Valero Energy: Management Committed To High Yield, But Risks Remain (NYSE:VLO)

Meghann Showers

Introduction When this latest Covid-19 economic downturn hit the world, it seemed quite likely that Valero Energy (VLO) would join the list of companies reducing their dividends. To their credit, they have managed to defy this pressure and keep their dividends flowing amidst this turmoil. Although when looking at their […]

Introduction

When this latest Covid-19 economic downturn hit the world, it seemed quite likely that Valero Energy (VLO) would join the list of companies reducing their dividends. To their credit, they have managed to defy this pressure and keep their dividends flowing amidst this turmoil. Although when looking at their current and future situations, there are still risks that keep me from getting excited about this high 9% dividend yield.

Executive Summary & Ratings

Since many readers are likely short on time, the table below provides a very brief executive summary and ratings for the primary criteria that was assessed. This Google Document provides a list of all my equivalent ratings as well as more information regarding my rating system. The following section provides a detailed analysis for those readers who are wishing to dig deeper into their situation.

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*There are significant short and medium-term uncertainties for the broader oil and gas industry, however, in the long-term they will certainly face a decline as the world moves away from fossil fuels.

Detailed Analysis

Valero Energy cash flows

Valero Energy notes 1

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Instead of simply assessing dividend coverage through earnings per share, I prefer to utilize free cash flow since it provides the toughest criteria and best captures the true impact to their financial position. The extent that these two results differ will depend upon the company in question and often comes down to the spread between their depreciation and amortization to capital expenditure.

The impacts from this Covid-19 economic downturn are easily apparent when reviewing their cash flow performance from the first half of 2020. Their operating cash flow decreased a massive 71.30% year on year during this period of time and even if the unfavorable working capital movements are removed, this was still a significant 41.19% decrease year on year. This naturally suppressed their once very strong dividend coverage during 2017-2019 to a very weak negative 98.75%.

This situation would often cause many companies to reduce their dividends but their management has nonetheless remained steadfast in their commitment. When asked about their dividend payout ratio during their second quarter of 2020 results conference call, they gave the following commentary.

“You’re right. We’re well above it. Now I think Homer said, we’re at 96% year-to-date on payout. But with this being an extraordinary and short-term event, we’re not going to — we don’t adjust that based on this type of a situation. So we stick with our guidance. We won’t vary from it. I don’t know if we have an exact number on how long we would be comfortable with that.”

-Valero Energy Q2 2020 Conference Call.

Their ability to continue supporting their dividend despite these tough operating conditions will depend upon their capital structure, leverage and liquidity. When looking even further ahead into their long-term future and they clearly face a very real risk as the world moves away from internal combustion engines, which has been recently highlighted by California banning the sale of new gasoline cars by 2035. Regardless of exactly how fast the world transitions to electric vehicles, it does not change the fact that they face a long-term decline that will eventually erode their earnings or require significant investments to mitigate, either of which will restrain their future dividend prospects.

Valero Energy capital structure

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It can be seen that their net debt increased significantly during the first half of 2020 from $7.089b to $10.358b, as the pain of sustaining their dividends throughout this downturn is felt across their capital structure. Seeing an increase of this magnitude in such a short length of time is never ideal, but the extent that it matters will depend upon their broader leverage and liquidity.

Valero Energy leverage ratios

Valero Energy notes 2

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Thankfully they entered this downturn with only moderate leverage, as primarily evidenced by their gearing ratio of 23.93% at the end of 2019 and thus this allowed them to lean upon their financial position to sustain their dividends. The pain of this choice is evident with their gearing ratio now reaching into the high territory at 33.42%, which indicates their ability to safely continue down this path is limited to the short-term since this is quite a significant increase in leverage in only six months. Normally when assessing leverage it would be preferable to utilize the other metrics available, such as net debt-to-EBITDA, but given the high volatility in their earnings during the downturn these are essentially rendered useless and thus their gearing ratio provides a suitable proxy.

The worst of this downturn should be over but their dividend remains risky since economic conditions are yet to completely recover and thus they still require leaning on their already highly leveraged financial position for longer. Whilst this leverage does not currently pose a risk to their ability to remain a going concern, seeing any further increases are certainly not ideal given their likely long-term capital requirements to diversify their earnings. Long-term shareholders would be wise to keep an eye on this consideration since too much leverage in the short-term could easily paint themselves into a corner when the world moves away from fossil fuels, as they would be unable to invest adequately without heavily reducing their dividends.

Valero Energy liquidity ratios

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They clearly have strong liquidity with a current ratio of 1.75 that is further supported by a decent cash balance and thus a cash ratio of 0.32. Even if operating conditions were to take a prolonged period of time to recover, at least this should ensure that they remain a going concern despite their high leverage. Due to their large size, decent overall financial position and supportive central bank policy, there are no reasons to be concerned that they cannot find support in the debt markets to provide liquidity and refinance any upcoming debt maturities when required.

Conclusion

It seems reasonable that they will sustain their dividend providing operating conditions have in fact already passed their worst point in the previous months, but this remains risky given the damage their financial position suffered in only six months. So even though a high 9% dividend yield certainly sounds desirable, given these short-term risks and the long-term clean energy transition, I believe that a neutral rating is appropriate.

Notes: Unless specified otherwise, all figures in this article were taken from Valero Energy’s Q2 2020 10-Q, 2019 10-K and 2017 10-K SEC Filings, all calculated figures were performed by the author.

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.

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