Valero Energy (VLO)

Quarterly Earnings

On July 29, Valero Energy reported weaker-than-expected second-quarter 2008 earnings of $1.37 per share (our estimate was $2.20 per diluted share), compared to $3.57 per share in the year-earlier quarter. The year-over-year negative comparison was due to reduced product margins (especially gasoline, asphalt and fuel oil) on the back of higher crude oil prices, and an increase in refinery operating expenses, partially offset by substantially higher margins on distillate products such as diesel and jet fuels, whose global demand remained high. We have reduced our earnings estimates to reflect the quarterly miss and the weak product margins, particularly for gasoline blends. Our new full-year 2008 and 2009 EPS estimates are $4.13 and $5.03, down from $5.74 and $6.43 before, respectively.

Throughput volumes during the quarter were 2.75 MMBbl/d, down nearly more than 2% year-over-year, primarily due to lower volumes in the Gulf Coast, northeast, and West Coast regions. This was partially offset by the 17.7% year-over-year volume increase in the Mid-Continent region. The Gulf Coast accounted for approximately 55% of total volumes, while the Mid-continent, the northeast, and the West Coast regions accounted for 16%, 19%, and 10% of the total, respectively. By feedstock composition, heavy sour crude, medium/light sour crude, and sweet crude accounted for 22%, 26%, and 24% of the total, respectively, while the remaining volumes came from residuals, blend-stocks, and other feedstocks. On the call, management guided that the company's third quarter throughput would be around 1.45 1.50 MMBbl/d in the Gulf Coast region, 430 MBbl/d in the Mid-continent region, 280 290 MBbl/d in the West Coast and 540 550 MBbl/d in the northeast system.

Company-wide throughput margin decreased more than 40% year-over-year to $10.82 per barrel, primarily due to the lower margins for gasoline and secondary products, such as asphalt, fuel oils, petroleum, coke and petrochemical feedstocks on the back of rising feedstock costs and an increase in refinery operating expenses. Average throughput margin realized in the Gulf Coast region was $13.25 per barrel, down more than 28% year-over-year, while throughput margin in the Mid-Continent and Northeast regions were $7.85 per barrel and $5.81 per barrel respectively, both down roughly 61% year-over-year. West Coast margin was $11.92 per barrel, down 41% from the year-ago level. In terms of feedstock differentials, the Maya (heavy-sour) discount averaged $20.99 per barrel, while the discount for Mars (medium-sour) crude oil averaged $6.96 per barrel. Cash operating cost per barrel was $4.53 during the quarter, down from $4.69 in the previous quarter but up from $3.87 in the year-ago quarter. The year-over-year increase in operating costs was primarily due to higher energy costs from the increase in the cost of natural gas and electricity, as well as lower throughput volumes. The unit DD&A expenses increased to $1.35 per barrel from $1.19 per barrel in the year-ago quarter. However, it was down from the previous quarter's level of $1.40 per barrel.

Capex, Share Repurchases, and Capitalization

Second-quarter capital spending totaled $741 million, of which $100 million was for turnarounds. The company repurchased 3.8 million shares in the second quarter for approximately $182 million. At the end of the quarter, the company had cash and cash equivalents of approximately $1.64 billion and long-term debt of approximately $6.48 billion.

On July 16, Valero announced that it had decided to take part as a prospective shipper on the 500,000 barrel per day expansion of the Keystone crude oil pipeline system. After completion, the pipeline will allow crude oil to be transported from Western Canada to the U.S. Gulf Coast at Port Arthur, Texas. Valero anticipates being one of the largest recipients of the low-cost heavy sour crude oil from this expansion project. In addition to its commitment of shipping crude oil through the pipeline, Valero also holds the option to acquire an equity position in the Keystone partnerships.

On July 7, Valero Energy completed the previously announced sale of its 85,000 barrels-per-day Krotz Springs, Louisiana, refinery to Alon USA Energy Inc. in a deal worth up to $433 million. The price includes $333 million plus an additional earn-out provision valued at more than $100 million (on the attainment of certain milestones). Both companies' Boards of Directors have approved the transaction, and the sale is expected to close in July, pending regulatory approvals. The sale is part of the company's plans to focus on its core refineries, where it expects higher returns.

On May 5, Valero announced that it has agreed to buy 72 convenience stores and fueling kiosks from Albertson's LLC. The retail gasoline stations and stores are located in Texas, Colorado, Arizona and Louisiana. Post completion of the deal, Valero will expand its company-owned retail presence in these markets. The companies did not disclose the financial terms of the deal. Valero expects to close the transaction in August this year. The newly purchased sites will then be re-imaged to the Valero Corner Store brand and will sell Valero-branded fuel.

On May 1, Valero announced a 25% increase in its quarterly dividend to $0.15 per share ($0.60 per share annualized). The new dividend was paid on June 18 to shareholders of record on May 28, 2008.

On February 28, Valero announced a new $3 billion share repurchase authorization. The company already has just over $1 billion remaining under a previously announced $6 billion buyback authorization, thereby giving it $4 billion available for stock repurchases in total. The Board also approved Valero's largest-ever capital investment project - an expansion at the Port Arthur refinery in Texas. The project will comprise the construction of a 50,000 barrel-per-day hydrocracker, a 45,000 barrel-per-day coker, along with revamps and expansions of a number of other units.

This program, expected to cost approximately $2.4 billion, is likely to increase the refinery's overall throughput capacity to 415,000 barrels-per-day, making it one of the country's largest refineries. This will help the company to increase its capacity to process heavy sour feedstocks that trade at a discount to light sweet crude oil. The hydrocracker project is scheduled to be finished in the fourth quarter of 2010 and the coker project is expected to be complete during the second quarter of 2011.

KEY POINTS

Valero is the largest North American refiner, with significant presence in each refining market.

Valero enjoys the greatest leverage among refiners to the still-wide light-sweet/heavy-sour spreads as 70% of its total refining capacity is capable of processing heavy/sour crude grades.

After successfully achieving growth through acquisitions in the run up to the current up cycle, Valero is responding to the current downturn by opportunistically restructuring and rationalizing its portfolio. This involves upgrading its core refineries to process more volumes of the low-cost heavy sour oil and divesting the non-core assets.

Valero is moving ahead with two large growth projects at its core refineries. The St. Charles project includes a new 50,000 barrels-per-day hydrocracker plus 45,000 and 10,000 barrels-per-day expansions to the crude and the coker units, respectively, while the Port Arthur project includes the construction of a 50,000 barrel-per-day hydrocracker and a 45,000 barrels-per-day coker.

A combination of slower than anticipated growth in global refining capacity, tighter fuel specifications, and continued demand growth are expected to continue to have a favorable impact on Valero's near to medium performance.

The company remains focused on returning capital to shareholders it bought back more than $5 billion worth of its own shares since last year and recently announced another $3 billion buyback authorization.

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