Valero Energy (VLO, Financial) is one of the few energy sector companies that has the ability to outperform in fiscal 2017 along with providing increased shareholder returns. With oil prices expected to trend higher, I believe Valero could be a good value pick.
Company overview
Valero, through its subsidiaries, is an international manufacturer and marketer of transportation fuels, petrochemical products and power. The company has 15 refineries with 3 million barrels per day (BPD) of capacity. More than 70% of its capacity is located in strategically advantaged locations on the Gulf Coast and mid-continent U.S. The company also has majority of its ownership in Valero Energy Partners LP (VLP, Financial), which is a 100% fee-based master limited company. This allows Valero the advantage of dropping down significant inventory to Energy Partners. In addition to being an independent refiner, Valero is also one of the largest producers of ethanol in North America.
Strong presence in advantageous locations
Out of Valero's 70% capacity, more than 55% throughput capacity is located in the U.S. Gulf Coast. The location provides a competitive advantage over peers like Marathon Petroleum (MPC, Financial) and Phillips 66 (PSX, Financial) because it provides access to low-cost natural gas and foreign crudes along with a deep pool of skilled labor. With growing demand in Mexico and Latin America, the location further provides proximity to growing export markets. Thus, with strong geographical presence, Valero has access to some very rich assets, which in turn provides greater synergy with its clients.
Strong liquidity profile with balanced debt
Valero maintains a strong balance sheet with sustainable capital expenditures and disciplined capital allocation. As of Sept. 30, 2016, the company had total debt of $8.8 billion, of which $1.1 billion is payable within one year. For third-quarter 2016, the company had operating cash flow of $3.8 billion and cash and cash equivalents of $5.9 billion.
Even if Valero increases its capital expenditure to an estimated $2.7 billion for 2017 (from an estimated fiscal 2016 capital expenditure of $2.4 billion) and operating cash flow of $4.7 billion remains the same, cash flow from operating activities would be enough for the company to meet its capital expenditure requirements and debt repayment of $1.1 billion in fiscal 2017.
Further, cash and cash equivalents of $5.9 billion as of September 2016 and a revolving credit facility of $3 billion gives additional liquidity of $8.9 billion. Historically, the company has demonstrated disciplined capital allocation and with a target of about 75% payout of its adjusted net income, I believe investors can expect an increase in its shareholder return in 2017.
A dividend stock
Valero is currently trading at a dividend yield of 3.8% with a dividend payout of $840 million for the first nine months of 2016, as compared to $608 million for the same period in 2015. This increase in dividend yield is attributed to a steeper rise in the company’s dividends compared to its rise in price. Compared with its peers, Valero's dividend yield looks relatively attractive. Marathon Petroleum offers a dividend yield of 2.9% and Phillips 66 currently has a dividend yield of 2.97%.
Attractive valuation
Valero has a market cap of $30 billion. In comparison, Marathon Petroleum has a market cap of $26 billion and Phillips 66 has a market cap of $43 billion. In terms of EV/EBITDA, Valero Energy is currently trading at 5.9, well below its peers (Phillips 66’s EV/EBITDA is 16.3 and Marathon Petroleum's EV/EBITDA is 8.1). In terms of price-earnings (P/E) ratio, Valero Energy is trading at a P/E of 10.7 against Marathon Petroleum’s P/E of 13.4 and Phillips 66's P/E of 14.5. Both parameters suggest gross undervaluation for Valero Energy.
Conclusion
Valero Energy has the potential to outperform in the medium to long term based on its strategic asset location in the U.S. Gulf Coast and mid-continent along with a strong balance sheet. Considering a high 12-month return on equity of 11% and increasing dividends, I am of the opinion that Valero Energy could be considered an undervalued dividend stock.
Disclosure: No position in the stock discussed.
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