Valero: Time to Declare Victory

 | Sep 14, 2012 | 2:00 PM EDT  | Comments
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By far, the hardest decision for an investor is when to sell a position, and often the greatest questions involve selling a winner.

Valero Energy (VLO) is a good case in point. We recommended the stock in our May 22 column. The refiner was trading at $21.88 that day, valued at a compelling 5.9x 2012 estimated earnings and just 0.76x book value, with a solid 2.7% yield.

We expected that industry and company fundamentals would improve over the following year, thanks to cheap prices for natural gas (an input to the refining process), improving refining crack margins from lower crude prices due the shale oil revolution, and the completion of costly plant additions this year that will swing into massive free cash-flow generation next year as the new capacity comes online. On the basis of our valuation process, we posited a fair value for Valero in the low $30s, about 50% upside from the May 22 price.

Happily, our investment thesis has played out as hoped, by and large. Gas prices have stayed low. Refining crack spreads are still large, and more shale oil will be making its way to Valero's Gulf Coast refineries in the coming months and years. Some missteps by competitors have helped Valero: a Chevron (CVX) refinery fire in northern California, and major start-up problems for a Motiva refinery in the Gulf. In addition, management has decided to spin off its retail gas station business in the U.S. to shareholders, unlocking a further $1 to $3 a share within the next six months.

While many things played out as we envisioned, we were also pleasantly surprised that the stock moved up so sharply so quickly.

After reviewing all aspects of current industry conditions, we believe our target of low $30s still makes sense. (In our value discipline, the determined fair value for a company is our desired sale target price.)

Conditions look particularly good in the near term, and investor sentiment has moved to being very positive, and we believe that's what has driven the stock to these levels. Further, an analysis of the refining industry and its stocks' prices over the past five years shows a history of sudden and unanticipated about-faces -- in both directions -- for both industry trends and stock prices.

Given that, we would recommend taking half or more of your position off the table. Yes, many of the characteristics of the investment case are still unfolding, but the question is how much of that now-common knowledge is imputed into the stock price. Many of the same factors that drove Valero up 50% are still present, but now the stock is that much more fairly valued. While momentum and favorable near-term trends will probably take the stock higher in the near term, we believe the lion's share of the gains have been achieved, and we would be increasingly concerned about its risk (and vulnerability to a pullback) as it rises from current levels.

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