Valero Beat Continues Momentum for Industry

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

Valero (NYSE: VLO) beat estimates and everyone should be sufficiently happy about it. The circumstances that created the positive news for Valero are useful to look into for industry guidance and to help us analyze direct peers and other oil firms, and for great business practices and strategic decisions that you can look for with other companies. Everyone is watching Valero to look for broader lessons, better understand the industry, and find a stock that benefits from the same circumstances that is flying under the radar. I did not find that hidden gem, because the entire sector is on fire, but there are still some solid companies to invest in for a longer outlook on cheap crude and expensive gas.

Valero Assaults the Estimates

Valero beat by so much it makes you wonder about estimates in general. Netflix and VMware are just the most recent extreme moves that are "surprises," and those massive movements are becoming a regular occurrence. Instead of exuding infallible confidence, exude confidence with discussion about the unknowns. Valero's beat was not force majeure, or an act of god--it was great revenues, around $34 billion versus an estimate of around $31 billion, and margins that were 20% higher than expected.

All the numbers are great for investment purposes, but boring over all--the why is much cooler. Valero was helped by North American oil from places like North Dakota and Canada. If you are not familiar with the boom going in North Dakota it is well worth reading about. The crude coming from the Midwest is cheaper than some other sources. Valero used this cheaper crude to push down costs. It also imported crude from Canada that requires some special equipment, but is also cheaper once the investment is made.

Valero has every intention of continuing to use the cheaper crude. It has the benefit of having refining operations close to that area. Rail and barges will help transport the oil in addition to existing pipelines. Ethanol margins were terrible and actually offset the fantastic margins that Valero posted. Think about that--ethanol actually lowered overall margins, but margins were 20% higher than expected. The price of corn was the cause of eroding margins. Revenue surprises will probably be harder, since estimates will take the new information into account. If Valero pulls back some it might be worth a buy into the next earnings announcement.

What is in Store for the Peers?

Valero has national operations, and refineries that are not in the Midwest or Gulf area are not able to get the benefit of cheap oil. Perhaps a smaller company with more local operations will be better. Having the refineries within shouting distance of the cheap crude would help margins. I bet local crude tastes better too, just like local vegetables if you are from a good growing area.

HollyFrontier (NYSE: HFC) has five refiners in the Midwest and Rockies. The map of operations reveals that each refinery has access to crude via pipelines, rail, and road if need be. That means that there does not need to be a lot of work done to ease the logistics. By truck is probably the least efficient way to move crude, after mules.

The balance sheet looks healthy, like Valero's, with over $2 billion in cash and a low debt-to-equity ratio of 0.2117. Net income for the trailing twelve months is $1.6 billion, off around $19 billion in revenue ttm. Comparing Valero's $2 billion net income ttm to its $134 million revenue ttm would suggest that HFC has been enjoying larger margins, 11.5% net, for a while. HFC seems to have been doing better and a significant margin surprise might not occur.

It could be worth a shot to buy the stock into earnings. You could also try to find some cheap calls, but that is probably unlikely considering the focus on the sector now. Expectations of a rise probably demands a higher premium. Simply buying the stock would be the only realistic option. Valero was a "surprise," so you are at best making an assumption of the same event based on being in the same industry. I will say that refiners are expected to continue their rise, so that suggests going long is a solid decision, but assumptions are never guaranteed to hold true.

At a market cap of $10 billion, HFC is one of the smaller companies. Marathon Petroleum (NYSE: MPC), on the other hand, is a $25 billion company. Net margins are at 5.75%, and if HFC is a guide there is some room for improvement there. Marathon is another company that has already been seeing benefits from the cheaper crude. If you peruse the internet some, yes peruse, you will see that both HFC and MPC have been cited as benefiting from the cheaper crude. MPC is up 98% in the last year, maybe more once this article appears. These companies are benefiting from a positive macro environment that is likely to continue, but upside might be limited since it has already risen so much.

MPC's operations are more easterly than HFC's, but are still located appropriately to benefit from Canadian and Midwest crude. Marathon reported solid earnings as I write this last paragraph, but I am more interested in the long-term trajectory of the company, which is governed by the macro environment. MPC is a lot bigger than HFC, and for that reason I would go for HFC. Expansion is the key, and HFC has the room to grow. I think that on a percentage basis HFC will see greater gains from expansion, and it has a PE of 6.5, which means there is no reason to wait for the price to subside after a Valero-fueled lift all boats event. Look for HFC to have a P/E of 9 with increasing earnings.

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