34 per barrel through 2015—higher than the current level of $7.50 per barrel.
Supply
The advent of hydraulic fracturing and
horizontal drilling has made it economically
sound to extract from the tight oil plays
located in the Bakken (North Dakota),
Permian (West Texas), and Eagle Ford (Texas)
Basins. E&P production in North America
has accelerated, and is forecasted to increase
1mmbpd by 2015. Combined with improved
logistics, increasing supply will afford VLO
cheaper feed stocks and facilitate the
continued disconnect between WTI and Brent
crude prices.
FINANCIALS
Revenue VLO has two reporting revenue segments going into FY2014, refining and ethanol. The refining segment (5-Year
CAGR: 16.8%) cracks crude oil into transportation fuels such as: conventional gasoline; reformulated gasoline; ultra-low
sulfur gasoline; clean fuel additives; diesel; commercial, military, and defense standard jet fuel; and methanol. The
remainder of crude is then processed into petrochemicals (See
Appendices: VLO Major Products & Services). The ethanol segment (5-Year
CAGR: 31.5%) continues to generate strong revenue for VLO, $5.2B
in FY2013. VLO acquired 11 ethanol plants which produce over 1.3
billion gallons of ethanol per year, establishing VLO as the first
traditional refiner to enter the production of ethanol, under the
subsidiary VLO Renewables. The Company produces more ethanol
than it can blend, selling the remainder on the market. VLO entered the
ethanol market by purchasing the 7 plants in fire sales in 2Q2009,
acquiring the entire portfolio for 35% of estimated replacement cost,
and earns a 40% cash IRR.
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The Company reported $138.1B in total revenue for FY2013, down from $139.3B in FY2012, despite seeing refining
revenue grow $99mm (+<1%) and ethanol revenue grow $810mm (+18.3%). This decrease was a result of VLO
spinning off its lower-yielding retail segment (accounting for +$12B revenue in FY2012) as a new publicly-traded
company, CST Brands, Inc (NYSE: CST). After it was spun-off to shareholders on May 1, 2013, VLO held a minority
interest until November. As this segment was discontinued, FY2013 retail segment only accounted for $3.9B in revenue.
Going into FY2014, VLO is expected to see a further drop of 2.8% as there will no longer be retail revenue.
*Bloomberg has expected revenue for FY2014 to be $121.7B, or -12% YoY growth. Upon further investigation, this forecast is the result of
two outlier analyst expectations ($93B and $95B) pulling down the mean revenue estimate of a sample size of only six. These estimates imply
that VLO’s revenue would drop 31% in one year – a highly unlikely scenario. Each analyst is unranked, one is from an undisclosed firm,
and the other still maintains an “Outperform” rating on VLO with a TP of $63.00/share. After conducting our due diligence on VLO, we
believe the only factor attributable to such a large decrease in revenue would be the crude export ban being lifted – which we feel is not feasible
in the near-term. Excluding these two anomalies, the mean estimate reverts to a more realistic $135B in revenue, representing a modest -1.8%
YoY growth, which is in-line with our expectations of flat-to-decreasing oil prices through FY2014 and absent retail revenue.
EBITDA
Due to the sometimes volatile nature of revenue, EBITDA is the best measure of a refiner‘s performance. VLO‘s
EBITDA in FY2013 was $5,185mm, down from $6,180mm in FY2012. This was a result of decreased margins on
gasoline prices and the completion of VLO‘s retail segment spin-off to CST Brands, Inc. Despite this recent decrease,
EBITDA has grown at a 5-Year CAGR of 28.7% from numerous growth investments in hydrocracking/distillate
production and light crude capacity expansion. FY2014 EBITDA estimates are $6,702.3mm, +17.9% YoY. As VLO
eliminated costly retail operating expenses and continues to add light crude capacity, distillate yields should appreciate
further and drive EBITDA to these estimates or higher (See Appendices: Charges & Yields)
Margins As the WTI-Brent spread expands, so too will VLO‘s margins. Also, it is highly likely that the passing of the Keystone
XL pipeline will also boost margins for VLO in the short term. VLO invested more than $1.4B in its logistics projects
and is forecasted to invest another $1.3B by 2015. By moving cost-advantaged WTI more efficiently, margins on this
feed stock will expand. The increase in volume has also been a key driver in VLO‘s margins. They have increased their
Gulf Coast refineries output by 139,000 barrels which now represents 57% of the total output. VLO currently has a
margin of $12.25 per barrel, which is much higher than the previous quarter‘s $7.88 per barrel. VLO has invested in
distillates (Diesel, Kero, jet fuel) in 2013, which yielded a $16 per barrel margin, compared to a $12.25 per barrel margin
for gasoline. Beneficially, global demand for diesel and jet fuels is growing 1.5x faster than the demand for gasoline.
