Description

Valero (VLO) $37.08

Main Points:
„h US refining assets to increase in value over time as regulation, environmental issues and significant capital requirements constrain capacity.
„h VLO will become the largest US refiner once its acquisition of UDS is completed in Q4. Its 2 million bpd capacity represents 12% of US refining market.
„h Through UDS, VLO gains significant marketing operations (gas stations), thereby stabilizing earnings though the cycle (thus becoming ¡§acceptable¡¨ to Wall Street).
„h At that point VLO will most likely be included in the S&P500, replacing Tosco (TOS) which was acquired by Phillips (P).
„h Current market cap is $2.2bln, only 4.4x 2001 earnings.
„h Pro-forma VLO/UDS market cap is 3.9bln, which represents a valuation of 4.7x ¡§normalized¡¨ earnings and 3.9x ¡§normalized¡¨ free cash flow.

Description

When Valero completes its acquisition of UDS in Q4, it will become the largest refiner in the United States. Although refining oil is not a sexy business it is VITAL to the normal functioning of the US economy and way of life. If you paid any attention to our ¡§energy crisis¡¨, you know that the US refining infrastructure has been operating very close to capacity for the past year, subjecting the system to the risk of unforeseen outages and consequently excess profits for the remaining refiners. No new, large refineries have been built since the early 1980¡¦s and since then the number of operating refineries has been cut in half. In this environment VLO finds itself owning extremely valuable assets as long as demand continues its 2% secular growth.

The earnings power of these assets was clearly shown in Q2 when VLO (without UDS) earned $4.23 per share. What was also clearly demonstrated is that Wall Street does not predict or appreciate these earnings. During the conference call that pre-announced that VLO would earn over $4.00 in the quarter, CEO Bill Greehey actually said: ¡§I am curious to go see the estimates tomorrow, because I know you guys won¡¦t believe me.¡¨ Sure enough, after the pre-announcement, estimates slowly increased from the $1.50 level to the $3.00 level!

VLO (with UDS) will operate 14 refineries with a throughput capacity of 2 million barrels/day (bpd), representing 12.5% of US refining capacity. The combined companies will have annual revenues of $30 billion (good enough to be #50 in the Fortune 1000). VLO will have a dominant position in the West Coast, where it will have a 20% market share. VLO¡¦s capacity will be fairly evenly distributed between the West Coast, Gulf Coast and East Coast. Through UDS, VLO will add over 4,300 retail marketing outlets throughout the South West US to its 350 existing California locations. This will make VLO the 4th largest operator in the US, with #1 positions in Texas, Oklahoma, Colorado and New Mexico. Acquiring this marketing presence was important to VLO as marketing provides stability, its revenues being inversely correlated to the core refining business. I don¡¦t think that Bill Greehey feels a particular need for this stability (he is comfortable with the large but lumpy cash flows) but he does want to address his company¡¦s low valuation and stabilizing the earnings is one way he can do it.

Compared to other independent refiners, Valero is strategically positioned to take advantage of the combination of 2 important realities/trends in today¡¦s refining environment: On the one hand environmental regulations are requiring gasoline with reduced sulfur content. On the other hand, an increasing portion of world¡¦s crude supply is sour (higher sulfur) rather than sweet (lower sulfur). (As I understand it) To produce the reformulated gasoline required by the regulations, refiners can either invest (heavily) in desulfurization plants, or use sweeter crude. Thus demand for sweeter crude is growing while the supply of sour crude is growing (relative to sweet). As a result, sour crude is becoming available at a growing discount to sweet crude. VLO has undertaken the capital projects required to be able to use sour crudes and indeed 75% of VLO¡¦s ¡§slate¡¨ is sour.

Over the last 5 years (1996-2000) the ¡§sour crude discount to WTI¡¨ has averaged $2.64. In 2000, the discount widened to $3.53. In the tight 2001 market it jumped to $4.90. Interestingly, one of VLO¡¦s arguments against Californian antitrust concerns is based on the use of sour crudes. VLO argues that given its new scale in California, its now economical to charter Very Large Crude Carriers from the Arabian Gulf to supply the west coast refineries. Traditionally these refineries have been supplied with Alaskan North Slope (ANS) crude. Thus VLO will be able to reduce costs by importing cheaper, sour crude. Additionally, the reduced demand for ANS will lower its price, and hence the costs for the other west coast refiners. Ultimately this will benefit the consumer.


Valuation

VLO is currently trading at $36.93 (after having been as low as $32.00 only 4 days ago!) At this price VLO is trading at 4.6x 2001 EPS. On a pro forma basis, after accounting for the shares they will issue to purchase UDS, VLO has a market cap of $3.9 billion. This equates to 4.7x and 3.9x ¡§normalized¡¨ earnings and free cash flow, respectively. VLO calculates normalized earnings by taking the average refining margins of the past 5 years (1996-2000) and passing it through their 2 million bpd system. Normalized may actually be understating the potential earnings as the calculation does not take into account the fact that the sour crude discount has widened so sharply in the 2000 and 2001 (particularly).

VLO will take on $2 billion in debt to fund half of the UDS acquisition. Pro forma EV will be $8.6 billion. Normalized annual cash flow is expected to be $1.6 billion. Expected annual capital requirements for maintenance, environmental, turnarounds and dividends of $535 million per year result in free cash flow of $1.1 billion, or $10 per share. VLO¡¦s plans to use this cash flow to pay down debt, make acquisitions in the marketing and midstream sectors, and to repurchase shares.

On top of this, UDS recently spun out its Gulf Coast pipelines and terminals business in the form of Shamrock Logistics LP (UDL-$34.15) and retained a 76% ownership. UDS¡¦s stake has a market value of $498 million. UDL not only reduces the implicit valuation the market is assigning to VLO¡¦s refining assets, but it also provides VLO with a growth vehicle to use for expansion into the mid-stream oil sector.

On June 30th VLO¡¦s book value per share was $32. Q3 earnings will bring this number up by at least $1. Buying scarce, not replaceable and vital assets at 1.1x book seems like a reasonable idea. The fact that these assets have the ability to generate a cash payback in 4 years (and are not located in an emerging market) makes the idea that much more reasonable.

Catalyst

„h VLO will become a ¡§must own¡¨ stock for large institutional portfolios once the UDS merger is completed.
„h Probable inclusion in S&P500.
„h Seasonality. Perhaps investors will begin looking at energy stocks as we approach winter. At least they might stop shorting them.
„h Share repurchases. VLO announced that now that shareholders have approved the UDS merger, VLO will reactivate its $100 million share repurchase program.
„h Merger arbitrage short sellers will soon be out of the way.
„h If all else fails, $10 per share in free cash flow might help.