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Ticker: VLO Sector:Oil & Gas Refining & Marketing Valero Energy Corp. (VLO) Company Profile Recommendation: SELL (all 530 shares) Pricing Closing Price 52-wk High 52-wk Low $67.18 (09/28/07) $78.68 (07/10/07) $47.52 (10/04/06) Market Data Market Cap Trading vol $37.48B 10.34M (3mon avg) Valuation EPS (ttm) P/E (ttm) PEG Div Yield $10.01 6.76 0.43 0.70% Profitability & Effectiveness (ttm) ROA 14.37% ROE 34.21% Profit Margin 6.91% Oper Margin 10.00% Valero Energy Corporation operates as a crude oil refining and retailing company. Its refining activities include refining operations, wholesale marketing, product supply and distribution, and transportation operations primarily in the Gulf Coast, Mid-Continent, West Coast, and northeast regions. The company produces reformulated gasoline, conventional gasoline, California Air Resources Board Phase III gasoline, customized clean-burning gasoline blends, clean-burning oxygenates, gasoline blendstocks, low-sulfur gasoline, low-sulfur diesel and ultra low-sulfur diesel, jet fuel, aviation gasoline, kerosene, home heating oil and stove oil, petrochemicals, asphalt, lube base oils, sulfur, crude mineral spirits, bunker oils, petroleum coke, and Propane-Octene. As of July 31, 2007, Valero Energy owned and operated 17 refineries in the United States, Canada, and the Caribbean with a combined throughput capacity of approximately 3.1 million barrels per day. Its retailing activities include the sale of transportation fuels at retail stores and unattended self-service cardlocks; convenience store merchandise through its retail sites; and home heating oil to residential customers in the United States and Canada. As of the above date, the company operated through 5,800 retail and branded wholesale outlets in the United States, Canada, and the Caribbean under various brand names, including Valero, Diamond Shamrock, Shamrock, Ultramar, and Beacon. Valero Energy was founded in 1955. It was formerly known as Valero Refining and Marketing Company and changed its name to Valero Energy Corporation in 1997. The company is headquartered in San Antonio, Texas. Products ANALYST Varun Chikhliwala [email protected] Reformulated gasoline (RFG) Conventional gasoline Premium grades of reformulated and conventional gasoline California Air Resources Board (CARB) Phase III gasoline 1 Customized clean-burning gasoline blends for export markets (i.e., Mexican CARB) Clean-burning oxygenates Gasoline blendstocks (alkylate, raffinate, naphtha, reformate) Low-sulfur gasoline (less than 30 ppm) -- Atlanta grade Low-sulfur diesel and ultra low-sulfur diesel (less than 15 ppm) Jet fuel (commercial and military) Aviation gasoline Kerosene Home heating oil and stove oil Petrochemicals (mixed xylenes, benzene, toluene, chemical- and refinery-grade propylene) Asphalt Lube base oils (industrial and automotive) Sulfur Crude mineral spirits Bunker oils Petroleum coke Propane -- Octane Competitive Forces Historical Stock Price The performance of Valero has been very volatile compared to the S&P 500 over the last 2 years. So it is a risky stock in a risky industry. 