U.S. Markets closed

Better Buy: Calumet Specialty Products Partners LP vs. Valero Energy Corporation

Matthew DiLallo, The Motley Fool

Valero Energy (NYSE: VLO) and Calumet Specialty Products Partners (NASDAQ: CLMT) have richly rewarded shareholders over the past year, rocketing 57% and 80%, respectively. Given those gains, investors might wonder if either company has any fuel left in the tank. The short answer is yes, they both do. However, due to their vastly different risk profiles, one stands out as offering the best balance of risk versus reward.

The case for and against Valero Energy

Valero is currently the world's largest independent petroleum refiner, as well as a leading ethanol producer. It also owns a large stake in midstream MLP Valero Energy Partners (NYSE: VLP). That large-scale business has helped Valero keep its costs toward the low end of its peer group range over the years, enabling it to generate boatloads of cash that it uses to buy back shares and pay an above-average dividend. In fact, Valero currently offers the highest yield in its peer group (3%) and has reduced its share count by nearly 25% since it started repurchasing stock in 2011.

A storage tank with the sun rising in the background.

Image source: Getty Images.

Valero also generates ample excess cash to reinvest back into its business, with the company consistently spending capital on high-return growth projects that collectively earned the highest return on invested capital in its peer group over the past year. It currently has several expansions underway in both its refining and logistics segments that should significantly boost earnings in the coming years. Meanwhile, Valero has maintained a top-tier balance sheet backed by a low leverage ratio of 0.8 times debt to EBITDA, which is below the 2.0 times average of its peers.

About the only knock on Valero is that it currently trades at 7.4 times its enterprise value to EBITDA, which is a common valuation metric in the energy sector. That's only slightly below the peer group average of 7.7 times after the stock's run-up in the past year. However, a high-quality company like Valero should fetch a premium over its competitors, suggesting that it should have more upside ahead. 

The case for and against Calumet Specialty Products Partners

Calumet is an MLP that produces high-quality specialty hydrocarbon products like solvents, asphalt, and lubricants. These products tend to carry some of the highest margins in the refining sector. However, Calumet has struggled to consistently make money from its operations due to some legacy money-losing businesses that it has since sold. In addition to that, the company made some poor investment decisions in the past, which caused it to rack up debt.

Because of its financial issues, Calumet doesn't generate much excess cash. What money it does produce goes mainly toward paying down debt so that it can get some more breathing room. That has enabled the company to reduce its leverage ratio from an unsightly 21.8 times debt to EBITDA in the third quarter of 2016 to a slightly more comfortable 4.9 times in the first quarter of this year, which has helped lift some of the weight holding down its valuation. As a result, Calumet now trades at about 8.5 times EBITDA. While that's higher than the average multiple of refiners like Valero, it is below the range of specialty chemical producers and branded product makers, which tend to trade between 10 to 13 times their enterprise value to EBITDA. This gap implies that Calumet could have significant upside as it continues to pay down debt and turn around its operations.

It's all about the risk/reward profile

Valero and Calumet offer investors two vastly different risk/reward profiles. Calumet is on the higher end of both since it still has a mountain of debt weighing it down. If the company can continue turning around its operations, then it could climb much higher. Valero, on the other hand, is a top-tier company that generates gobs of cash flow, giving it plenty to send to investors and reinvest in high-return growth projects. While risk-tolerant investors might prefer Calumet's untapped upside potential, Valero's strong balance sheet and ample cash flow increase the probability that it can continue generating market-beating returns. That lower-risk upside makes it the better buy right now.

More From The Motley Fool

Matthew DiLallo has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.