Is it really different this time?
One of the knocks on Valero
After Monday's announcement of its proposed $8 billion acquisition of Premcor
Before we talk about the wisdom of this deal, the cost, and what it means to shareholders of both companies, let's stop for a moment and admire what Valero's management, headed by CEO William Greehey, has wrought. In the early 1980s, Valero was little more than an also-ran pipeline company when it bought a single Texas oil refinery. With the prospective close of this deal, Valero will have increased its number of refineries from that one in 1997 to 19. The most transforming transaction may have been Valero's 2001 takeover of Ultramar Diamond Shamrock, which not only nearly doubled the size of the company but also gave it a 5,000-outlet retail presence.
Valero's history is one of contrarianism. Refining has often been considered the least economically attractive link in the process from oil exploration to end use. And truth be told, over much of the past 30 years, refining has delivered extremely low returns on investment for shareholders. In fact, many companies closed marginal refiners since demand was low and keeping them operational was extremely expensive. As other companies were closing or otherwise disposing of refineries, Valero expanded. What's more, Valero made the extremely capital-intensive decision to convert many of its refineries to be able to handle sour crude, which sells at a discount to the sweet crude prices.
It's easy to look back now and say that it was an obviously good decision to concentrate on being a big, low-cost refiner. But at the time, it was counterintuitive. No one wanted to be in the refining business. Valero strode in and bought and converted where it could, and it took on a healthy slug of debt in the process, thus putting its longer-term financial health on the line. It turns out that Valero didn't have to wait long: With capacity decreasing and demand increasing, very soon the company was spitting out cash almost as fast as it was making distilled petroleum products. When demand puts pressure on supply, and the supply really cannot grow, the result is higher prices.
It was this whole dynamic that enticed me to Ultramar Diamond Shamrock, then to recommend Valero in the September 2002 edition of Motley Fool Select at $17.15, and then again to recommend it for the inaugural issue of Motley Fool Hidden Gems at $18.93, both selections of which have been three-baggers. Refining supply in the United States cannot grow, and Valero's assets were priced well below (theoretical) replacement value. That's the kind of cushion an investor dreams about regarding a money-making business.
Given Valero's managerial brilliance in building a refining powerhouse, who is possibly going to question its takeover of Premcor now? Well, I am, for one.
The Premcor deal makes perfect operational sense. Valero picks up refining capacity on the East Coast and access to the Midwest and even potentially Canada -- markets where it currently has a lower level of exposure. The company will be able to wring plenty of operational savings from the consolidation. But there was one thing present in every single one of the Valero acquisitions to date that does not exist with Premcor: a discount.
Valero is paying as much as a 75% replacement value for Premcor's refining capacity. This makes sense: When Valero bought UDS, Huntway, and its other facilities, it was buying them during a time when refining was a hated part of the supply chain. It bought from distressed sellers, or from companies that simply wanted to be out of the business, and it bought cheap, as low as $0.20 on the dollar. Not so this time. Where Valero got UDS's 850 million bpd capacity as well as its huge retail network for $6 billion, this time around the price is 33% higher while Premcor has less capacity. Not all capacity is created equal, yet it should be clear that the price paid this time around is much, much higher.
Yet some investors are pointing to management's statement that the merger will be immediately accretive to earnings. This is true, but it almost can't help being so, since so much of the offering isn't in the form of new equity, but rather in cash (for which Valero will take on more debt), as well as the assumption of Premcor's net debt. Valero is levering up in a big way, and while debt is cheaper than equity, it must be serviced annually. That means that Valero can ill afford for refining margins to drop.
All of the big credit rating agencies -- Fitch, Standard & Poor's, and Moody's
Many analysts believe that we're actually nearing the top of the refining cycle. Of course, very few of these analysts were of much use in picking the bottom of the selfsame cycle. But as legendary investor Jeremy Grantham recently noted, "We should be extra careful, as oil could burn us badly either way." The top refining executive at Exxon, Edward Galante, remarked in a February speech that he wasn't convinced that the big refining margins would last. High oil prices are actually a negative for Valero and the refiners, which must purchase raw oil. If crude spikes and depresses demand, the assumptions made surrounding the Premcor acquisition may have been optimistic.
I really like Valero, and I admire what its management has done. Like the front office of a champion sports franchise, it has earned the benefit of the doubt. But this transaction, at this price, with this level of debt, has definitely stoked that doubt in my mind. Ignoring such, in my past experience, has almost always proved foolhardy.
For more of our historical coverage on Valero, see also:
- Bill Mann's "You Don't Know the Future"
- Chris Mallon's "The Best Oil Stock You Don't Own"
- Bill Mann's "In Search of Cheap Oil"
Bill owns none of the companies mentioned in this article.