My beginning-of-the-year thesis on Valero (NYSE: VLO), the second-largest U.S. refiner after ExxonMobil (NYSE: XOM), continues to play out. After posting a narrower loss in the first quarter, the U.S. independent refiner delivered second-quarter profits, enabling investors to breathe a sigh of relief.
Income for continuing operations totaled $530 million, or $0.93 per share. In the second quarter of 2009, the company lost $0.39 from continuing operations. Meanwhile, the recent quarter's operating income, or EBIT, came in at $921 million, versus a $192 million loss in the year-ago period.
Driving that zippy bottom-line performance were such catalysts as higher margins on refined products and deeper discounts on lower-quality crude inputs. However, management reported that the strength of these tailwinds has already waned somewhat. Similarly, integrated giant BP (NYSE: BP) cautioned in its Q2 release that it's expecting the "usual seasonal decline in refining margins" in the current third quarter, which follows the June-ish peak in U.S. gasoline demand.
And the thing is, this year's peak wasn't even that impressive. From May through June 11, U.S. weekly gasoline demand was below the five-year average. As for the current four-week average-demand number, it's only a shade above last year's figure. Rather than a sharp economic recovery, that's indicative of a slowdown in consumer activity.
In the company press release, CEO Bill Klesse remarked, "Valero makes and sells fuels, so we need consumers to get back to work and the economy to grow faster." At the same time, the company highlighted its historically low price-to-book ratio (currently 0.67) in a June investor presentation. Two thoughts here. First, when in an earnings release management essentially admits that it's hostage to a punk economy, then shares probably deserve to be bouncing along the valuation lows.
Second -- and I've argued this before -- what good is book value? Take the case of Valero's Delaware City refinery, which in a recent sale fetched a mere $220 million. Prior to the transaction, Valero had written down the book value of Delaware City by a whopping $1.4 billion.
Similar writedowns could be in the offing. Valero is exploring "strategic alternatives" for its Paulsboro operation, and the currently shuttered Aruba refinery will be reopened only "if conditions are profitable." Notably, the company's most recent 10-K warns that "the likelihood of a potential sale could result in a significant writedown of these assets." In other words, investors who are chasing book value could be in for a dose of vertigo.
Ultimately, Valero's story so far this year is one of sequential and year-over-year improvement, overshadowed by a dubious longer-term outlook. Shares, which are roughly flat on the year, could double, but only if we get a picture-perfect U.S. recovery, combined with further reduction of spare refining capacity.
In my view, investors would fare better wagering on a global economic recovery. Accordingly, I'd look to cyclical industries outside the refining sector, where DuPont (NYSE: DD), Eaton (NYSE: ETN), and Cummins (NYSE: CMI), for instance, have all reported increased demand. Because of international exposure, investors can at least give these names the benefit of doubt -- something Valero may never be able to earn.
