DGI Adventure – 12-10-2015 Investment Thesis – Valero Energy Corporation (VLO) – $66.40/share

Please visit the core
philosophies
article on my
investment thesis process
for a full explanation of the components of this
article.

Dividend Cycle

VLO should go ex-dividend sometime in mid-early February. I
anticipate the quarterly dividend to be $0.50/share again. This quarter’s
payment marks the first at this distribution rate, which is an increase of 25%
over the previous dividend of $0.40/share. Valero just recently broke into
Challenger status on the CCC
list
, having raised the payout for 5 consecutive years. They’ve
consistently made dividend payments of some kind over the last 15 years, but
there was a pretty steep cut in the depths of the recession, and some up and
down amounts in 2005 and 2006. Although the pattern hasn’t been a steady upward
climb, all-in-all the dividend has gone from $0.08/quarter in 2000 to
$0.50/quarter now, which represents a 35% annualized DGR.  

Investment

I think I’d like a piece of that refinery action, which is
why I’ve placed a limit order for 26 shares at $66.40/share. That represents a
total investment of $1,733.35 (including $6.95 trade commission). Shares closed
today at $71.38. The limit is ~7% below the current market price.

Let’s refine our reasoning for this purchase:

The QC (Quantitative
Case)

*Okay…these are yellow because technically they’re under the
target threshold, but come one…they are both practically 10%.

**It’s worth noting that since the recent dividend increase
hasn’t actually hit the balance sheet yet, I had to adjust the dividend payment
assumption when calculating the cushion: I took TTM dividends paid out and
multiplied by 1.25 to approximate the payout at the new rate. They are buying
back shares at a torrential pace (over $2.5B TTM), so this quick math probably
overstates the actual amount that would be paid out…and there’s still plenty of
room.

Holy shit that is a great cash flow situation! 17% payout
ratio…of free cash flow? Yes please!

LOL (Limit Order
Logic) – $66.40

Sorry, no elaborate wave theories or chart analytics on this
one.

$66.666666 is not
only an evil number, but it happens to be the threshold price for the current
annual dividend of $2.00 to represent a 3% yield. I want me some 3% yield. With
a $6.95 trade commission, a purchase of 26 shares at $66.40 comes to a cost
basis of $66.67/share. No support levels. No moving average significance. None
of that. It’s just that the 3% yield is important to me. $66.40.

QWaF (Qualitative
Warm and Fuzzy)

According to
Morningstar analyst Allen Good, Valero is one of the more diversified and
complex US refiners. They have the ability and capacity to refine either
imported heavy crude or domestic light crude into high quality products. So
basically they can just flip a switch and use whatever is most profitable.
Their flexibility and geographical/logistical distribution was enough of a
strength that Allen was willing to give the company a “narrow” moat rating. Any
kind of “moat” in the commodities space is pretty tough to get, so they must be
doing something right.

In general the global petroleum market’s situation seems
positive to me for refining companies. They have to buy crude to make their end
products, and crude is probably going to be cheap for a while. Domestically low
unemployment, etc. should mean more demand for gasoline. This seems like an
obvious play that is much safer than most of the names in the energy sector
right now. Maybe I’m missing something even more obvious? I hope not…

So it makes a lot of sense to me to invest in a refining
company. Which one to pick? Well…Valero has an amazing cash flow situation, so
I feel pretty confident about the dividend. And Allen’s brilliant commentary
notwithstanding, Valero is a “familiar” company to me…I know the Valero brand.
They have a big refinery in our area and are one of the biggest employers in
town. So why the hell not Valero?

CPR (Cold and Prickly
Risks)

There are the broad general risks to consider; for instance,
refining capacity is growing outside of the US which will put pressure on
margins of domestic refiners who export their finished products. Force Majeure
is always a concern for a company like Valero that has billions of dollars’
worth of assets in the gulf coast just hoping to not get hit by a hurricane.

There is also much political debate about lifting the ban on
crude exports, which could have a profound impact on domestic refiners. They
currently benefit from the significant spread between domestic and imported
supplies. If that spread flattened out or went away, there would be an effect
on margins.

Fortunately Valero is super flexible about what
type of crude they use for their feedstock, so even if the market shifts,
presumably they’ll be able to adapt. And good lord do they have an enviable
cash position. Sign me up. 

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