2 Market Position The performance of Valero has been very volatile compared to the S&P 500. But so have the prices for Chevron and Exxon Mobil, which have performed better than Valero in this current period. This is overall a very volatile industry. Competition Valero is an extremely small company in terms of market cap compared to its larger competitors like BP, Chevron and Exxon Mobil with a market cap of less than a third of its closest competitor. It has a lower quarterly YoY revenue growth rate, gross margin, operating margins, price/earnings ratio, and peg ratio than its competitors and the industry as a whole. It does have a higher EPS than any of the competitors and the industry. VLO BP CVX XOM Industry Market Cap: 37.21B 221.16B 199.49B 513.36B 4.51B Employees: 21,836 97,000 62,500 106,400 2.48K Qtrly Rev Growth (yoy): -5.50% -0.40% 4.00% -1.00% 14.60% Revenue (ttm): 88.41B 263.89B 189.82B 366.24B 8.35B Gross Margin (ttm): 13.05% 19.01% 33.39% 34.89% 14.83% 3 EBITDA (ttm): 10.12B 34.25B 34.59B 72.36B 1.42B Oper Margins (ttm): 10.00% 9.31% 13.99% 16.49% 13.34% 5.97B 21.15B 18.89B 40.28B 494.54M 10.008 6.47 8.725 6.988 4.98 P/E (ttm): 6.71 10.72 10.73 13.25 9.70 PEG (5 yr expected): 0.43 1.84 1.5 1.89 0.98 P/S (ttm): 0.42 0.83 1.05 1.41 0.83 Net Income (ttm): EPS (ttm): BP = BP plc CVX = Chevron Corp. XOM = Exxon Mobil Corp. Industry = Oil & Gas Refining & Marketing MSN Money Screener For the MSN Stock Screener, I used the recommendations form the Portfolio Committee report. I used the below mentioned parameters based on the recommendations Industry sector: Oil & Gas Refining and Marketing Market cap: Large cap S&P 500 membership Price/earnings ratio: As low as possible Net profit margin: As high as possible Relative strength: As high as possible Debt/equity ratio: As low as possible Revenue growth: As high as possible Rev Net Symbol MRO Debt to P/E Growth Company Profit Market Equity Ratio: Name Margin Capitalization Ratio Current Marathon Oil Ord Shs S&P Index Industry Membership Year vs Year 8.20 39 Bil 0.29 8.10 OilGasRef S&P 500 3.30 6.74 37 Bil 0.38 6.90 OilGasRef S&P 500 11.80 5.41 21 Bil 0.44 13.40 OilGasRef S&P 500 23.50 4.31 13 Bil 0.25 19.80 OilGasRef S&P 500 20.50 2.92 9 Bil 0.77 7.50 OilGasRef S&P 500 14.70 Valero VLO Energy Ord Shs HES MUR SUN Hess Corp Murphy Oil Corp Sunoco Inc 4 Recent News Valero restarts fuel production in Port Arthur following Humberto1 After surviving the aftermath of Hurricane Humberto last week, the workers in Port Arthur have completed the facility's intensive start-up process and limited fuel production has begun. They was forced to shut down the 325,000-barrel-per-day refinery in Southeast Texas after the hurricane knocked out power to the area. Valero reports "strategic asset review"2 Valero Chairman and Chief Executive Bill Klesse is scheduled to discuss a "strategic asset review" of the company’s 16 North American refineries, with sales or acquisitions possible. "It's taking a look at our entire portfolio," said Valero spokesman Bill Day. "That could include a sale, an acquisition, a joint-venture, an asset swap." Spend millions for pollution controls3 Valero agreed to pay a $4.25 million penalty and spend $232 million to upgrade pollution controls at refineries in Tennessee, Ohio and Texas after reaching the agreement with the Justice Department and the Environmental Protection Agency to come into compliance with the Clean Air Act, the Justice Department said. Under the agreement, new pollution controls will be installed at refineries in Port Arthur, Texas; Lima, Ohio; and