This Refinery's 5.8% Dividend Yield Is Betting on a Recovery

The integrated energy companies have had a difficult time amid the COVID-19 pandemic, but refiners have faced even tougher challenges. Not only did commodity prices slump materially, but the amount of product being refined has declined as well. Still, there are standouts in the space -- like high-yielding Valero Energy . Valero is one of the largest refiners in the U.S., meaning it would stand to benefit greatly from a continued recovery in the U.S. economy. With oil prices recently on the rise, the entire energy sector could see a lift in 2021. With a nearly 6% dividend yield, Valero stock is attractive for income investors in the oil industry. Business Overview Valero Energy owns 15 refineries in the U.S., Canada and the U.K. and has a total capacity of about 3.2 million barrels per day. It also has a midstream segment, Valero Energy Partners LP, but its contribution to total earnings is under 10%. Valero should be viewed as a nearly pure refiner. U.S. refiners are facing a severe downturn due to the Covid-19 pandemic, which has caused an unprecedented collapse in the demand for refined products. The global demand for refined products decreased from 102.2 million barrels per day in 2019 to 93.2 million barrels per day in 2020. This 9% decrease has led refining margins to plunge -- and hence all the U.S. refiners incurred material losses in 2020. In the fourth quarter of 2020, refinery throughput slumped 15% over the prior year's quarter due to the collapse in demand for refined products caused by the pandemic. In addition, refining margins fell and Valero switched from a profit of $2.13 per share to a loss of -$1.06 per share. On the bright side, Valero posted record annual sales of renewable diesel and will boost its investment in this segment, though this division is too small to offset the losses in the refining business. For the year, Valero posted an adjusted loss of -$3.12 per share, compared to a gain of $5.70 in 2019. While we expect commodity demand to pick back up as the pandemic attenuates, the timeline of this remains uncertain. Moreover, the depressed demand for jet fuel is likely to remain in place beyond this year. In addition, all the refiners are facing a strong headwind due to the aggressive production cuts of OPEC and Russia, which have greatly supported the price of oil but have squeezed refining margins. However, we are more optimistic over the longer term. We expect Valero to post modest growth in 2021, but use the company's mid-cycle earnings of $6.19, representing the five-year average through 2019, as a valuation baseline. Growth Prospects From 2011 through 2019 Valero grew its earnings-per-share by an average compound rate of 5.9% per year. However, this growth came in fits and starts, topping out at $7.99 in 2015 and declining to $5.84 in 2019. Notably, 2020 saw a loss, which was the first time since 2008 and 2009 that had happened. We view the headwind from the pandemic as temporary, but significant, and expect the demand for oil products to recover later this year. Valero has a promising pipeline of growth projects for the next three years. The OPEC and Russia production cuts have helped oil prices rebound, but as noted above, that doesn't automatically mean better prospects for refiners. Moreover, bitter cold and a string of storms in the U.S. has curtailed supply in the short-term as wells have to be shut in. Weighing the short-term uncertainty against the long-term fundamentals of increased global demand, we are expecting 3% annual growth off of the company's mid-cycle earnings. If this were come to fruition, it would imply the potential for $7.18 in earnings-per-share after five years. This is not a large stretch, considering that the company has posted results that were better than this in both 2015 and 2018. Dividend Safety Refining is a highly cyclical business, and all the refiners are vulnerable to declining crack spreads. Crack spreads tightened significantly during the Great Recession, when the demand for oil products greatly deteriorated and gasoline became cheaper than crude oil for almost three months. As a result, Valero posted operating losses and cut its dividend. A similar picture is evident in the ongoing recession, as the price of crude oil has recovered more than the prices of refined products off the bottom in March, thus exerting pressure on refining margins. On the bright side, Valero has a competitive advantage over its peers, namely the high complexity of its refineries, which enables the company to benefit from the gyrations of oil prices and refined products by optimizing its blend of feedstock and products. Nevertheless, investors should note that U.S. refiners have now lost a significant past advantage. During the downturn of the refining sector in 2011-2013, about 20% of refineries worldwide went out of business. The domestic refiners were not affected, as they were protected thanks to the ban on oil exports that prevailed back then. However, now that the ban has been lifted, they are more vulnerable in the current downturn and thus they all incurred material losses in 2020. If the pandemic lasts longer than expected, Valero could cut its dividend again. The current dividend, which has been paid for five straight quarters, sits at $0.98 per quarter or $3.92 on an annualized basis. Based on mid-cycle earnings, that represents about 63% of the company's potential profits. However, Valero may not make enough this year to cover that payment. In terms of dividend safety, Valero's payment is very much dependent on the speed of the recovery. Valuation/Expected Return Based on a current share price of $68, a $0.98 quarterly dividend and $6.19 in mid-cycle earnings, Valero is presently trading with a high yield of 5.8%, an 11x mid-cycle P/E ratio and a ~63% payout ratio. Keep in mind that these figures are based on the company's underlying earnings potential. If Valero is able to grow by 3% annually, it could earn $7.18 in five years' time. If shares were to trade at 10x earnings, this would imply a potential share price of ~$72. If you hold the dividend constant at $3.92, you would anticipate collecting just over ~$19 per share in cash dividends during the next half decade. Altogether, that works out to the potential for ~$91 in total value or 6.1% annual gains. This view could be too conservative or optimistic depending on the recovery. Final Thoughts Valero has put together a solid, albeit irregular record in the last decade. The company lost money during the last recession, but generated solid profits in the 2010 through 2019 period, while paying an increasing dividend. Hard times have come once again, but the dividend has not yet been cut. If the payment is maintained, not only do you collect the 5.8% yield, but there's also the possibility for outsized returns from a quicker than anticipated bounce back in demand.

This Refinery's 5.8% Dividend Yield Is Betting on a Recovery

Valero Energy's dividend has not been cut, despite hard times. There is the possibility for outsized returns from a quicker than anticipated bounce back in demand, but clear risk remains.

Columnist Conversation

The INDU and Our Bounce Zone

This Weekend on Real Money

Friday on Real Money Pro

COLUMNIST TWEETS

Please Join or Log In to manage and receive alerts.