Four months ago, I recommended purchasing Valero (VLO) for its cheap valuation, its growth prospects, and its generous dividend. Since my article, the stock has rallied 23%. In addition, the refiner is expected to announce its next dividend hike in the next few days. In this article, I will discuss what dividend hike its shareholders should be expecting.
The major factor behind the rally of Valero since September is the implementation of the new international marine standard, which is called IMO 2020, from January 1st. According to the new standard, all the vessels sailing in international waters are now obliged to burn very-low-sulfur fuel oil or diesel instead of high-sulfur fuel oil. As a result, the global demand for diesel is expected to increase by 1.3-2.5 million barrels per day this year. As the price of diesel is much higher than the price of heavy fuel oil, this growth in the demand for diesel will provide a great boost to the earnings of refiners. To be sure, Valero is expected to nearly double its earnings per share, from $5.09 in 2019 to $9.82 this year.
Valero is also likely to greatly benefit from another tailwind this year, namely the widening discount of Canadian crude oil to WTI. Due to the enforced production cuts of Alberta last year, that discount narrowed significantly last year, from about $40 per barrel at the end of 2018 down to $10 per barrel in 2019. However, Alberta has somewhat eased its enforced production cuts in recent months. Consequently, the discount between Western Canadian Select and WTI has risen to $24 per barrel, the highest level since November-2018. Valero will certainly take advantage of this opportunity and thus it will greatly enhance its refining margins via abnormally cheap input, just like it did in late 2018.
While analysts have already priced the effect of IMO 2020 on the earnings of U.S. refiners, they have not priced the wide discount of Canadian crude to WTI yet, as the latter is a recent development. Of course, it is impossible to predict how long the wide discount will remain in place. However, as long as the discount remains around its current level, it will provide a strong tailwind to the earnings of Valero.
Unfortunately, the two major growth catalysts of Valero, namely IMO 2020 and the discount of Canadian crude to WTI, are beyond the control of the company. Nevertheless, Valero does its best to grow its earnings by investing in growth projects that enhance its refining margins, reduce its operating expenses, and enhance its market reach. Notably, the refiner invests only in growth projects that have a return on investment above 25%. As these projects take only a few years from inception to the generation of cash flows and have such high returns, they are essentially risk-free.
Valero, currently, has a promising pipeline of growth projects. The refiner expects to spend approximately $1.0 billion per year on these projects over the next few years and enhance its annual EBITDA by $1.2-1.5 billion thanks to these projects. If the company meets its guidance, it will grow its EBITDA by 16-20% compared to 2018.
Valero has among the most complex refineries in the U.S. The complexity of refineries is of paramount importance, as the most complex refineries take advantage of the swings of the prices of crude oil and refined products and enhance their earnings by optimizing their blend of feedstock and products. During periods of depressed refining margins, the least complex refineries are the least resilient and thus they are driven out of business. In the fierce downturn of the refining sector, between 2011 and 2013, about 25% of the global refineries went out of business. The vast majority of those refineries were of very low complexity. Fortunately, for the U.S. refiners, they were protected from that downturn thanks to the ban on oil exports that prevailed back then. However, as the ban on oil exports has been lifted, they will be less protected whenever the next downturn shows up. To cut a long story short, the complexity of the refineries of Valero provides a significant competitive advantage to the company.
Moreover, Valero has the lowest operating cost per barrel of throughput in its peer group. It thus enjoys wider refining margins than its peers at a given set of benchmark refining margins.
Valero has stated that it targets a payout ratio of 40-50% as well as a sustainable and growing dividend, with a payout ratio at the high end of its peer group. The company has raised its dividend aggressively over the last decade. To be sure, it has more than doubled its dividend in the last four years, from $1.70 in 2015 to $3.60 in 2019.
Valero currently has a payout ratio of 63% but its payout ratio will greatly improve, to 37%, based on the expected earnings per share of $9.82 this year. As the company has raised its quarterly dividend by $0.10 per share for four consecutive years, it is safe to assume that the company will raise its dividend at the same rate this year, given its healthy payout ratio. In such a case, Valero will raise its annual dividend from $3.60 to $4.00 this year and thus it will soon be offering a 4.1% dividend yield, which is near the top of the historical range of the company.
All the refiners are highly vulnerable to recessions, as the demand for refined products decreases during rough economic periods and thus refining margins shrink. In the Great Recession, the price of gasoline remained below the price of crude oil (!) for a few months, thus resulting in negative refining margins. It is thus not surprising that Valero posted a loss of $0.65 per share in 2009. However, while no-one can predict the time of the next recession, there are no signs of an imminent recession on the horizon.
Another risk for Valero is a possible rally in the price of crude oil. Higher crude oil prices tend to affect adversely the demand for refined products and thus exert pressure on the refining margins. When the price of oil jumped in the recent conflict between the U.S. and Iran, all the stocks of the U.S. refiners plunged on that day. Fortunately, for them, the price of oil pared all its gains on the following days and thus the stocks of the U.S. refiners retrieved their losses. Even better, according to a recent study, the U.S. shale oil production is expected to continue growing for another decade. As a result, the price of oil is not likely to enjoy a sustained rally from its current level for the foreseeable future.
Valero will announce its next dividend hike in the next few days. Thanks to its strong growth prospects, its healthy payout ratio and its consistent dividend growth trend in each of the last four years (hikes of $0.40 per year), the refiner is likely to raise its annual dividend by 11%, from $3.60 to $4.00. As a result, the stock will soon be offering a 4.1% dividend yield.
On the other hand, due to its 23% rally in the last four months, the stock is not as attractive as it was a few months ago. It can rally by another 20% thanks to the aforementioned wide discount of Canadian crude to WTI and still be reasonably valued, at a price-to-earnings ratio of 11.8 (=1.2*97/9.82). However, most of the easy money has been made on the stock. Therefore, investors should probably wait for a more opportune entry point, in the $80s.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.