Introduction
Apple (AAPL) is having somewhat of a hard time. Five of its past six quarters had negative sales growth, dragged down by its flagship product, the iPhone, which is pressured by headwinds, including stronger competition from Chinese producers.
However, its shares soared by more than 6% after the recent earnings release, as the producer noted that it expects the next quarter to see growth.
It also revealed $110 billion in additional buybacks!
To put things in perspective, at current prices, that's enough to buy every single share of the Boeing Company (BA).
That said, I believe the market may be overreacting. Yes, $110 billion is a lot. However, it's just 3.6% of Apple's $2.8 trillion market cap.
While it will certainly have a meaningful impact on the company's bottom line, it's not a buyback program that gets me excited.
That's where Valero Energy (NYSE:VLO) comes in.
At the risk of comparing apples to oranges (pun intended), we're dealing with a fascinating company.
Even including the pandemic, which caused Valero's free cash flow to implode, the company has bought back a (slightly) bigger chunk of its shares outstanding over the past ten years than Apple.
Over the past five years, VLO has bought back more than a fifth of its shares. Apple has bought back 15% of its shares.
In fact, over the past five years, Valero has been buying back stock only since 2022, which makes it even more impressive.
During this buyback period, Valero shares have returned 120%, beating the 46% return of Apple by a considerable margin. That said, going further back into the past, Valero has massively underperformed Apple.
This is also where the comparison to Apple ends, as this article is about Valero and its ability to generate tremendous shareholder wealth in a very cyclical industry.
My most recent article on the company was written on February 13, when I went with the title "Riding The Refinery Wave: Why Valero Should Be On Your Radar."
Since then, VLO shares have returned 10.4%, beating the S&P 500 by slightly more than 700 basis points.
In this article, I'll update my thesis using the company's latest earnings and "big picture" developments, starting with a closer look at fossil fuel demand.
So, let's get to it!
Demand Tailwinds & Investments In Growth
Last month, the Energy Information Administration published its short-term energy outlook. In this case, "short-term" includes 2025.
Despite challenging economic conditions in various regions, including Europe and China, the EIA upgraded its guidance, expecting higher growth than previously estimated. I added emphasis to the quote below.
This month’s STEO incorporates the recent update to our International Energy Statistics for 2022. This update increased our assessment of global liquid fuels consumption for 2022 by nearly 0.8 million barrels per day (b/d) compared with last month’s STEO. Most of this change reflects non-OECD consumption that is higher than we previously estimated. The higher baseline historical data for 2022 in turn increased our estimate of consumption in 2023 and our forecasts for 2024 and 2025. - EIA
Unsurprisingly, demand growth is mainly driven by lesser-developed nations, which makes sense, as they have simply more growth in basic needs, including energy.
This bodes extremely well for Valero.
Although the company is completely dependent on oil producers for its input - it's a pure-play refiner - it has fantastic assets in place to service both domestic and international demand.
This includes 2.7 million barrels of daily refining capacity. More than half of this is located close to suppliers on the Gulf Coast. It also has European and South American exposure through nine international terminals and one refinery in the United Kingdom.
Going back to the Gulf Coast, in this region, the company has access to both oil production from Eagle Ford and the Permian and the ability to process a wide range of different oil types (not all oil is equal).
Generally speaking, this is a huge benefit for margins and operational reliability, as it is not dependent on a certain feedstock.
On top of these "traditional" assets, the company has a wide range of growth projects aimed at improving earnings power and its overall competitive advantage.
During its 1Q24 earnings call, the company noted that its DGD sustainable aviation fuel ("SAF") project at Port Arthur is progressing ahead of schedule and is expected to be operational in the fourth quarter of this year.
Once this project is completed, Diamond Green Diesel is poised to become one of the largest SAF manufacturers in the world. It would also boost the total renewable fuel capacity to 1.2 million gallons per year, as we can see in the chart below.
Even better, these operations are increasingly profitable. Last year, for example, renewable diesel generated $700 million in free cash flow (EBITDA - CapEx).
Moreover, using S&P Global (SPGI) data, global SAF production is expected to rise from roughly 4 million metric tons in 2024 to roughly 17 million metric tons by 2030.
Valero, being early in this industry, is also in a good spot to boost SAF production, as the company explained in the Q&A session of its 1Q24 earnings call:
But what I'd say from a macro view, you could clearly -- the units are cookie cutters of each other. The project is nearly identical, the execution time and all of that is going to be very similar. So it's not a technically challenging project or something that would be difficult to fund. It's a question of how we see this market develop and when we decide internally is when we would say something externally. - VLO 1Q24 Earnings Call
Unexpected Strength Is Set To Last
As good as the numbers above may look, Valero is expected to remain in a long-term earnings decline.
Using the FactSet data in the chart below, EPS growth is expected to decline through at least 2026:
-12%
Year EPS Growth 2024E -31% 2025E -19% 2026E
However, this is not due to poor management.
This is simply the result of analysts expecting industry margins to normalize.
As the orange line in the chart below shows, EPS is still expected to remain at above pre-pandemic levels.
What we are dealing with is a company that benefitted tremendously from strong demand and sky-high margins during the immediate post-pandemic years.
A lot of refineries (especially overseas) were shut down as a result of lockdown-related demand weakness. It took time to bring back supply growth.
