Valero’s Retail Spinoff Is Worth Watching

Juicy crack spreads have kept downstream refining facilities profitable for the past year, but Valero (VLO) might be offering investors something even better via its retail operations spinoff CST Brands (CST).

The business of turning raw crude oil into gasoline, jet fuel and other petroleum products has been a cash cow for firms during the last year, thanks to the wide spread between West Texas Intermediate crude and international benchmark Brent. Yet, with that spread shrinking to just $8, many in the downstream sector are looking for ways to ensure their profitability.

One method has been to place various pipeline, storage and refinery assets into master limited partnership subsidiaries to save on taxes. But there’s more than one way to skin a cat.

Valero’s recent retail spinoff could be the wave of the future for downstream players seeking to balance out profitability.

However, CST Brands might be a titillating buy in its own right.

Size & Scale

While an estimated 100 million Americans visit a convenience store on any given day, margins for those sodas, cups of coffee and Slim-Jims can be tight. And like many retail establishments, convenience stores do see some ebb and flow when it comes to consumer spending.

With that in mind, a variety of downstream firms have been tossing around the idea of spinning off or selling their retail operations in order to preserve the more robust profitability of their refining operations. For example, Hess (HES), according to a company spokesperson, is currently in the process of evaluating divestiture options for its iconic green & white flagship retail outlets, regardless of whatever happens with its recent bout of shareholder activism. So it’s no surprise that Valero has gone down the same route.

Last year, Valero decided to spin off CST Brands in a move that will concentrate its operations to strictly refining petroleum. That will make VLO a much leaner refining operation and will remove much of the “uncertainty” of retail from its earnings. Valero also is considering spinning off its midstream assets into an MLP to gain the tax advantages of being general partner.

All in all, these moves should help the largest independent refiner keep its crown as one of the best in the business. (The company’s latest earnings reports beat analysts’ estimates by a healthy 18 cents per share.)

But the operations that Valero is casting off still could hold plenty of value for investors.

While the convenience store industry is the single largest retail subsector — with roughly 35% of the retail market in the U.S., according to the Association for Convenience & Fuel Retailing — the industry is largely populated with small, independent mom-and-pop operators. Almost 65% of U.S. convenience stores are owned by individuals that operate 10 or fewer stores. That provides very little in the way of purchasing power and marginal profitability.

CST, on the other hand, is a completely different story.

The company is the second largest convenience store chain operating in the nation, with more 1,880 convenience and retail stores. This includes 1,032 company-operated fuel and convenience stores in the U.S. and 848 retail sites in Canada. That size and scope has given CST some pretty nice profitability over the last few years.

In 2012, the retailer of cigarettes, monster-sized sodas and Valero-produced gasoline managed to generated revenue of $13.1 billion and would have made $379 million in EBITDA as a stand-alone entity. Additionally, CST sold around 5,083 gallons of fuel per site per day, with the average margin of 15.8 cents per gallon last year. That’s a pretty juicy margin considering most convenience store operators actually lose money on the gasoline they sell. Those margins have helped the company generate free cash flow of $240 million.

The other ace up CST’s sleeve is that it owns the real estate for around 79% of its stores, compared to an average of 52% for its peer group. That provides the company with the potential to participate in leaseback transactions in the future and reduce the company’s fixed costs in the present.

Attractive Valuation

Given its profitability, CST Brands looks already like a “buy” — or at least a “hold” if you received shares in the spinoff. The deal looks even better when you compare it to its major publicly traded competitors.

Based on several metrics, CST is the cheapest of its peer group. Based on projected earnings, CST can be had for a forward P/E of just 14, compared to 17.6 for Susser Holdings (SUSS) and 18.33 for Casey’s General Stores (CASY). On the enterprise value/EBITDA, CST Brands is still better than its two peers, clocking in at just 8.2. That compares 8.4 and 9.3 for its respective rivals.

While it currently trades at a discount, CST won’t stay that way for long. With long-term pricing contracts for gasoline still in hand from its former parent, along with its healthy real estate advantage (can you say a REIT potential?), analysts estimate CST should and will eventually trade for a hefty premium in the space. Just how hefty? If CST can approach the industry average for EV/margins, shares should trade about 70% higher than current prices.

Add in the fact that CST management has already stated its intention to pay a dividend, and you have a recipe for long-term success.

As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities. Although he could go for a Sheetz MTO right about now.

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