Valero Energy Corp. (NYSE:VLO) has seen a precipitous drop in its stock price this year, currently hovering just above its 52-week lows. Despite the dropoff, the company increased its already impressive dividend by 20% in the first quarter, where it currently sits at 4.6%. The dividend increase seems to suggest that Valero is bullish on its future and intent on following through on its guidance of returning 75% of its net income to investors this year.
Should you agree with this assessment?
The stock is cheap
Refining stocks took a beating in the first quarter of this year, as overall crack spreads, or profit margins from refining crude oil into petroleum products, dropped from their 2015 highs. Valero CEO Joe Gorder attributed the drop to a warmer-than-usual winter and a challenging market that refined at high levels. Valero's first-quarter refining operating income, which dropped to $695 million from $1.641 billion one year earlier, shows the impact of the reduced margins.
In part because of the lower margins and reduced operating income, Valero reported $15.7 billion in revenue and $495 million of net income during the first three months of 2016, down from $21.3 billion and $964 million respectively from one year earlier. That's a troubling decline and is a primary reason for its reduced stock price.
In fact, the decline has brought Valero's trailing-12-month price-to-earnings ratio all the way down to around 7x. Compared with some of its competitors, such as Marathon Petroleum (NYSE:MPC) and Phillips 66 (NYSE:PSX), which have P/E ratios of 9x and 11.5x, respectively, Valero appears remarkably cheap, even when considering the fact the company's return on equity over the past five years has lagged behind these two competitors.
On top of that, Valero's 4.6% dividend yield towers over Marathon Petroleum's 3.9% and Phillips 66's 3.2%. The company spent $547 million in the first quarter on dividends and share buybacks in an effort to return 75% of net income to investors this year. Valero has managed to maintain these hefty returns to shareholders while keeping its debt to capital ratio at 26% and cash on hand at $3.7 billion, giving it lots of room to maneuver should refining margins create further drops in income this year.
Margins should increase
Fortunately, this is where Valero appears bullish about its future. As Gorder puts it, "Here in the U.S., distillate inventories have shown favorable reductions recently, and the summer driving season is quickly approaching, which should support gasoline margins."
The U.S. Energy Information Agency agrees with that sentiment, claiming this summer's wholesale gasoline margins in the U.S. to be $0.47 per gallon, which is $0.07 higher than the average of the previous five summers. Additionally, the EIA expects overall motor gasoline consumption to rise an average of 120,000 barrels per day over last summer.
Valero is well positioned to benefit. The company's refineries averaged 2.9 million barrels per day of throughput volume in the first quarter, with an industry-leading $5.31 in total operating costs per barrel. While the throughput margin per barrel fell to $7.96 in the first quarter of 2016 compared with $12.39 in the same period of 2015, I would expect to see those margins recover as the crack spread and gas usage increases .
What about the Brexit?
The Brexit remains a tricky X-factor when analyzing oil and gas companies, even as it continues to pummel current stock prices. As far as Valero is concerned, I'm really not too concerned about long-term effects.
Valero owns and operates the Pembroke Refinery in Wales, which processes 270,000 barrels of sweet crude oil per day. While the current impact of the Brexit has been limited to a drop in price of Valero's stock, the long-term impact could be how it affects the export of its refined petroleum products to continental Europe. With the actual Brexit potentially two years away, this isn't an immediate concern and could ultimately depend on the negotiations and economic agreements that need to be hashed out between the U.K. and the EU.
Valero feels confident in its high dividend yield because of ample cash reserves and a bullish view of the future. The company should maintain its 2.9 million barrels per day of throughput volume and will profit from increased gas margins and usage for the remainder of 2016. Its stock appears undervalued and could be a great bargain play, particularly if the Brexit drives prices even lower.
David Lettis has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.