Credit analyst sees little reason to believe worst is over for Valero Energy

By Ronda Fears

Nashville, Tenn., Sept. 30 - Valero Energy Corp. may be able to stay within recently revised bank covenant margins, but Carol Levenson, director of research at Gimme Credit, sees little chance of it restoring credit quality anytime soon.

"Perhaps we will be accused of locking the barn door after the horse has been stolen, but we are no longer as sanguine about the ability of the acquisitive refiner Valero Energy (Baa2/BBB) to restore its credit quality within a reasonable time frame," Levenson said in a report Monday.

"There's already been some damage from recent events - an earnings warning for the third quarter, outlook changes to negative from both major rating agencies and a disturbing emergency pass from its bankers - and we see little reason to believe the worst is over.

"Granted, if margins improve Valero should be well within its revised debt covenants.

"But we're uncomfortable with its impaired financial flexibility, and we see additional downside here."

Valero's acquisition of Ultramar Diamond Shamrock last year was supposed to temper its earnings volatility by enhancing its business and geographic diversification.

No doubt the UDS contribution made a lousy second quarter less lousy than it otherwise would have been, Levenson said.

But, despite the acquisition, however, the company's EBITDA was down a dizzying 60%.

And the increased debt burden from the acquisition supplied a double whammy, sending EBITDA coverage of interest from 23x to less than 3x.

Moreover, free cash flow was negative by $500 million in the first half even with the benefit of a sizable tax refund.

"Net debt reduction is likely to come to a screeching halt now that the major mandated asset sales are completed. We project that in the best case scenario the company will only break even on free cash flow in the second half," Levenson said.

The need to seek an amendment to its bank agreements so soon seems to have taken many by surprise, including management.

The company made no mention of approaching the EBITDA/interest limit in its second quarter 10-Q or earnings conference call.

Management even took Moody's to task for downgrading its outlook last month, claiming it would remain well within the debt covenants in its bank agreements.

The in-compliance mantra was repeated early this month despite an accompanying lowered earnings outlook. Yet less than a month later, there was Valero, renegotiating the covenants.

"Although we don't know what, if anything, Valero had to pay or give up in order to secure this amendment, we hope it wasn't much as the headroom hasn't exactly become commodious," Levenson said.

"After all, when Valero first agreed to the covenants, its EBITDA coverage was well into the double digits, so 2.75x must have seemed like a no-brainer to achieve."

Gimme Credit estimates trailing 12 months coverage was 3.5x in the second quarter and presumably isn't much worse this quarter since the amendment only applies to the fourth quarter and 2003.

"As of August 30, Valero reported $800 million drawn under its bank lines, so the covenant issue is not merely an academic one," Levenson said.

"Naturally we're accustomed to looking at a refiner's debt protection measures throughout the cycle, not just at the trough. But apparently the bank loans were not set up to accommodate this volatility."

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