Memphis, Tennessee. Risk Factors4 Volatile refining margins The financial results are primarily affected by the relationship, or margin, between refined product prices and the prices for crude oil and other feedstock. It also depends on, among other things, the availability and quantity of imports, the production levels of domestic and foreign suppliers, levels of refined product inventories, U.S. relationships with foreign governments, political affairs, and the extent of governmental regulation. Compliance with and changes in environmental laws The principal environmental risks associated with the operations are emissions into the air and releases into the soil, surface water, or groundwater. Violation or failure to comply with the laws and regulations could result in fines or other sanctions. Because environmental laws and regulations are becoming more stringent and new environmental laws and regulations are continuously being enacted or proposed, the level of expenditures required for environmental matters could increase in the future. 1 http://www.bizjournals.com/sanantonio/stories/2007/09/17/daily23.html http://uk.reuters.com/article/oilRpt/idUKN0443792920070904 3 http://online.wsj.com/article/SB118732125741300762.html 4 2006 Valero 10-K filing 2 5 Disruption of ability to obtain crude oil A significant portion of the feedstock requirements is satisfied through supplies originating in Saudi Arabia, Mexico, Iraq, Kuwait, Venezuela, Colombia, and Africa. So they are subject to the political, geographic, and economic risks attendant to doing business with suppliers located in, and supplies originating from, those areas. If they are unable to obtain adequate crude oil volumes or are able to obtain such volumes only at unfavorable prices, their results of operations could be materially adversely affected, including reduced sales volumes of refined products or reduced margins as a result of higher crude oil costs. Competitors Competitors that produce their own supply of feedstock, have more extensive retail outlets, or have greater financial resources may have a competitive advantage. They are after all a much smaller company than some of the other competitors like BP, Chevron and Exxon Mobil. Valuation The first step is to calculate the discount rate, or the rate of capitalization. I use the risk free rate of 3.82% which is based on the 90-day T-Bill rate, the beta of 0.72 from Google Finance, and a market rate of 10.23%. Discount Rate K=Rf+β(Rp) K=3.82+0.72(10.23-3.82) K=8.44% Based on the above calculation, the required discount rate is 8.44%. But because this is a volatile stock in a volatile industry, investors’ need a higher return on their investments. So I’ve increased the discount rate by 20%, i.e. a discount rate of 10.13 %. Warren Buffett Way Owners' Earnings Discount Model I use the Warren Buffett Way Owners' Earnings Discount Model for my valuation. Analysts on yahoo finance have predicted a growth rate of 22.4% over the next 5 years. So if I use a second phase growth rate of 3%, the company is under-valued. So based on the analysts’ estimates if I take a growth rate of 20%, I get an intrinsic value of $118.61 per share. The Owner’s Earnings Discount Model is computed as under: Warren Buffett Way Owners' Earnings Discount Model assuming discount rate (k) of Owner Earnings in 2006: Net Income Depreciation 