Valero's Deep Discount

Shares of San Antonio, Texas-based Valero Energy have been battered over the past several weeks and days of trading, dropping more than 20% from their all-time high of $78.58 on July 10, and losing 10% since July 26.

Investors dumped Valero Energy on Wednesday as the stock tanked more than 5%, closing at $63.58 per share, or 6.6 times analysts' consensus forecast for 2007 earnings per share of $9.62.

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Ken Kam, founder and CEO of stock picking Web site Marketocracy.com and editor of the Marketocracy Marketscope newsletter, recommends buying shares of Valero Energy.

Valero is the largest North American refiner with the capacity to process approximately 3.1 million barrels of oil per day at its 17 refineries throughout the U.S., Canada and the Caribbean. It also operates about 5,800 retail and wholesale stores throughout the U.S. and Canada under names that include Valero, Diamond Shamrock, Shamrock, Ultramar and Beacon.

Kam is bullish on Valero both for fundamental reasons as well as the popularity of the stock among the most successful of the more than 60,000 portfolios he tracks on Marketocracy.com. Valero is the 11th biggest holding among the M100, Marketocracy's top 100 investors, and it is also one of nine stocks in Kam's "Best Ideas" portfolio.

"It has been more than a generation since anyone built a new refinery in the U.S.," says Kam. "Valero's ability to refine cheaper high sulfur or sour crude and its market-leading position among refiners suggests that this company should be trading at much higher multiples than the market currently assigns to it."

Indeed, Valero's P/E ratio of 6.6 times current year earnings is about one-third of the average P/E multiple for the S&P 500 Index. Furthermore, with analysts looking for 10.82% annualized growth over the next five years (compared with 114% annualized growth over the past five years) Valero has a slender price-to-earnings growth (PEG) ratio of 0.61. A PEG ratio of less than one suggests that investors are buying future growth at a discount.

On July 31, Valero reported earning $2.25 billion, or $3.89 a share, in the third quarter, beating expectations for $3.75 EPS. Earnings grew 30.5% from the second quarter of 2006, even though revenue dropped from $25.6 billion to $24.2 billion. Sales dropped primarily due to numerous refinery shutdowns for maintenance, which also constrained the supply of gasoline in the spring of this year.

Valero and other refiners make their money on the "crack spread"--or the difference between the cost of crude and the price of refined products. That spread had been especially wide in the second quarter, but that gap tightened considerably as oil hits new highs and refineries come back on line producing more gasoline.

One advantage that Valero enjoys over competitors is that it can process high-sulfur "sour" crude in its refineries. According to its quarterly report, during the second quarter, "Maya" heavy sour crude oil averaged $9.60 less per barrel than West Texas Intermediate, and the discount for "Mars" medium sour crude averaged $2.70 per barrel. The differential on Maya crude has since increased to nearly $10.40 per barrel.

Kam and his gurus are not alone in their ardor for Valero. On July 31, Standard and Poor's raised its 12-month target price to $78 from $58.