Valero: 5-Star Buy in Refining

11/23/2015 7:00 am EST


Weak prices in energy are a boon for refiners: they represent a big portion of the input costs that a refiner faces, explains Seth Glickman of S&P Capital IQ in Standard & Poor's The Outlook.

Our latest Focus stock is Valero Energy (VLO), which carries S&P Capital IQ's highest investment recommendation of 5-Stars, or strong buy.

As one of the leading oil and gas refining companies in our coverage universe, with above-average projected returns, strong exposure to the US Gulf Coast, and attractive valuation, we think VLO should outperform peers.

We also anticipate a slight boost to the Brent-WTI crude oil spread over the next 12 months, which should benefit VLO as that should widen margins and encourage more export growth for refined products.

VLO is a major independent refiner, turning that crude oil into refined products such as gasoline, diesel fuel, jet fuel, heating oil, and so on.

For 2015, we see EPS of $8.65, which compares with 2014 normalized EPS of $6.68 and reflects the sizable drop in input costs.

For 2016, however, we see a modest decline to $7.17 per share. As of early November 2015, the Brent-WTI spread had dwindled to about $2.60 per barrel.

However, using recent forecasts from Bentek Energy, we think this spread could widen to the $4.50 per barrel range in 2016, which, all else being equal, should be a tailwind for refining margins.

On a variety of comparisons vs. peers, we find VLO attractive. For 2016, we estimate return on invested capital of about 10.9%, above the peer median of 10.3%.

In addition, we think VLO is currently trading at a superior free cash flow yield (7.7%) than the peer median (5.6%).

Finally, even though VLO just recently hiked its quarterly dividend by 25%, to $0.50 per share from prior $0.40 per share, we think there is potential for further such hikes in the near-term. The most recent boost to the dividend, announced in October, was the fourth such increase in the last eight quarters.

On valuation, VLO is trading at a 7.0X multiple of projected 2016 operating cash flow, below the peer median of 7.5X.

We think VLO merits a slight premium rather than a slight discount to peers. Our 12-month target price is $82, which suggests about a 17% projected gain (including the 2.8% yield).

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