Is Valero Energy Corporation a Buy?

Valero  (NYSE: VLO  ) is one of the biggest U.S. refiners, but it is not the highest-yielding company. Refiners are known for their low margins, high volumes, and steady dividend payments. Even though Valero's dividend could improve, it is still a promising long-term investment. 

Business fundamentals
Big companies get a bad rap for being slow movers and lacking innovation. Yet the refinery business is a capital intensive, long-term game where size can work in a company's favor. Valero owns prime real estate along the U.S. Gulf Coast with throughput of 1.605 million barrels per day (mmbpd). This gives it great access to imported crudes and export markets for refined products. 

It is true that it took a while for Valero to respond to the North American oil boom, but now it is putting its capex budget to good use. From Q1 2013 to Q1 2014, its Quebec refinery's feedstock went from 0% North American crude to almost 50% North American crude. It has put a big portion of its capital into improving its midstream access, and it expects its Gulf Coast region will have 140 mbpd of rail offloading capacity by Q1 2015.

Marathon Petroleum  (NYSE: MPC  ) is smaller than Valero, with a bigger focus on the Eastern Midwest. Its entire throughput of 1.714 mmbpd is slightly more than Valero's Gulf Coast capacity.

In 2014 and 2015, Marathon Petroleum expects to put around $1 billion into pipelines and other midstream assets to get better access to discounted crudes. It has a big focus on Canadian and Bakken crudes. Its $250 million Southern Access Extension should come online in Q2 2015 to reduce bottlenecks from Enbridge's mainline.

Tesoro (NYSE: TSO  ) and HollyFrontier (NYSE: HFC  ) are two smaller competitors with very different businesses. Tesoro's homeland is on the West Coast. It is still working on a number of midstream upgrades to decrease its use of expensive foreign crudes and Alaskan North Slope in its West Coast refineries. It hopes that by 2015, cheaper North American crudes will be 38% of its West Coast feedstock.

HollyFrontier, on the other hand, is a pure play on Midwest production. Its refineries are small and located close to producing areas. Its location has given it fat earnings in recent years. In the past four quarters, its feedstock cost was on average $3 to $5 below WTI.

Valuation
The oil markets move in boom bust cycles. Recessions cut demand for refined products and crush refiners' margins. For this reason, it is very important to value refiners based on their average P/E ratios, not just recent numbers.

VLO PE 10 Chart

VLO P/E 10 data by YCharts.

The above chart shows how Valero's 10-year average P/E ratio is actually below its historical average. The recent U.S. oil boom has sent Valero's income soaring and given its export business new life, but in terms of valuation, the company is not too expensive.

  Valero Marathon HollyFrontier Tesoro
Dividend Yield (Dividend per Share / Stock Price) (%) 1.8 1.9 2.6 1.8
Payout Ratio (Dividend per Share / EPS) (%) 19 37 44* 34

*Excludes special dividends.

Valero's dividend yield is comparable to those of fellow large refineries, but it is far below HollyFrontier's. Yet raw dividend yields do not tell the whole story. HollyFrontier pushes a huge portion of its income into its dividend, while Valero is conservative with a payout ratio of 19%.

Risks
One of the biggest challenges with refiners is the industry's exposure to economic cycles. The P/E 10 chart above shows how it is completely normal for Valero's stock to collapse when the economic cycle compresses margins. Given the industry's cyclical nature, dividend payout ratios are very important. Valero's low payout ratio shows that even in the event of a downturn, it is in a good position to maintain its dividend payments. 

In the modern world of low oil demand growth in developing nations, increasing demand for refined products is more likely to come from developing nations. Valero is one of the best long-term plays on developing nations because of its Gulf Coast access, but it also means China's growing refinery industry may become a formidable competitor.

Valero holds promise
Valero's valuation is reasonable, its dividend is backed by earnings, and it continues to put money into profitable organic investments. Valero is not as nimble as Tesoro or HollyFrontier, but it offers world-class export capacity in an industry growing thanks to emerging markets.


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