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Operating Expenses VLO‘s overall operating margin decreased by 7.5% in
2013 after the spin-off of its retail and convenience store,
CST Brands in May 2013. This decreased the VLO retail
segment‘s operating expenses by $267mm, or 67%. The
refining segment‘s operating expenses increased by $36M
mainly due to an increase in natural gas prices. Finally,
there were higher operating expenses in the ethanol
segment, amounting to $55mm, due higher corn
commodity prices driven by droughts in the Mid-Western
US. VLO production rose during this period which
demanded increased chemicals, which also increased
operating expenses.
Earnings VLO reported 4Q2013 EPS of $2.38 v. $1.50 estimates. These earnings were above analyst‘s estimates by 58.35%. This
compared to $1.82 EPS in 4Q2012. This large beat included a nontaxable gain of $0.60 per share from the disposition of
VLO‘s retained interest in its retail segment to CST Brands, Inc. Excluding this unusual item, adjusted EPS was $1.78
which still beat estimates by 13.2%. Although earnings are affected by the seasonality of the business, VLO has beaten
estimates 9 of the last 12 quarters.
A key catalyst for future earnings growth is VLO‘s MLP,
VLP, which currently houses three of VLO‘s logistic
assets (See Appendices: VLP MLP). VLP is a traditional
MLP and generates cash flow from tariffs and fees for
transporting crude and does not source earnings from the
commodity itself. The first drop down to VLP is
expected to be in 3Q2014 and is forecasted to increase
distributions 20% annually for the next three years.
Dividend
VLO‘s board of directors recently announced an 11.1% increase to its quarterly dividend, raising it from $0.22 to $0.25
per common share. This represents 65% dividend growth rate in the last three years, and a dividend yield of 1.89%. In
FY2103 VLO distributed $1.4 billion to shareholders through dividends and share buybacks, doubling that of FY2012.
Valero is strongly committed to shareholder return and consistently increasing the dividend.
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PEER GROUP IDENTIFICATION
This peer group includes the other members of the S&P 500 Oil
& Gas Refining & Marketing index, as well as other US refiners.
Tesoro Corporation (NYSE:TSO)
Marathon Petroleum Corporation (NYSE:MPC)
Phillips 66 (NYSE:PSX)
Delek US holdings (NYSE: DK)
Holly Frontier Corporation (NYSE: HFC)
Relative Valuation
TARGET PRICE
The target price was calculated using an implied
EV/EBITDA multiple. Once VLO‘s catalysts are
realized, the company will trade more in-line with its peer
group, represented by a target multiple, of 6.31X.
Peer Analysis Target Price = $73.68
Target Multiple EV/EBITDA = 6.31x
NTM Consensus EBITDA = $6,659
Projected Return: 39%
Debt Total Debt: $6.56 Billion Debt to Equity: 32.9% Interest Coverage Ratio: 12.0
After $1.2 billion in debt was issued between FY2008 and FY2010 to fund aggressive capital expenditures to expand
refining capacity, VLO has been reducing its leverage. Debt has been decreased each year since by an average of 6%.
VLO‘s debt to capital ratio at the end of 2013 was 24.8%, compared to 28% in FY2012 and 32% in FY2011. Currently,
VLO holds total outstanding debt of $6.56 billion. Despite this burden, VLO is more than capable of meeting its short
term obligations, with an interest coverage ratio of 12.0, as well as a current ratio of 1.50. VLO is solvent as evidenced
by a debt-to-equity ratio of 32.9%. VLO is scheduled to pay off $200 million notes in April 2014 and maintains an
‗investment grade‘ debt rating by S&P.
