Why This Refiner Is Too Cheap to Ignore

Matthew is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

At a time when many companies seem to be hitting new highs on a daily basis, there are still some bargains to be found. After soaring for most of 2012 and the early part of this year, Valero (NYSE: VLO) has been on a steady decline since March. Now down more than 30% since that time, I think Valero may be one of the few great bargains left in this market, and the company has definitely landed itself back on my radar. Let’s take a closer look at this refiner, and see how it stacks up to the alternatives.

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A bit about Valero

Valero is one of the largest petroleum refiners in the world, operating 16 refineries in the U.S., Canada, U.K., and the Caribbean. The company also until recently had an extensive retail operation with about 6,800 branded stores, and still has a sizeable ethanol business, with 10 ethanol plants that combine for 1.1 billion gallons of total annual production capacity.

The company recently spun off its retail operations, which recently began to trade as CST Brands (NYSE: CST), and Valero investors received one CST share for every nine Valero shares they owned. If you look at the chart, this explains the sharp drop of around $3 at the beginning of May.

Now, Valero is purely a refiner and makes most of its money from its petroleum operations. In fact, the company lost money on its ethanol operations. Going forward, Valero should benefit from higher demand for distillates that should come from the improving economic conditions in the U.S., as well as increasing demand from emerging markets. The company’s leading position on the Gulf Coast should give it the best economies of scale, allowing for a very favorable cost structure.

The numbers

At the current share price, Valero trades for just 7.5 times this year’s expected earnings of $4.85. While growth is expected to be somewhat slow over the next few years, there is a great deal of uncertainty in regards to the level of demand and pricing in the industry, which is partially responsible for the depressed share price. The consensus of analysts who follow Valero calls for about 7% annual earnings growth going forward, but this is far from agreed upon. In 2015, for example, analyst estimates range from a low of $2.09 per share to a high of $8.87, an extremely wide range. Even if earnings simply meet expectations, Valero is trading at an incredible value. However, that is a big if, so let’s see what our other options are…

Alternatives: big and small

Tesoro (NYSE: TSO) is a very comparable refiner and marketer, and still maintains a retail operation in the middle and western U.S. Tesoro has seven refineries, all in the U.S., and derives the vast majority (92%) of its income from its refining business. Tesoro’s chart looks very similar to Valero’s, and the companies have similar-looking earnings estimates, with the main difference being the more narrow range for Tesoro. In 2015, as I referenced above for Valero, the estimate range for Tesoro only varies between $6.24 and $8.67. For this reason, Tesoro trades at 9.5 times this year’s projected earnings; still cheap but not as much of a discount as Valero.

Another way to go is with an oil giant such as Exxon Mobil (NYSE: XOM), which I love except for the fact that it seems to keep going up and up. Just when I think Exxon’s rally is running out of steam, it seems to break through to new highs regularly, and is now trading very close to its peak during the 2008 oil bubble. Unlike the other two companies mentioned, Exxon only makes 28% of its money from its refining and marketing operations, with the majority (64%) coming from exploration and production operations. 

Despite the ever-rising share price, Exxon still seems somewhat cheap, at just 11.9 times this year’s expected earnings. Exxon also has an extremely strong balance sheet, which features more cash than debts. The company has one of the best track records of any in the market when it comes to creating shareholder value, and back in March I wrote an article detailing the merits of Exxon as a long-term investment.

Final thoughts…

While the profitability of Valero is highly dependent on the demand for their products and their materials costs, I still think that the risk/reward here is well worth it. I am very bullish on oil in general over the next few years, and one interesting statistic that I keep reading is how world energy demand is projected to increase five-fold over the next four decades. As the total supply of oil continues to decline and global demand gradually continues to rise, it should translate to profits for companies like Valero.

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Matthew Frankel owns shares of ExxonMobil. The Motley Fool owns shares of CST Brands. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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