Adding to Conviction Buy List—Margin level, not direction, the key
Goldman Sachs' Rating/Coverage View is Buy/Attractive
May 21, 2007
Source of opportunity
We are adding the shares of Valero Energy to the America Conviction Buy List, with 22% upside to a $90, 12-month target price. We continue to believe the Street is woefully underestimating the earnings power of Valero and other refiners over the next several years, with our EPS estimates 22%, 46%, and 56% above the First Call consensus average for 2H 2007, 2008, and 2009, respectively. Importantly, we believe our current $10/bbl Gulf Coast 3:2:1 (WTI) benchmark refining margin assumption is likely to prove conservative, given resilient oil demand, increased “unplanned” downtime, and delays in major new Middle East projects.
Catalyst
The most important catalyst for Valero is a renewed cycle of major upward EPS revisions by the Street, the primary driver of which is refining margin strength. In our view, the benchmark margin needs to only stay at $10/bbl or higher in order for positive revisions to continue. Valero has the potential to further boost EPS through additional stock buyback, disciplined organic investments, and select acquisitions.
Valuation
Valero trades at a 2008E P/E of just 7.0X, which is at the low end of its 6X-12X forward P/E band since 2004 (i.e., a period of high refining margins). Our $90, 12-month target price corresponds to a 2008E P/E of just 8.7X. In terms of a sensitivity analysis, if we instead assumed a $15/bbl GC 3:2:1 margin, Valero’s 2008E EPS would be over $15/share and its P/E under 5X.
Key risks
The key risk is a decline in refining margins to under $10//bbl. Refining margins are inherently volatile, a fact not lost on most investors. In contrast to Street fears, we observe that Valero’s shares have not historically fallen much during periods that temporary spikes dissipated, so long as confidence in the underlying cycle existed. |
