Refiners Still Look Like Good Bets

09/10/2007 12:00 am EST

Focus: STOCKS

Ken Kam

CEO, Marketocracy, Inc.

Ken Kam, editor-in-chief of Marketocracy Data Services, says that refiners are among Marketocracy’s top investors’ best ideas because the fundamentals are strong and valuations are cheap.

Profit margins in the refining industry grew last quarter as economic growth continues to strain refining capacity. Refining margins are hitting all-time highs.

Valero’s (NYSE: VLO) earnings for the second quarter were $3.89 per share. That means they are currently trading at a run-rate price/earnings ratio of about four times. Tesoro (NYSE: TSO) trades at a similar multiple, having earned $3.17 per share in the latest quarter.

Even when the refining industry was plagued with 25% excess capacity, these companies traded at a P/E of 4x. Now that there is a shortage of refining capacity, these shares should command a higher multiple.

The P/E of the Standard & Poor’s 500 index is about 16x. I think prospects for both Valero and Tesoro are on a much firmer footing than that of the average S&P 500 company. I don’t think either of these companies should trade at such a steep discount.

To justify the current prices, Wall Street assumes that today’s high refining profits will not last long. The conclusion is based on the generally sound premise that industries that produce high profits will attract competition that eventually brings profit levels down.

In this case, however, new competitors are not entering the industry because government—at all levels—has made it virtually impossible to build a new refinery. Without new competitors, refining margins are likely to stay high as long as we don’t have a recession.

The gauntlet of government hurdles necessary to build a new refinery is so difficult that I think anyone considering it would at the same time consider buying either Valero or Tesoro.

Here’s why: a P/E of 4x means that there is one dollar of earnings for each $4.00 of stock price. If I paid the current market price for all of the outstanding shares I could use the earnings to pay myself an annual dividend equal to 25% of my purchase price.

The best part is that I could borrow the money I need to pay the existing shareholders and use the company’s own earnings to pay the interest and the interest would even be tax-deductible.

At the end of the transaction, I would be certain to be one of the biggest players in the refining business with multiple refineries. Or, I could run the government’s gauntlet and maybe I could open my first refinery in a few years.

This is an easy choice. I would even be willing to pay existing shareholders a premium over the current price to make sure the deal goes through. (Valero closed above $69 Friday, while Tesoro closed under $50—Editor.)

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