Free Cash Flow VLO FCF has a 5-year CAGR of 26.9% with $3.44B reported in FY2013 and $2.04B in FY2012. Management has given FY2014 CAPEX guidance of ~$3.0B. They anticipate 50% of this to fund growth projects while 50% will be allocated to maintenance. Refineries are operational 24/7/365 and due to the intense pressure, heat, and mechanisms involved in the refining process, regular maintenance is crucial to ensure continued operations without outages. VALUATION
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Valero Energy Corporation (VLO) Comparable Analysis($ in millions except per share)
Stock Equity Enterprise Current Interest Debt/ Debt/ Dividend
Price Market Market Gross EBITDA Net ROE ROA ROC Ratio Coverage Equity Capital Yield
Value Value Ratio
Company Current LTM NFY LTM NFY LTM LTM LTM NTM NTM NTM LTM LTM MRQ LTM LTM
Undervaluation On a 3-year EV/EBITDA basis, VLO has deviated below where it normally trades, relative to its peer group. With industry tailwinds of decreasing oil prices, increasing distillate international demand, and continued discounted crude feed stocks, we believe VLO is currently undervalued at its current multiple of 5.44X. Given our bullish outlook for VLO over the next twelve months, we expect 16% multiple expansion from 5.44X to the implied multiple of 6.31X.
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APPENDICES
VLO Capacity Dominance
VLO is the dominant independent refinery in its peer group, as well as in the GC region
Charges & Yields (2013, 2012, 2011)
VLO has been increasing the amount of sweet crude it has processed in the last 3 years by almost 10%. This has
resulting in higher yields. Our focus is on VLO‘s refineries in the GC, as they have reduced sour charges since 2011 and
doubled the amount of sweet crude charges, improving yields in both gasoline and distillates as a result.
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WTI – BRENT Historical Spread over 10 year period
VLO EV/EBITDA to S&P 500 Oil Refiner Index EV/EBITDA over 10 year period
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VLO Major Products & Services
Reformulated gasoline blend stock for oxygenate blending (RBOB)
Conventional gasoline
Premium grades of reformulated and conventional gasoline
California Air Resources Board (CARB) Phase III gasoline
Customized clean-burning gasoline blends
Clean-burning oxygenates
Low-sulfur gasoline
Low-sulfur diesel
Jet fuel Aviation gasoline
Kerosene
Home heating oil and stove oil
Asphalt Lube oils
Crude mineral spirits
Bunker oils
Propane
Octane
Alkylate
Naphtha
Raffinate
Reformate
Anhydrous ammonia
Ammonium thiosulfate
Benzene
Iso-octanes
Mixed xylene
Methyl tertiary butyl ether (MTBE)
Petroleum coke
Petroleum coke gasifier slag
Spent metal catalyst
Spent sulfidic caustic
Spent sulfuric acid
Sulfur
Toluene
Ethanol
VLO 3-Year Historical EV/EBITDA Benchmarked to S&P 500 Oil&Gas Refiner Index
VLO 5-Year Historical EV/EBITDA
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VLP
NEWEST UNITED STATES REFINERIES
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DISCLAIMER
This report is prepared strictly for educational purposes and should not be used as an actual investment guide.
The forward looking statements contained within are simply the author‘s opinions. The writer does not own any
Valero Energy Corporation stock.
TUIA STATEMENT
Established in honor of Professor William C. Dunkelberg, former Dean of the Fox School of Business, for his
tireless dedication to educating students in ―real-world‖ principles of economics and business, the William C.
Dunkelberg (WCD) Owl Fund will ensure that future generations of students have exposure to a challenging,
practical learning experience. Managed by Fox School of Business graduate and undergraduate students with
oversight from its Board of Directors, the WCD Owl Fund‘s goals are threefold:
Provide students with hands-on investment management experience
Enable students to work in a team-based setting in consultation with investment professionals.
Connect student participants with nationally recognized money managers and financial institutions
Earnings from the fund will be reinvested net of fund expenses, which are primarily trading and auditing costs
and partial scholarships for student participants.
