Trading Idea: VLO

June 30, 2008

167

Here’s a trading idea, courtesy of Daniel Jones of Option Notions, along with a summary of his recent trades. Today’s pick is a call spread on VLO.

UPDATE: GM LONG, SPREAD

Last week we mentioned that the market was almost past the technical "Panic point" that we saw at the 11,800 Dow Industrials point. The "left field" loop appeared on Thursday with Goldman’s friendly downgrade of GM, and the mention that Goldman’s analyst figured they would have to raise capital sometime soon. Thus, the market’s vulnerability was exposed and the rest, as they say, is history. Here we sit this morning about 400 points lower. Can the bottom be far away? It’s always darkest before the dawn, and with last week’s downside action, I have to say I think we’re approaching a very tradable bottom in the markets.

We mentioned GM in a bullish pick on 16 June 2008 (ouch!) with long-term 2010 LEAPs and January 2009 calls being recommended. We don’t think the company will have to raise capital, nor will they go bankrupt. They have $40+ billion in the bank and a solid cash flow. Something will happen here from a strategic point – GM is presently valued at only $6.4 billion in equity. That’s shark bait and some private equity player will pounce. We’d like to go on record today as recommending investors add to those GM call spreads at this time. The stock is at a 53-year low this morning (30 June 2008) due to the remaining investors throwing in the towel on them for end-of-quarter window dressing, and of course, the impact perceived from higher oil prices, which are skyrocketing today. We would recommend buying another position of the January 2009 $15 calls that we are long in that spread for $1.45 this morning, and sell the Jan 2009 $25 calls for $0.30, for a net cost to the spread of $1.15. The same goes for the 2010 LEAPS if you got those long. If you didn’t, now is a great time to buy Jan 2010 $20 LEAPS at $1.55 and sell the Jan 2010 $30 LEAPS for $0.55, for a net cost of $1.00.

We sent an update on the FDX and UPS puts last week. We hope you are enjoying those and waiting for the recommended sales prices we highlighted. Those picks are holding up well and nearly to the sales targets. Also, last week’s HBC puts are doing nicely. We think we’re participating in the downside in the market fairly well, so this week’s pick is an upside play.


TODAY’S RECOMMENDATION:  CALL SPREAD ON VLO

You would think that with oil prices skyrocketing, the people who turn barrels of crude oil into usable products like gasoline for our cars and heating oil for our homes would be absolutely minting money. Well, unfortunately, when the refineries’ input commodity (crude oil) price skyrockets, the margins for the finished products (outputs) actually get compressed. This margin is often referred to as the "Crack Spread" and it’s something that is highly cyclical and thus, the refinery stocks that live and die by the spread are also highly volatile. One such name that we’ve followed for quite some time is Valero Energy (VLO). Today’s pick is a call spread on VLO.

Valero Energy (VLO) Corporation operates as a crude oil refining and marketing company in the United States and internationally. Its refining activities include refining operations, wholesale marketing, product supply and distribution, and transportation operations primarily in the Gulf Coast, Mid-Continent, West Coast, and northeast regions.

The company produces conventional gasoline, distillates, jet fuel, asphalt, petrochemicals, lubricants, and other refined products, as well as reformulated gasoline mixture, gasoline meeting the specifications of the California Air Resources Board (CARB), CARB diesel fuel, low-sulfur and ultra-low-sulfur diesel fuel, and oxygenates. As of 31 December 2007, Valero Energy owned and operated 17 refineries in the United States, Canada, and Aruba with a combined throughput capacity of approximately 3.1 million barrels per day.

The company’s retailing activities include the sale of transportation fuels at retail stores and unattended self-service cardlock sites; sale of convenience store merchandise in retail stores; and sale of home heating oil to residential customers in the United States and Canada. As of the above date, it operated approximately 5,800 retail and wholesale branded outlets under various brand names, including Valero, Diamond Shamrock, Shamrock, Ultramar, and Beacon.

The company was founded in 1955. It was formerly known as Valero Refining and Marketing Company and changed its name to Valero Energy Corporation in 1997. Valero Energy Corporation is based in San Antonio, Texas.

The chart here shows VLO for the last six months. The stock has been compressed as the profit margin of each barrel of oil they refine has been similarly impacted negatively by the irsing price of crude oil. The Relative Strength Index (RSI) and Moving Average Convergence / Divergence (MACD) stochastic lines are both rounding out at low levels, indicating a bounce, at least on a technical basis could be coming.

VLO’s Fundamental Data:

Current Price: $40.86
Shares Outstanding: 528.5 million
Market Cap: $21.6 billion
Forward Price / Earnings (avg. Est): 6.8x
PE/G Ratio (5 Year Expected): 5.7x
Price / Book: 1.2x

Valero’s revenues have been surging lately. As you can imagine, just selling the same amount of energy product while the price soars nearly 100% will give you a revenue boost of 100%. But VLO has been unfortunately not making as much of a profit per barrel of oil as they did in 2007. The 2008 annual earnings estimates for VLO are averaging about $5.23 per share right now for the full year ending in December 2008, versus a 2007 full year figure of $8.17 per share. Try to get your head around the fact that VLO’s revenues have surged over 42% in that time, and you’ll fully understand the seriousness of the compression of the crack spread. VLO’s operating environment in higher oil price conditions is just plain brutal. 2009’s earnings estimates are currently posted at $6.03 per share, though revenues are expected to grow another 10%.

Given VLO’s current valuation and earnings expectations, we think the market has basically denied them any potential benefit of either a respite from rising oil prices (which could happen) or a cessation in the compression of the crack spread. The second potential factor would immediately follow the first. We think the present value of VLO, given its earnings and revenues outlook under what is today arguably a "worst case" scenario has much downside risk to it. Quite the opposite – we see the price today representing a great value and a free call option to the upside.

Valero’s balance sheet has a nice-sized cash cushion of over $1.4 billion. The debt they carry though, amounts to over $6 billion. Still, with the annual revenue run rate of over $130 billion, they have an EBITDA number on a trailing twelve month basis of over $6.64 billion. If they wanted to, they could probably pay off the company’s debt within one year – that’s powerful. Certainly within two years, but then that’s probably not the best use of funds for the Company. Share buybacks have happened here in significant size in years past, and we would expect that to continue. VLO pays a $0.60 dividend, and that could easily see an increase, as the payout ratio is currently at only 6.0%.

Our recommendation this week is to buy VLO stock at its present price of $40.86. We would also buy a September call spread in the $42.50 / $52.50 strike prices. We would look to acquire the VLO Sept $42.50 call for $3.00, and write the Sept $52.50 puts for $0.70, for a net cost of $2.30 to this spread. We would look to sell this put spread at a level of $8.00 or higher between now and the future expiration, giving us a return of just over triple the money.

We’ve heard from a few of our readers who just want straight option buy recommendations, rather than spreads. For investors who do not wish to write the higher strike call, a direct purchase of the September $42.50 call for $3.00 would be an alternative. We would look to sell that call at a level of $9.00 or higher.

Please note: Options trades all involve a high degree of risk and the potential to lose some or all of your investment. These recommendations are general in nature, and you should consult your own financial professional who is familiar with your situation as to the appropriateness of these trade ideas.
Disclosure: Analyst has no position in VLO stock or VLO options.