10.13% $ $ 5,463,000,000.00 1,155,000,000.00 6 Amortization Capital Expenditures Owner Earnings $ $ $ (3,187,000,000.00) 3,431,000,000.00 Year: Prior Year Owner Earnings First Stage Growth Rate (add) Owner Earnings Discounted Value per annum $ $ Sum of present value of owner earnings 2006 3,431,000,000.0 20.0% 4,117,200,000.0 $4,117,200,000.0 $24,621,667,674.1 Residual Value Owner Earnings in year 10 Second Stage Growth Rate (g) (add) Owner Earnings in year 11 Capitalization rate (k-g) Value at end of year 10 $ $ $ Present Value of Residual Intrinsic Value of Company 8,537,425,920.0 3.00% 8,793,548,697.6 7.13% 123,331,678,788.22 $46,991,385,597.98 $71,613,053,272.11 Shares outstanding assuming dilution Intrinsic Value per share 603760000 $118.61 Analysts’ Opinions Looking at analyst’s opinions on both Yahoo Finance and Msn Money, there are analysts that recommend selling the stock. This is very interesting because using the Warren Buffett model the stock is under-valued. This means that there are analysts who believe that either this stock is at its high point and not going to grow any further, or its risks do not match potential gains from the stock. Current Month Last Month Two Months Ago Three Months Ago Strong Buy 4 4 5 5 Buy 6 6 5 5 Hold 7 6 5 7 Sell 2 1 1 1 Strong Sell 1 2 2 0 Yahoo! Finance 7 Analyst Ratings Recommendations Current 1 Month Ago 2 Months Ago 3 Months Ago Strong Buy 5 5 6 5 Moderate Buy 1 1 1 1 Hold 8 7 5 6 Moderate Sell 0 0 1 1 Strong Sell 1 2 2 1 Msn Money Recommendation Based on the valuations, the volatility of the stock, and most importantly the fact that we need to reduce our holdings in the Oil & Gas sector, I recommend that we sell the shares of Valero. I think on its own it is a good stock, but I think there are better stocks in this sector that we can buy or hold. It has a total market value of $35,605 which constitutes about 2.5% of our portfolio. All else being the same, it would mean our holdings in the OIL & Gas sector at around 9.83%, which would bring us close to the recommended 9% mark for this sector. 8 Income Statement (Amt in millions) 2006 2005 2004 2003 2002 Revenue 91,833.0 82,162.0 54,619.0 37,968.6 29,047.9 Total Revenue 91,833.0 82,162.0 54,619.0 37,968.6 29,047.9 Cost of Revenue, Total 81,267.0 74,547.0 49,897.0 35,243.1 27,194.8 Gross Profit 10,566.0 7,615.0 4,722.0 2,725.5 1,853.1 1,401.0 1,316.0 1,138.0 993.0 932.9 Research & Development 0.0 0.0 0.0 0.0 0.0 Depreciation/Amortization 1,155.0 840.0 605.0 510.5 449.3 Interest Expense (Income), Net Operating 0.0 0.0 0.0 0.0 0.0 Unusual Expense (Income) 0.0 0.0 0.0 0.0 0.0 Other Operating Expenses, Total 0.0 0.0 0.0 0.0 0.0 8,010.0 5,459.0 2,979.0 1,222.0 470.9 -210.0 -266.0 -260.0 -261.3 -285.7 0.0 0.0 0.0 0.0 0.0 389.0 94.0 -9.0 25.9 -35.5 Income Before Tax 8,189.0 5,287.0 2,710.0 986.6 149.7 Income Tax - Total 2,726.0 1,697.0 906.0 365.1 58.2 Income After Tax 5,463.0 3,590.0 1,804.0 621.5 91.5 Minority Interest 0.0 0.0 0.0 0.0 0.0 Equity In Affiliates 0.0 0.0 0.0 0.0 0.0 U.S. GAAP Adjustment 0.0 0.0 0.0 0.0 0.0 5,463.0 3,590.0 1,804.0 621.5 91.5 0.0 0.0 0.0 0.0 0.0 5,463.0 3,590.0 1,804.0 621.5 91.5 Selling/General/Administrative Expenses, Total Operating Income Interest Income (Expense), Net NonOperating Gain (Loss) on Sale of Assets Other, Net Net Income Before Extra. Items Total Extraordinary Items Net Income Msn money 9 