Valero Energy (IL/A): Continue to prefer COP as a less expensive way to gain refining exposure; VLO favorite pure-play - Goldman Sachs - April 26, 2006
We remain bullish on the macro outlook for refining but continue to prefer ConocoPhillips (COP) (OP/A) over the independent R&Ms as a less expensive way for investors to gain US refining exposure. In our view, the R&Ms currently garner an unsustainable valuation premium over the implied R&M valuations of the integrateds and, in particular, COP. We estimate the shares of Valero Energy currently trade at 6.4X 2007E EV/DACF and the R&Ms at 6.5X on average, which compares to the implied R&M EV/DACF for COP of merely 2.8X. Among the R&Ms, we still favor VLO given its diversified refining asset base, complex refining system, and track record of operational execution. We see 39% upside to a $92 "super-spike"-adjusted peak value, which is consistent with discounting a $9.50/bbl long-term Gulf Coast 3:2:1 crack spread. We maintain an In-Line rating on Valero in the context of an Attractive coverage view.
With multiple potential refined product supply bottlenecks, believe likelihood of supply disruptions remains high In our view, various product specification changes taking effect throughout the year will likely mute refined product supply growth in 2006. We think the issue is not necessarily any one particular regulation that is necessarily difficult to adjust to, but rather the many moving parts of which we think even limited disruptions could cause product prices to spike higher. For example, California, New York, and Connecticut are among several states that had banned MTBE and essentially forced the blending of ethanol prior to 2006 with no significant apparent hurdles. However, given the larger scope of the ethanol mandate for 2006, third (and final) phase of Tier 2 low-sulfur gasoline, and upcoming ultra-low-sulfur diesel requirement for on-road diesel, the logistical and operational complexity in meeting the specifications likely has been compounded. If it is not the lack of ethanol that causes gasoline supply disruptions, it then could be the transportation of ethanol; if not the transportation of ethanol, then the blending terminals; if not ethanol production/transportation then finished gasoline imports; if not gasoline, then ultra-low sulfur diesel; and so on and so forth.
Specification waivers, if given, could be positive for R&M equities, not negative In our view, despite what appears to be a popular belief that refined product specification waivers would be a negative for R&M-levered equities, we believe it is the contrary. First, we believe that specification waivers are unlikely unless actual meaningful supply disruptions occur. If that is the case, then by definition waivers would suggest there are actual severe bottlenecks in the system that need to be resolved. Although it is true that massive spikes in refining margins are likely to be avoided if waivers are given (i.e., $50/bbl+ Gulf Coast crack spreads seen immediately following Hurricanes Katrina and Rita), the likelihood of an adverse demand shock are minimized and as such the potential for longer "robust" refining margins ($10/bbl+) while the bottlenecks are resolved are higher.
Independent R&M valuations do not look inexpensive; we prefer Conoco for refining exposure While our bullish refining outlook would suggest a favorable outlook for R&M shares and, in particular, Valero, we believe the unreasonably large discount of Conoco's implied R&M valuation to that of Valero and R&M overall is too much to ignore. Assuming a domestic oil/E&P average EV/DACF multiple on Conoco's E&P business, we estimate that the implied R&M 2007E EV/DACF is currently 2.7X. This compares to Valero's 2007E EV/DACF of 6.4X and the independent R&M average of 6.5X. Put another way, the independent R&Ms are currently trading at a 1.5X premium (versus a historical discount) over Conoco's overall cash flow valuations and at only a 0.5X discount to ExxonMobil.
Our preference for Conoco over other integrateds is due to the fact that the company's refining assets reflect those of a "bellwether" US refiner given its geographically diverse asset base, medium- to high-conversion capacity, track-record of execution, and limited retail marketing exposure. For investors who do not care for Conoco's E&P exposure but wish to remain long refining, we believe a structured trade of long Conoco and short a basket of E&Ps could make sense. In this scenario, for every $1 long Conoco, an investor would want to short $0.65 of a basket of E&Ps (for more details, see our report published on April 3, 2006, "US R&M: Conoco preferred over R&Ms for refining exposure" Message 22322575 ).
Valero's 1Q 2006 results in line with expectations Valero's adjusted and reported 1Q 2006 EPS of $1.32 was in-line with the $1.32 First Call consensus and our $1.31 forecast. Slightly lower-than-expected refinery runs and marketing earnings were offset by higher-than-expected realized gross margins and lower shares outstanding.
Updated estimates
We are updating our 2Q-4Q 2006 EPS estimates as well as our full-year 2006-2010 EPS estimates. Our respective 2Q-4Q 2006 EPS estimates now stand at $2.15 ($2.10 before), $2.47 ($2.41 before), and $2.13 ($2.08 before). Our full-year 2006-2010 EPS estimates are now $8.05 ($7.90 before), $8.60 ($8.45 before), $3.35 ($3.25 before), $3.50 ($3.37 before), and $3.65 ($3.50 before), respectively. Our EPS adjustments reflect actual 1Q 2006 results, a lower assumed share count, updated throughput estimates, higher assumed realized gross refining margins, and higher assumed operating costs. Note, we maintain our $11/bbl Gulf Coast 3:2:1 and commensurate other regional crack spread assumptions for 2Q 2006, which could ultimately prove conservative given the recent move higher, in order to remain consistent with our current WTI oil and Henry Hub natural gas price assumptions.
See Exhibit 1 for comparative valuation. 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. |
