A New Way to Invest in Valero

Investing in energy can be straightforward. Buy shares of a drilling company and hope it strikes new gas or oil. Or invest in a royalty trust or master limited partnership that owns rights to production from proven reserves. You’ll collect reliable dividends.

But energy also has its fill of complicated investments that take tremendous effort to understand. For example, under the banner of San Antonio’s Valero empire, you’ll find three publicly traded entities. Valero Energy (symbol VLO), the patriarch, owns refineries and gas stations. Valero LP (VLI) owns the pipelines, terminals and crude oil storage tanks. Both have been excellent investments, notwithstanding Valero Energy’s fall from $69 to $53 in the last six weeks. Valero LP has also lost around 20% in the same downturn, as oil prices fell, but at $50, it now yields almost 7%. Most of Valero LP’s cash distributions count as a tax-deferred return of capital. This reduces your basis in the shares and increases your capital gains tax when you sell. But paying a top rate of 15% on a capital gain sure beats paying taxes on a distribution at the ordinary-income rate.

Now there’s a new member of this corporate family, one that analysts are eagerly recommending. Bearing an inscrutable name, Valero GP Holdings (VEH) went public in July at $22 and now trades for $20. Valero Energy owns 59% of the GP, while the public now has 41%. It has a $1.20 annual distribution, for a yield of 6%, with most of the income treated as return of capital -- same as Valero LP.

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Valero GP makes money in three ways. First, as the general partner, it gets 2% of Valero LP’s cash distributions up front. Then it owns 21% of the limited partnership’s shares. And it has something called "incentive distribution rights." There’s a formula, but what it means in plain English is that whenever the LP raises its dividends, the GP gets a greater share of the extra dividend income.

Got it? Let’s let A.G. Edwards analyst Mark Reichman, who is a big booster of the GP stock, try to explain: "The advantage is you have accelerated growth in cash distributions, though you sacrifice a little yield" at first, he says. He predicts that the "incentive distribution rights" will kick in at some point not too far ahead and give the GP shareholders a higher yield than owners of the LP units. But the LP owns actual business assets, like pipelines, while the GP owns pieces of paper and IOUs. Merrill Lynch, speaking generally about this type of corporate structure, calls GP shares "higher risk, potentially higher reward."

Our conclusion: Why invest in something so difficult to understand as Valero GP? After all, whatever dividends GP shareholders get originate from the same pipelines and terminals and tank farms as Valero LP. The limited partnership will be changing its name because the government wants to see more "separation" among all these related entities. But in five years’ time Valero LP has gone from $400 million in market value to more than $2 billion, paid great dividends, and seen the value of its assets mushroom. It’s a proven success. At $50, it’s a good buy -- and something you can fathom.