Balance Sheet (Amt in millions) 2006 2005 2004 2003 2002 Cash and Short Term Investments 1,590.0 436.0 863.6 369.2 378.9 Total Receivables, Net 4,421.0 3,634.0 1,838.7 1,327.7 1,558.2 4,430.0 4,039.0 2,317.8 1,913.1 1,436.1 Prepaid Expenses 145.0 65.0 44.6 44.9 37.6 Other Current Assets, Total 174.0 172.0 199.7 162.4 125.6 Total Current Assets 10,760.0 8,346.0 5,264.4 3,817.3 3,536.4 Property/Plant/Equipment, Total - Net 21,098.0 17,856.0 10,317.4 8,195.1 7,412.0 Goodwill, Net 4,211.0 4,926.0 2,401.2 2,401.7 2,580.0 303.0 298.0 310.7 320.2 341.1 0.0 327.0 264.6 264.5 0.0 Assets Total Inventory Intangibles, Net Long Term Investments Note Receivable - Long Term 0.0 0.0 0.0 0.0 0.0 1,381.0 1,045.0 833.3 665.4 595.7 0.0 0.0 0.0 0.0 0.0 37,753.0 32,798.0 19,391.6 15,664.2 14,465.2 Accounts Payable 6,864.0 5,563.0 2,963.4 2,288.2 1,825.0 Payable/Accrued 0.0 0.0 0.0 0.0 0.0 510.0 581.0 519.2 355.6 294.2 Other Long Term Assets, Total Other Assets, Total Total Assets Liabilities and Shareholders' Equity Accrued Expenses 0.0 0.0 0.0 0.0 476.7 Current Port. of LT Debt/Capital Leases Notes Payable/Short Term Debt 476.0 222.0 411.6 0.0 0.0 Other Current Liabilities, Total 972.0 1,009.0 639.3 420.5 410.8 8,822.0 7,375.0 4,533.5 3,064.3 3,006.7 4,657.0 5,156.0 3,901.2 4,245.1 4,866.6 4,047.0 3,615.0 2,011.2 1,604.6 1,240.7 0.0 0.0 0.0 0.0 116.0 1,622.0 1,602.0 1,147.7 1,015.0 926.9 19,148.0 17,748.0 11,593.6 9,929.0 10,156.9 Total Current Liabilities Total Long Term Debt Long Term Debt Capital Lease Obligations Deferred Income Tax Minority Interest Other Liabilities, Total Total Liabilities Redeemable Preferred Stock 0.0 0.0 0.0 0.0 0.0 Preferred Stock - Non Redeemable, Net 0.0 68.0 208.1 200.5 0.0 Common Stock 6.0 6.0 2.6 2.4 1.1 10 Additional Paid-In Capital 7,779.0 8,164.0 4,357.5 3,921.4 3,436.7 Retained Earnings (Accumulated Deficit) 11,951.0 6,673.0 3,199.6 1,482.7 913.6 Treasury Stock - Common -1,396.0 -196.0 -198.5 -41.4 -42.0 265.0 335.0 228.7 169.6 -1.1 Total Equity 18,605.0 15,050.0 7,798.0 5,735.2 4,308.3 Total Liabilities & Shareholders’ Equity 37,753.0 32,798.0 19,391.6 15,664.2 14,465.2 Other Equity, Total Msn money Cash Flow (Amt in millions) 2006 2005 2004 2003 2002 Net Income/Starting Line 5,463.0 3,590.0 1,804.0 622.0 91.5 Depreciation/Depletion 1,155.0 840.0 605.0 511.0 449.3 0.0 0.0 0.0 0.0 0.0 290.0 255.0 345.0 287.0 1.5 Non-Cash Items -452.0 83.0 23.0 -432.0 -61.2 Changes in Working Capital -144.0 1,082.0 203.0 429.0 -208.8 6,312.0 5,850.0 2,980.0 1,417.0 272.3 -3,187.0 -2,133.0 -1,292.0 -976.0 -811.2 216.0 -2,767.0 -1,393.0 -355.0 1,059.8 -2,971.0 -4,900.0 -2,685.0 -1,331.0 248.6 143.0 -13.0 -8.0 10.0 -13.7 -184.0 -106.0 -79.0 -51.0 -42.3 Issuance (Retirement) of Stock, Net -1,898.0 -389.0 201.0 276.0 56.5 Issuance (Retirement) of Debt, Net -249.0 -874.0 71.0 -371.0 -412.9 Cash from Financing Activities -2,188.0 -1,382.0 185.0 -136.0 -412.4 1.0 4.0 15.0 40.0 1.0 1,154.0 -428.0 495.0 -10.0 109.5 436.0 864.0 369.0 379.0 269.4 1,590.0 436.0 864.0 369.0 Amortization Deferred Taxes Cash from Operating Activities Capital Expenditures Purchase of Fixed Assets Other Investing Cash Flow Items, Total Cash from Investing Activities Financing Cash Flow Items Other Financing Cash Flow Total Cash Dividends Paid Foreign Exchange Effects Net Change in Cash Net Cash - Beginning Balance Net Cash - Ending Balance 378.9 Msn money 11