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By Adib Motiwala of http://adibmotiwala.blogspot.com/

I am currently doing a review of all the holdings in my stock portfolio. I thought it would be a good exercise to write down my thoughts in an article here. There are quite a few advantages to this.

(1) It will help clarify my thoughts as I write this down and I can review this in the future.
(2) I can get some good feedback on my thought process from fellow investors.

The first company I am reviewing is Valero Energy corp (VLO).

“Valero Energy Corporation operates as an independent petroleum refining and marketing company. The company operates through three segments: Refining, Retail, and Ethanol. The Refining segment engages in refining operations, wholesale marketing, product supply and distribution, and transportation operations. This segment owns and operates 15 refineries located in the United States, Canada, and Aruba. The Retail segment sells transportation fuels at retail stores and unattended self-service cardlocks; convenience store merchandise and services in retail stores; and home heating oil to residential customers in the United States and Canada. The Ethanol segment produces ethanol. This segment owns 10 ethanol plants in the Midwest.” – Source: Yahoo Finance

Lets look at the last 10 years Sales and EBIT numbers along with the P/E,P/B, EPS and Average EPS uptil that year.

Year  | Sales (billions)      | Op Income (millions)    | P/E     | P/B  |  EPS    | Average EPS|
————————————————————————————————————–
2000 | 14.6                    | 784                             |  6.6    | 1.5  |  1.4    |  1.4
2001 | 15                       | 1001                           | 4.3     | 0.6  |  2.21  |  1.81
2002 | 27                       | 471                             | 44.4   | 0.9  | 0.21   |  1.27
2003 | 38                       | 1222                           | 9.1     | 1.0  | 1.27   |  1.27
2004 | 54.6                    | 2979                           | 7.0     | 1.5  | 3.27   |  1.67
2005 | 82                       | 5459                           | 8.5     | 2.1  | 6.1     |  2.41
2006 | 91.8                    | 8010                           | 5.9     | 1.7  | 8.64   |  3.3
2007 | 95.3                  | 6918                          | 9.1    | 2.1 | 8.88   |  4.0
2008 | 119                     | 563                             | -10     | 0.7  | -2.16  |  3.3
2009 | 68                     | -58                             | -25.8 | 0.6 | -3.67 |  2.62
TTM  | 73.9                     |  120                            | -11.0  | 0.7  | -4.39  |    –

Sales have grown year over year except in 2009 when sales fell 43%. Op Income had been growing leaps and bounds but faced slow down in 2008 and 2009 was the first year of negative Op. Income. Even though its not easily obvious from the table above, oil refining is clearly a cyclical business.

When and why did I buy:
(1) Having sold VLO in the $70 range in 2007, I bought it back in 2008 at $40 level ( purely based on the price, clearly a speculative decision)
(2) I again bought VLO this time in late 2009 at $18. This time my reasoning was that VLO was trading well below book value at a P/B of 0.65-0.7.

Graham said that a P/E ratio based on last years earnings is of limited use and instead suggested to look at the “average earnings” over a business cycle.

The reason I present the average EPS for each of the years in the table above is to consider using that average earnings number to compute the P/E. So, in 2007 when I sold VLO at $70, the average EPS (from 2000 to 2007) was $4 v/s the reported earnings of $8+. The stock was trading at 70/4 = 17.5 v/s the trailing P/E of 9.  In 2007, the stock was clearly not cheap and potentially way overvalued. I was lucky to sell at the peak.

In 2008, the P/E using average EPS of 3.3 would be in the range of 12-14. Clearly, not cheap and the cycle had clearly changed for the worse.

Computing the average EPS over the 10 year period from 2000 – 2009, I get $2.62. Dividing the price on 7/8/2010 ($17.9) by this average earnings, I come up with a P/E = 6.8. This seems like a decent valuation.

Finally, the average P/B over the same 10 year period is 1.27 v/s the current P/B of 0.7. VLO seems attractive when looking at P/B as well.

Valero has total assets of $36.5 billion against total liabilities of $21.8 billion. That leaves shareholders’ equity of $14.6 billion that is trading in the market for $10 billion. ( Some times it helps to express the P/B in actual $ terms)

Some other things to consider:
– VLO has high capex needs averaging $1600 million over 10 years and $2400 million from 2007-2009.
– Z score is low at 1.45 ( predictor of bankruptcy)
– LT Debt / Equity = 0.53
– Cash $2 billion. Current ratio 1.4
– Negative FCF in 2009. Average FCF over 10 years is $1.2 Billion.
– Average Interest expense $400 million over last 3 years.
– Company bought back stock in 2008 at possibly the worst time.
– Company has cut dividend by 66% this year. Current yield is 1.2%
– The company has shut down one refinery in Aruba since July 2009.
– VLO sold one refinery in Delaware recently for $220 million.
– Extra refining capacity coming on in Asia.
– Weak economic conditions and low demand means poor margins for extended period of time.
If I am patient and do not get scared by the current terrible economics of the refining business, VLO could turn out to be a good potential investment. The question is can they hang in there till their earnings turn positive. Investing in cyclical companies is typically contrarian in nature and embodies the buy low and sell high mantra. You want to buy shares when the business is at its lowest point (indicative of high P/E or negative P/E) and sell when the business is doing really well and indicated by low P/E. I would not deny that there is an element of timing to this kind of investing. However, using the average earnings should help along with an eye on the news about the company. When there is fear and panic and disgust for such companies, that is the best time to buy. That is value investing for you.
I am sure there are many experts here who know the refining industry much better than me and who have invested successfully in cyclical companies. I would appreciate some feedback on this write up.

Reference articles:

Cyclical stocks
How to invest in cyclical stocks by Henry Lu
Valuing Cyclical Stocks by Joshua Kennon

Disclaimer: I have a long position in shares of Valero at the time of publishing this post. My position may change at any time without any further updates. Please conduct your own research before considering investments based on these or any ideas on this blog.