Moreover, demand came roaring back, which met subdued spending on growth projects and the war in Ukraine after 2021, which caused demand for non-Russian refined products to increase.
Using the data below, we see that both 2022 and 2023 were superior years in terms of total refinery margins and profitability compared to peers.
The company's latest earnings reflect this normalization, as the company reported net income of $1.2 billion, with earnings per share of $3.75.
In the first quarter of last year, the company generated $3.1 billion in net income, which was $8.29 per share.
Adjusted net income for the quarter was $1.3 billion, or $3.82 per share, reflecting a decrease from $3.1 billion, or $8.27 per share.
We are also seeing some margin headwinds in refining, although elevated throughput is a good sign for the total demand picture.
Refining throughput volumes averaged 2.8 million barrels per day in the first quarter of 2024, with a capacity utilization rate of 87%.
Regarding margins, refining cash operating expenses were reported at $4.71 per barrel, lower than initially expected, which was driven by reduced energy costs and increased throughput.
The same applies to renewable diesel and ethanol, both of which saw declines in operating income due to poor margins.
Looking ahead, the company expects to maintain elevated margins due to tight product inventories going into driving season.
Moreover, despite the startup of new refineries in the current year, product demand is projected to outpace supply in the longer term, which will likely allow Valero to beat very downbeat analyst expectations in the years ahead - all else being equal.
Good News For Shareholders
During the first quarter of 2024, Valero returned a significant amount of capital to its stockholders, totaling $1.4 billion.
This included $356 million paid as dividends and $1 billion used to buy back roughly 6.6 million shares of common stock, resulting in a payout ratio of 74% for the quarter.
As we already briefly discussed, through buybacks, the company has bought back a fifth of its shares since the end of 2021.
It has also grown its dividend by 17% per year since 2012, outperforming almost every single industry peer, as we can see in the overview below.
After hiking its dividend by 4.9% on January 19, it currently pays $1.07 per share per quarter. This translates to a yield of 2.7%.
On top of strong earnings, all of this is supported by a healthy balance sheet.
The company ended the quarter with a debt-to-capitalization rate (net of cash and cash equivalents) of 17% with more than $5 billion in liquidity - more than 10% of its market cap!
On top of that, as reported by Seeking Alpha, Goldman Sachs (GS) has put Valero on its list of "top 50 strong balance sheet stocks."
Even better, despite analysts being downbeat about the company's earnings trajectory, they still expect $4.7 billion in 2026 free cash flow, which is 9% of its current market cap.
Unless the economy were to take a huge hit or Valero encounters unexpected costs, the company is in a fantastic spot to deliver high-single-digit to low-double-digit annual shareholder returns (as a percentage of its market cap).
Moreover, as the company keeps dividend growth subdued, we can assume that buybacks will continue to account for most of these distributions.
Valuation
Despite the expected long-term decline in earnings, analysts have made significant adjustments. When I wrote my last article in February, analysts expected 2026 EPS to be $10.12. Now, that number is expected to be $12.19.
Historically speaking, the company has traded at 9.8x earnings. It currently trades at a blended P/E ratio of just 7.0x, as the company never got the valuation it "deserved" during the past few years.
Applying a 9.8x multiple to its expected 2026 EPS (I expect that number to come in higher than expected) gives the stock a fair price target of $119, which is 23% below the current price.
In other words, for the Valero bull case to play out, we need Valero to consistently beat expectations, which I expect to happen.
Meanwhile, supply remains tight, geopolitical tensions remain high, and economic growth is strong enough to provide strong demand and elevated throughput.
However, given the company's recent rally, I will stick to cheaper oil and gas producers (instead of refiners) at this point. I like their valuations better, as a lot of good news has been priced into the refinery industry.
That said, I have little doubt that VLO will remain a buyback monster, which is a great buy on a 10-15% correction and a fantastic stock for inflation protection.
Takeaway
While Apple's recent buyback announcement grabbed attention, Valero's consistent buyback strategy over the past decade has outperformed.
With a focus on shareholder wealth and superior performance in refining, Valero stands out in a very cyclical industry.
Despite the anticipated earnings decline, Valero's strong balance sheet, dividend growth, and buyback program offer promising returns.
Moreover, while analysts remain cautious, Valero's potential to beat expectations through ongoing industry tailwinds and investments in growth makes it a compelling long-term investment on a potential correction.
Pros & Cons
Pros:
- Strong Buyback Program: VLO consistently buys back shares, indicating confidence in its future and good use of its free cash flow.
- Renewable Energy Investments: VLO's focus on renewable energy projects, like its DGD sustainable aviation fuel project, positions it well for future growth and aligns with evolving market trends.
- Healthy Balance Sheet: With a low debt-to-capitalization rate and ample liquidity, VLO has a solid financial foundation to support its growth initiatives, buy back stock, and withstand elevated interest rates.
- Favorable Supply/Demand: While we are seeing some normalization, Valero is upbeat about both supply and demand dynamics in its industry.
Cons:
- Earnings Decline Expectations: Analysts anticipate a decline in earnings through at least 2026, primarily due to expected industry margin normalization, which could pressure short-term investor sentiment.
- Valuation Concerns: While VLO's current valuation is discounted compared to historical levels, there's uncertainty around future earnings growth.
- Industry Volatility: As a pure-play refiner, VLO is exposed to the cyclical nature of the refining industry, which may result in earnings fluctuations and increased risk during economic downturns.
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