Intro

In last week’s blog (click here to read), we discussed how the “2-10-10” screen provided us a list of candidates (midstream and downstream energy companies) who have performed well so far and could continue to perform well in this volatile oil price environment. We also talked at a high level about how those companies make money and what drives their profitability. Those companies consist of the following:

In this blog we’ll look in more detail about what we like in high quality downstream companies. More specifically, we’ll focus on some of the quantitative metrics we like to use for further consideration as well as some of the qualitative factors that give us additional confidence in owning such companies.

Quantitative Metrics

There are a wide variety of metrics to look at when analyzing a company so we like to pick the metrics that give us sufficient confidence the companies we invest in are financially healthy, prudent in managing debt and show strong profitability. Although having a high ROE answers many of these questions, we will look a little deeper into a few other metrics that give us better insight into how the company manages its business. More specifically, we’ll want to ensure:

• Current assets >= 2 * Current liabilities
  • This can be found from the company’s balance sheet. Current assets are usually liquid assets that can be easily converted into cash while current liabilities are ones (ie. Debt or other payments) usually due within a year. Ensuring current assets are at least twice as great as current liabilities gives us confidence the company can easily meet its obligations should some short-term downturn occur and not risk insolvency.

• Debt / EBITDA < 4
  • This ratio looks at total debt compared to Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). Generally speaking, debt should not be so great that it overwhelms the company’s earnings. What we want to see is a declining ratio over time, which tells us that the company is getting better at managing its debt and/or increasing its earnings power.

• EBITDA / Interest Expense >> 1
  • By looking at EBITDA compared to the interest a company pays on its short-term debts, we can get a feel for how much of its earnings are used just to pay it’s interest liabilities. A ratio close to 1 should send up some red flags.

• Consistent history of dividend payments and sufficient growth
  • A dividend is what gets paid back to shareholders after operating expenses, taxes, interests on debt, etc. are paid. Generally speaking, we like to see a consistent and increasing dividend payment to shareholders over a long time period as this gives the investor insight into how well management is managing company finances and is able to generate some return to the investor with a consistent, increasing dividend payment.

• Return on Invested Capital (ROIC)
  • Probably one of the most important measurements of management effectiveness and ability to be profitable. It is calculated as: (net income – dividends) / Invested Capital. As a rule of thumb, the greater the ROIC, the more attractive the investment as this is an indication of how well management can earn returns on capital being employed. We aim for ROIC’s of greater than 15% or at least greater than the company’s weighted average cost of capital.

• Comparison of Free Cash Flow to competitors
  • Free cash flow is a key metric in measuring any company’s ability to generate sustainable profits. It is the amount of cash earned after taking into account what the company needs not only to maintain operations, but also to expand its business. The higher cash flow per share, the better.

• Higher profit margins compared to competitors
  • This one is self-explanatory. We want companies who have refined their operations and can generate higher income while maintaining a low operating cost compared to their peers.

The table below summarizes the past 10 years’ results of each of the three companies: Marathon Petroleum, Phillips 66 and Valero. Given the criteria we mentioned above and how we like our companies to perform historically, it is clear that Valero is the winner amongst the three and whom we would label as “best-in-class” for refiners.

Qualitative Factors

While Valero was our top pick in the downstream sector as measured across the various quantitative metrics above, there are a few other notable items about Valero we like, including:

• Large refinery asset base ~ 15 refineries with the capacity to refine 3 million bbls of crude oil per day, making it the largest independent refiner in the U.S.
• Strategic location of its refineries. The majority of them sit on the U.S. Gulf Coast, which not only benefit from discounted crude, but can reach a variety of local markets for sales as well as international markets that may fetch higher product premiums.
• Consistently high utilization rate in 2015, approximately 95% which is extremely high in this industry
• Complexity of its refineries. As mentioned in the previous article, refinery complexity is generally good as it allows additional flexibility in producing higher valued products from a wider range of crudes. Valero’s weighted average complexity is 12.4 making it the most complex refiner in the U.S.
• Valero’s ownership in Valero Logistics Partners, an MLP setup to increase operational flexibility, reduce logistical bottlenecks and better monetize their strategic assets while leveraging current operational strengths.
• Acute attention to high safety standards as can be reflected in its safety awards for multiple refineries from OSHA
• We also like that the CEO, Joe Gorder, a 28 year veteran of the company, has transitioned well into his role since 2014 as can be seen through Valero’s strong performance over the past several years.

Though we see Valero as a strong company over the longer-term, short-term dynamics such as potential economic slowing from the Brexit puts about 13% of Valero’s (2015) revenues at risk of slowing. Valero has refinery and marketing operations in the U.K. and Ireland so any economic headwinds from the recent Brexit may temper earnings growth in the near term.

Conclusion: VLO Currently Undervalued

We like to think of buying stocks not just as pieces of paper, but pieces of a company that creates real value from the assets (both physical and personnel) it has. Having said this, it is also important to differentiate value from price. There is a famous saying that goes:

“Price is what you pay, value is what you get”

– Warren Buffett

As you will see below, we estimate the intrinsic value of Valero to be much higher than its current share price. Why has Valero taken such a beating lately? We believe it is likely due to the overreaction of investors in response to the rapid rise in oil prices the first half of this year as well as uncertainty induced by what’s happening in Europe at the moment. Irrational, fear-based behavior by others creates opportunities for the few who can discern fear from fundamentals and the fundamentals of Valero remain sound.

Having said that, we at the Perceptive Investor like Valero for all of the points mentioned above and would be long-term owners, but only at the right price with respect to the share’s intrinsic value. Our price model estimates Valero’s shares have additional upside in them (barring any significant economic downturns or adverse impacts to the company’s operations). However, in order to provide a sufficient margin of safety, we are buyers at prices no higher than $51 per share. The margin of safety is necessary to ensure we don’t suffer massive capital losses.

Summary

To summarize, our downstream and midstream screener had shortlisted three refining companies that showed great potential to survive in this oil price environment, but only one stands out as a high quality company that we expect to continue to perform above its peers over the long-term and that is Valero Energy. Given management’s effective use of capital, financial discipline and efficient use of strategic assets, we believe Valero’s stock has appreciation potential in them and are buyers only at prices at $51 or lower. In the following weeks’ blogs we will come back to the midstream companies and take a look at some quality E&P companies as well. Stay tuned. Stay curious. Happy investing.

Disclosure: Mark has purchased shares of VLO as of July 11^th, 2016

Disclaimer: The price expectations mentioned in this blog are based on our internal estimates and may be used as points of consideration only and not to be taken as absolute truth. This blog is solely meant to help educate the reader on our investment thought process and how we perceive markets. How the reader makes his own investment decisions is up to him and we are not liable for any misuse of this information or investing decision that occurs as a result of this information.