Valero Stock: Growing Free Cash Flow To Support Dividend Growth (NYSE:VLO) (2024)

Overview

I previously covered Valero (NYSE:VLO) back in August of last year. Since then, it has stayed on par with the S&P 500 (SPY) and provided a total return slightly over 21%. Now that a few quarters has gone by, I wanted to revisit and provide some updated insights around the valuation, benefits as a dividend compounder, and the company's outlook. When it came to valuation, I previously conducted a discounted cash flow analysis to get a price target of $212. I want to now use a different valuation method to try and get a more conservative estimate around the fair value of VLO.

Just for a bit of context, Valero is energy based company that refines and sells its petroleum based products and petrochemical products on a global scale. The company operates between three main segments consisting of Refining, Renewable Diesel, and Ethanol. In my opinion, Valero is strategically positioned to benefit from the growth of the Biofuels market, with a forecasted growth CAGR of 5.2% through the end of 2029. We can see the ripple effects of this growth so far with cash from operations increasing and free cash flows growing.

As a result of this growth, I believe that Valero still remains undervalued and I maintain my prior strong buy rating. To reinforce this, I conducted a dividend discount calculation which shows significant upside potential. Speaking of dividends, I also wanted to first start this article off by discussing the safety of the dividend and how the growth rate fits my needs as an accumulator of shares as I plan to hold for the long term.

Dividend Income Growth

As of the latest declared quarterly dividend of $1.07 per share, the current dividend yield sits at 2.7%. The thing that I like here is that the dividend remains well-supported. The dividend payout ratio sits very low at around 20%, significantly undercutting the sector median payout ratio closer to 40%. The dividend is further supported by the fact that VLO's interest coverage over its debt is strong, with a coverage ratio above 16.3x.

The dividend growth history may first appeal very mild but this is only due to the fact that the company stalled raises in 2020 in an effort to preserve capital. This can be forgiven since VLO was simply trying to mitigate the risk levels from the uncertainty during the start of the pandemic. As a result, the dividend has increased at a mild CAGR (compound annual growth rate) of 4.2% over a five year period. However, when we zoom out to a ten year time horizon, the dividend increased at a much larger CAGR of 15.97%.

We can actually visualize how this dividend growth would have played out over time by running a back test with Portfolio Visualizer. This calculation assumes an initial investment of $10,000 back in 2015. It also assumes that a fixed monthly contribution amount of $500 was added every throughout the entire holding period, alongside all dividends received being reinvested back into VLO. Even though the dividend was not increased from 2020 through 2022, we can see how this consistent reinvesting of dividends and addition of capital can essentially create your own income growth over time.

In 2015, your starting dividend amount received would have only been $427 annually. If we fast forward to the full year of 2023, we can see that your dividend total would not be $4,873 received annually. In addition, your position size would have now grown to over $200,000 while simultaneously outpacing the S&P 500 (SPY) during that time. This is exactly why a long term outlook and consistency pay off when it comes to building a stream of dividend income. Now you'd be receiving nearly $5,000 a year in qualified dividends and since these dividends are qualified, this is the most tax efficient it could get no matter what sort of account you decide to hold the position in.

This sort of dividend growth is ideal for investors that may want to build a stream of income over time. While it may not be ideal for the investor looking for an instant source of higher yielding income that you'd be able to obtain from other sources such as REITs, Business Development Companies, or Master Limited Partnerships, it is perfectly suitable for those still in the accumulation phase that may not need the income just yet.

Valuation

In terms of valuation, I still believe there is some sizeable upside potential here, despite the run up over the past year. For instance, VLO currently trades at a price to earnings ratio of 7.63x, which undercuts the sector median of 10.38x. In addition, VLO has averaged a price to earnings ratio of 8.95x over the last five year period which may also indicate undervaluation here. On the flip side of this, the current price to book value of 1.94x does sit higher than both the sector median and VLO's own five year average of 1.69x.

Wall St. seems to believe that VLO has some solid upside potential since the average price target sits around $180.95 per share. This represents an approximate 17% upside from the current levels. The highest price target sits at $210 per share while the lowest is at $128 per share. This is a pretty large gap in price targets so I wanted to get another source of reference here. I decided that running a dividend discount calculation would be suitable here and we can do this by combining the previous payout histories with the estimated growth rate.

I started by compiling all of the annual dividend payout amounts dating back to 2018. We can see that the dividend grew at an average rate of 3% since then due to the fact that the dividend remained at the same level from 2020 through 2022. EBIT has grown at an average rate of 7% over the last five year period. Similarly, year over year revenue growth has averaged 14% over the last five years but if we take a more conservative approach, an estimated growth rate of 7.5% is certainly achievable.

With these inputs in mind, I get a fair value estimate of $171.20 per share. This represents a potential upside of 11.5% from the current level, assuming a 7.5% growth rate. When you combine this with the current dividend rate of 2.7%, there is a strong potential for double digit growth from this point forward. These growth estimates doesn't even include the fact that VLO maintains a strong buyback history. They've issued $5.2B in buybacks for 2023 and this is planned to continue throughout 2024. They aim to have the dividend payout ratio remain between 40% - 50% and since the current payout ratio only remains at 20%, we can expect this difference to be filled with buybacks.

