Valero Energy (OP/A): Remains a top US R&M pick, but risk/reward for refiners overall becoming less attractive relative to other oil equities - Goldman Sachs - January 31, 2006
We continue to have a favorable 2006 refining outlook, especially given more stringent environmental specification on refined products this year in an already tight supply-demand balance. However, with R&Ms trading 7% above our "traditional" peak values, we believe relative risk/reward is increasingly favoring E&P and integrated oil equities. By way of comparison, we see 15%-20% upside to traditional peak values for other oil equities. With that said, given our bullish refining margin outlook near- term, we believe R&Ms can trade toward our "super-spike" adjusted peak values, which would imply 31% upside on average. Valero remains our top US R&M pick given its track-record of execution, high conversion capacity, and inexpensive relative valuation. We see 33% upside to a $61 super-spike adjusted peak value for VLO and it remains Outperform rated relative to an Attractive coverage view.
US R&Ms CURRENTLY TRADING AT VALUATION MULTIPLES SIMILAR TO SUPER-CAP OILS We estimate US R&Ms currently trade at 5.9X 2006E and 5.3X 2007E EV/DACF (enterprise value to debt-adjusted cash flow), which compares to the super-cap integrated oil companies' average of 6.1X 2006E and 5.6X 2007E. In our view, the seeming deterioration in company fundamentals at several major oil companies following poor reserve replacement data, negative reserve revisions, and large acquisitions, with the fact that US refiners captured more of the economic rent in the current upcycle have led to R&M valuations being rated-up relative to the super-cap integrated oils. We believe this is unlikely to persist indefinitely given super-cap oils' business models that are geared toward generating robust returns over the long-run. With the super-cap oils showing +9%/+35%/+77% upside to traditional mid-cycle/traditional peak/super-spike adjusted peak values, large-cap E&Ps and integrateds showing -19%/+9%/+41%, and R&Ms showing -31%/-7%/+31%, respectively, we believe relative risk reward is becoming less favorable for the US R&Ms overall. See Exhibit 1 for risk/reward and valuation comparison.
Our continued Attractive coverage view of the US R&Ms stems from our bullish near-term refining outlook and our view that refiners can trade through our "traditional" peak valuations and toward our super-spike-adjusted peak values. Given various new EPA rules for 2006--such as the third phase of Tier 2 gasoline, ultra-low sulfur diesel, and ethanol mandate--we believe refined product supply-demand will remain tight and refining margins high over the foreseeable future.
Among the US refiners, we believe Valero stands out as having the most favorable risk/reward and attractive valuation. We estimate Valero trades at 5.7X 2006E and 5.2X 2007E EV/DACF, relative to the peer group average of 5.9X and 5.3X, respectively. In our view, given Valero's proven track-record of merger integration (i.e., for Premcor acquisition), operational execution (capturing spikes in refining margins), bellwether status (large-cap, diversified geographical exposure), and high conversion capacity (taking advantage of wide heavy-sour crude discounts), we believe its shares should trade at a premium to its peer group. We see 33% upside to a $61 super-spike adjusted peak value, relative to 28% downside risk to a $46 traditional mid-cycle value that is based on $5 per barrel long-term Gulf Coast refining margin.
4Q 2005 RESULTS SLIGHTLY ABOVE EXPECTATIONS Valero Energy's adjusted 4Q 2005 EPS of $2.00 ($2.06 on a reported basis including special items) was slightly ahead of the $1.94 First Call consensus and our $1.90 forecast. The positive variance was primarily driven from lower-than-expected operating expenses and D&A. Refinery throughput of 3.0 million barrels per day and gross margins of $11.91 were in-line with our expectations of 3.0 million b/d and $11.90 per barrel, respectively. Valero's 2006 capital budget of $3.4-$3.5 billion remains unchanged from previous guidance.
We view favorably that Valero management is open to share buybacks beyond merely offsetting stock-based compensation. Although the remaining $360 million authorization from Valero's Board for stock buyback is relatively small, we believe Valero could expand the program later in 2006 if refining margins continue to remain strong, as we currently expect. We also view favorably Valero management's reluctance to engage in acquisitions at current high asset prices. Although we believe there is always a chance of future acquisitions given Valero's focus on growth, recent management comments appear to have a broader emphasis on improving operations organically while maintaining a high hurdle for potential acquisitions both in terms of strategic fit and asset valuation.
UPDATING ESTIMATES We are updating our respective 2006 and 2007 EPS estimates for Valero Energy to $8.25 ($8.50 previously) and $8.75 ($9.00 previously). Our adjusted EPS estimates reflect lower assumed benchmark refining margins to account for weak 1Q-to-date prices, updated throughput estimates, and minor other adjustments. We are also introducing our quarterly 2006 estimates for Valero, which stand at $1.41 (1Q), $2.28 (2Q), $2.46 (3Q), and $2.10 (4Q). See Exhibit 2 for a summary model of Valero.
Each of the analysts named below hereby certifies that, with respect to each subject company and its securities for which the analyst is responsible in this report, (1) all of the views expressed in this report accurately reflect his or her personal views about the subject companies and securities, and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report: Arjun Murti, Luis Ahn. |
