There has been a record number of dividend cuts during the ongoing coronavirus crisis, particularly in the energy sector, which is one of the most severely beaten sectors. A bright exception has been the group of U.S. refiners, which have defended its dividends so far. However, as Valero (VLO) is poised to post material losses this year, it is likely to cut its dividend, given also the uncertainty arising from the pandemic. On the other hand, the stock has been beaten to the extreme and thus it has collapsed at its 7-year lows. In this article, I will analyze why Valero has become a conviction buy around its current price.
The effect of the pandemic
The pandemic has caused an unprecedented collapse in the demand for refined products this year. According to the Energy Information Administration [EIA], the global demand for refined products is expected to slump by 8.3 million barrels per day on average this year, from 101.4 to 93.1 million barrels per day. This will mark the steepest decline in the global oil consumption in at least three decades.
In its last conference call, at the end of July, Valero stated that the demand for gasoline and diesel had recovered to 85%-90% of normal, after bottoming at 50% and 70%, respectively, in April. However, the demand for jet fuel remained 50% lower than normal. As a result, Valero planned to ran its refineries at an approximate 79% utilization rate in the third quarter. This is a daunting utilization rate, particularly for the third quarter, which is the strongest quarter for refiners in normal years.
It is also important to note that Valero generates the vast majority of its earnings from its refining business. In addition, most of its refineries are coastal and thus they lack the benefit of some inland refineries, which purchase a portion of their crude oil at a material discount to the price of WTI. To cut a long story short, Valero is fully exposed to the fierce downturn of the refining business, which has been caused by the coronavirus crisis.
In the second quarter, the throughput of the refineries of Valero plunged 22% while its refining margin slumped 58%. The double hit caused the company to switch from an adjusted profit of $1.60 per share in the prior year’s quarter to an adjusted loss of -$1.25 per share. On the bright side, as the second quarter was marked by unprecedented lockdowns, the refiner will improve its performance in the second half of the year.
On the other hand, Valero is poised to incur a material loss of -$2.66 per share in the full year. Moreover, while the economy has reopened, the fast propagation of the virus has slowed the pace of the recovery of the energy market and thus the analysts’ consensus for the annual losses per share of Valero has greatly deteriorated, from -$0.91 in late July to -$2.66 now.
Valero has a decent dividend growth record, as it has raised its dividend every year since the Great Recession. Due to its 57% plunge in less than a year, the stock is currently offering a nearly all-time high dividend yield of 8.9%.
Valero has repeatedly stated that it targets a long-term dividend payout ratio of 40%-50%. In its latest presentation, in September, management reaffirmed this target and stated that it remains committed to raising the dividend in the long run. This is certainly positive for the shareholders, who are afraid that a dividend cut may be just around the corner.
On the other hand, Valero is expected to lose -$2.66 per share this year and earn only $2.74 per share next year. If it meets the analysts’ consensus and keeps its annual dividend intact at $3.92, it will post a payout ratio of 143% next year, which will be extremely high. As a result, management is likely to cut the dividend in order to preserve funds amid the unprecedented downturn in its business, particularly if the recovery from the pandemic stalls or proceeds at a slower pace than currently anticipated.
Why Valero has become a conviction buy
The coronavirus crisis has severely affected the energy market this year but it will not condemn the energy market to a permanent recession. There are numerous vaccine studies under way, with the most promising results coming from Moderna (MRNA), Johnson & Johnson (JNJ), AstraZeneca (AZN) and Pfizer (PFE). These companies have identified vaccines that block the coronavirus, though they still have to prove that their vaccines are adequately effective and safe on a large scale of volunteers (30,000-60,000). A vaccine is widely expected to be developed until early next year and distributed worldwide in about a year.
As soon as a vaccine is widely distributed, the pandemic will subside and the demand for refined products will recover. The Energy Information Administration agrees on this view, as it expects the global demand for oil products to rebound by 6.3 million barrels per day next year and thus retrieve most of its losses caused by the pandemic this year.
Analysts also agree on this view, as they expect Valero to report earnings per share of $6.15 in 2022, the first full year in which the pandemic is expected to play a minor role in the economy. Valero has traded at an average price-to-earnings ratio of 10.5 over the last decade. When the refiner recovers from the pandemic, it can be reasonably expected to trade around its historical valuation level. If this materializes, Valero will trade around $65 (=10.5 * 6.15) by 2022 for a 48% profit off its current stock price, without including its dividends.
The stock becomes even more compelling if one adopts a longer investing horizon. In five years from now, the pandemic is likely to be negligible for the global economy and the energy market. It is thus reasonable to expect Valero to return to its pre-COVID level of $100 over the next five years. If this proves correct, the stock will more than double over the next five years, for an approximate 18% average annual return (excluding the dividends). Overall, patient investors who have the courage to buy Valero amid the uniquely adverse business conditions prevailing right now are likely to be highly rewarded in the long run.
It is also worth noting that Valero has a healthy balance sheet and hence it can endure the ongoing downturn even if the latter lasts longer than currently expected. Its interest expense consumes only 23% of its operating profit while its net debt (as per Buffett, net debt = total liabilities – cash – receivables) stands at $22.0 billion. As this amount is just 9 times the earnings of Valero in 2019, it is certainly manageable, particularly given that the company had more than $8.0 billion of liquidity at the end of the second quarter and recently issued $2.5 billion of bonds.
Moreover, Valero has some significant competitive advantages when compared to its peers. First of all, it has among the most complex refineries in the world. Thanks to their complexity, its refineries take full advantage of the fluctuations of the prices of refined products and various types of crude oil and thus enhance their profits. In every downturn of the refining business, the least complex refineries are the least resilient ones and hence they are the ones that go out of business. Valero also has the lowest operating cost per barrel in its peer group. This is another competitive advantage in the current downturn, as it renders the refineries of Valero more resilient.
Just like the entire energy sector, the refining business is highly cyclical. Therefore, the best time to buy a refiner is during a downturn. The ongoing downturn, which has been caused by the pandemic, has led Valero to collapse to its 7-year lows. Thanks to its solid long-term fundamentals and a healthy balance sheet, Valero will easily endure the downturn and will highly reward investors off its current depressed price.
The only qualification investors need in order to make a huge profit from Valero is patience. Unfortunately, this is much easier said than done. Patience requires great confidence in the investing thesis and checking out the stock price very rarely. The latter is nearly impossible for most investors. Moreover, due to the cyclical nature of Valero, this is not a buy-and-hold forever stock. As soon as it approaches our aforementioned price targets (2-year target of $65, 5-year target of $100), investors should take their profits and look elsewhere for attractive returns.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.