Since Valero has large refining capacity in the U.S, the increasing demand for petroleum products in the U.S. will provide Valero with an opportunity to increase its revenues and improve its overall financial condition
Valero's balance sheet has a nice-sized cash cushion of over $1.4 billion. The debt they carry though, amounts to over $6 billion. Still, with the annual revenue run rate of over $130 billion, they have an EBITDA number on a trailing twelve month basis of over $6.64 billion. If they wanted to, they could probably pay off the company's debt within one year - that's powerful. Certainly within two years, but then that's probably not the best use of funds for the Company. Share buybacks have happened here in significant size in years past, and we would expect that to continue. VLO pays a $0.60 dividend, and that could easily see an increase, as the payout ratio is currently at only 6.0%.
Valero has a cost advantage, thereby higher margins as compared to its competitors because unlike any of its rivals, approximately 70 percent of the crude oil processed by Valero is sour crude, which is cheaper than the sweet crude used by its competitors.
The good news is that crack spreads in the second quarter have increased from the first quarter of this year. Also, since Valero’s refineries can process the cheaper "heavy sour" crude oil, the company has a sustainable competitive advantage over other refiners, giving its refineries staying power through rough times like these. For very-long-term holders, this is when you buy stocks such as this one; since the weaker rivals often disappear (the rivals either eventually get shut down, get sold off - or both), and the strong players emerge as the victors.
The U.S. government expects crack spreads to improve moving forward, but those spreads remain well below where they were in last year’s second quarter. That’s good because it means there’s room for improvement - in both the margins and the share prices.
Another plus is that as oil prices have been dropping precipitously recently from the high of almost $150 per barrel, crack spreads have been increasing. And the drop in prices of natural gas, which is an input to Valero’s refining process, has also declined, further adding to margins.
In the refinery sector, that strong player - and eventual victor - is Valero. But we are not there yet, and the lack of expansion in refining capacity in the U.S. market over the past decade has established a definite floor under crack spreads, meaning there’s only so low they can go.
Refiners like VLO do not benefit from the huge spike in oil prices such as others in the energy sector. Gas prices don't correspond exactly to crude - when oil went from $70 to $140, gas did not go from $3 to $6. Flipped around, now that oil has been cut in more than half, refiners like VLO are seeing an increase in margins.
Valero's revenues have been surging lately. As you can imagine, just selling the same amount of energy product while the price soars nearly 100% will give you a revenue boost of 100%. But VLO has been unfortunately not making as much of a profit per barrel of oil as they did in 2007. The 2008 annual earnings estimates for VLO are averaging about $5.23 per share right now for the full year ending in December 2008, versus a 2007 full year figure of $8.17 per share. Try to get your head around the fact that VLO's revenues have surged over 42% in that time, and you'll fully understand the seriousness of the compression of the crack spread. VLO's operating environment in higher oil price conditions is just plain brutal. 2009's earnings estimates are currently posted at $6.03 per share, though revenues are expected to grow another 10%.
Given VLO's current valuation and earnings expectations, the market has basically denied them any potential benefit of either a respite from rising oil prices (which could happen) or a cessation in the compression of the crack spread. The second potential factor would immediately follow the first. The present value of VLO, given its earnings and revenues outlook under what is today arguably a "worst case" scenario has much downside risk to it. Quite the opposite - the price today represents a great value and high upside.