Financials

VLO reported their Q1 earnings and the results showed a bit of weakness with revenue decreasing 12.8% year over year, totaling $$31.76B. However, earnings per share beat expectations by $0.60, totaling $3.82. The area of business with the largest negative impact was the refining segment. This segment's operating income amounted to $1.7B, which is a large decrease from Q1's total of $4.1B in the prior year. This was due to the lower refining barrels that dropped 2.8M barrels. Additionally, the decrease in income can be attributed to the fact that there are ongoing maintenance costs within their refinery systems. As started on the last earnings call:

Our team's ability to optimize and maximize throughput while undertaking maintenance activities illustrates the benefit from our longstanding commitment to safe and reliable operations. Refining margins remain supported by tight product balances with supply constrained by seasonally heavy refining turnarounds and geopolitical events. Product demand was strong across our wholesale system, with diesel demand higher and gasoline demand about the same as last year. - Lane Riggs, Chief Executive Officer

The Renewable Diesel segment also showed some losses with net operating income amounting to $190M. However, the decrease here was a bit less drastic over the prior year's total of $205M. Even though the net operating income was lower, this was offset by the increase in sales volume. Sales volume increased to $3.7M gallons per day, which was an increase of 741 gallons per day from the year prior. This higher level of volume can be attributed to the joint venture with Diamond Green Diesel, which has seen increased outputs. Despite the increase in volume, the net operating income was ultimately down due to a lower renewable diesel margin.

The Ethanol segment is the smallest for VLO but this also saw some slight decreases due to a lower margin as well, with total operating income amounting to $10M. The segment saw growth in volumes with production averaging 4.5M gallons per day. This is a slight increase over the year prior, with production seeing an increase in volume of 283k per day over the year prior. Despite the decreases throughout each segment, cash from operations and free cash flow has still improved above pre-pandemic levels. Liquidity also remains strong with cash and cash equivalents totaling $4.9B, which can help navigate these lowered volumes.

We can see how the relationship of VLO's price closely follows the general trend of crude oil production. Historically, as production trends upward, so does VLO's price. Naturally, these decreases are expected and operate on a cyclical basis since the volumes can be tied directly to the price of crude oil. Crude oil is their primary input source for their refining process and can increase or decrease the profit margins as the costs shift. It can be as simple as higher crude oil prices increasing profit margins. However, the drop in price can also mean that they are forced to price their refined products at unfavorable rates in combination with the fact that a lower crude oil price can mean that demand isn't as strong.

Additionally, VLO has long term debt totaling about $10B. For reference, their debt levels have normally ranged between $8B to $12B so there's nothing to worry about here. We can see that the free cash flow also sits close to all time highs previously reached in 2022. Free cash flow levels sit at $7B now, a slight decrease down from $9.6B at the end of 2023.

Risk Profile

As a refiner, VLO remains highly sensitive to the cyclical nature of the sector. As we can see from the recent lackluster quarterly earnings report, VLO is vulnerable to changes in the production and price of crude oil. Sharp changes can have an instant effect on margins and profitability, alongside the general risk of unfavorable market cycles. If we go through a period of time where the economy slows down, such as a recession, we can assume that the demand would further decrease and lower the volume at which VLO can operate at. If we go through an economic period of lower spending, this could also cause VLO's momentum to slow.

Additionally, the price has actually remained quite resistant to the interest rate hikes we've seen. The federal funds rate now sits at a decade high and there's a chance that future rate cuts get delayed until 2025. Their current debt load sits at about $10B and the higher interest rates can cause interest payments on their debt to rise. Additionally, since the cost of capital is more expensive, this can slow any new developments, research, or expansion opportunities that VLO may have down the pipeline.

Takeaway

In conclusion, Valero has the potential to be a strong dividend compounder when held with a long term outlook. The rising free cash flow in combination with a very healthy payout ratio, should be enough to support additional upside growth of the dividend. In addition, I believe that there is a double digit upside from the current level based on my dividend discount calculation. The inputs for my calculation were conservative and I think this increases the likelihood of my $171 estimated fair value of being achieved over time. While the business segments has seen decreases across the board, this isn't necessarily a cause for concern as VLO remains sensitive to changes in the crude oil price and production levels. The well-managed internals combined with the future growth potential in upside and dividend income makes this a strong buy for long term investors.

Financial analyst by day and a seasoned investor by passion, I've been involved in the world of investing for over 10 years and honed my skills in analyzing lucrative opportunities within the market.I specialize in uncovering strategies to utilize various investment vehicles - seeking out high quality dividend stocks, and other assets that offer potential for long term-growth that pack a serious punch for bill-paying potential. I use myself as an example that with a solid base of classic dividend growth stocks, sprinkling in some Business Development Companies, REITs, and Closed End Funds can be a highly efficient way to boost your investment income while still capturing a total return that follows traditional index funds. I create a hybrid system between growth and income and manage to still capture a total return that is on par with the S&P.After humble beginnings sharing my knowledge on Instagram (@thegamingdividend), I have decided to further expand my passion sharing insights here on SA.My money will always be where my mouth is; I am a strong proponent in the FIRE movement and have been perfecting this craft so that I can inspire the average 9-5'er like myself, that early retirement is within reach without compromising the safety of your portfolio.