CORPORATE OVERVIEW. Incorporated in 1981 under the name Valero Refining and Marketing Co., the company changed its name to Valero Energy Co. (VLO) in 1997. In 2001, VLO merged with Ultramar Diamond Shamrock, and in September 2005 with Premcor Inc., creating the largest refiner in North America, based on atmospheric distillation capacity. The company's business segments are refining (91% of 2006 revenues, 98% of operating income) and retail (9%, 2%). VLO serves customers in the U.S. (88% of 2006 revenues), Canada (8%), and other countries (4%); no single customer accounted for over 10% of consolidated operating revenues. The refining segment includes refining operations, wholesale marketing, product supply and distribution, and transportation operations. As of year-end 2006, the company owned and operated 18 refineries in the U.S., Canada and Aruba, with a combined throughput capacity of 3.26 million barrels per day (b/d). The refining segment by region consisted of the Gulf Coast (nine refineries, 53% of 2006 throughput capacity), the Mid-Continent (four, 19%), theWest Coast (two, 9%) and the Northeast (three, 19%). During 2006, sour crude oils represented 47% of VLO's throughput volumes, acidic sweet crude oils 9%, sweet crude oil 29%, residual fuel oil 4%, other feedstocks 3%, and the remaining 8% was composed of blendstocks. About 65% of VLO's current crude oil feedstock requirements were purchased through term contracts, with the remainder generally purchased on the spot market. About 75% of these crude oil feedstocks are imported from foreign sources, and around 25% are domestic. Average refinery yields for 2006 were composed of 48% gasoline and blendstocks, 32% distillates such as home heating oil, diesel fuel and jet fuel, 3% petrochemicals, and 17% other products (including vacuum gas oil, no. 6 fuel oil, petroleum coke, and asphalt). VLO is one of the largest independent retailers of refined products in the central and southwest U.S. and eastern Canada. Its retail operations are segregated geographically into two groups: Retail-U.S. System (sales of 116,600 b/d in 2006) and Retail-Canada (75,600 b/d). VLO markets its refined petroleum products through an extensive bulk and rack marketing network of about 5,500 retail and wholesale branded outlets in the U.S., Canada and the Caribbean under various brand names, including Valero, Diamond Shamrock, Shamrock, Ultramar and Beacon. Retail-U.S. stores are sold primarily under the Valero brand, with some sites selling under the Diamond Shamrock brand pending their conversion to the Valero brand.

IMPACT OF IMPORTANT DEVELOPMENTS. In December 2006, the company completed the monetization of its ownership interest in Valero L.P. (VLI; a master limited partnership that owns and operates crude oil and refined product pipelines and storage facilities) by selling all of its units in Valero GP Holdings, LLC, generating proceeds of $880 million and recognizing a pre-tax gain of $328 million. In 2003, VLO acquired Orion Refining Corp.'s 215,000 b/d St. Charles Parish, LA refinery for $400 million plus $149 million of inventory. In 2004, the company acquired El Paso Corp.'s 315,000 b/d Aruba refinery for $465 million plus $162 million in working capital. On May 31, 2005, VLO sold its Denver refinery to Suncor Energy (SU) for $30 million plus $15 million for working capital and inventories. On September 1, 2005, VLO acquired Premcor Inc. via the issuance of 85 million shares of VLO common stock, $3.4 billion in cash, and the assumption of about $1.9 billion of Premcor debt.

FINANCIAL TRENDS. Capital spending reached $2.59 billion (including $1.05 billion for regulatory and Tier II) in 2005 and $3.7 billion ($1.41 billion) in 2006, and VLO has budgeted $3.5 billion ($0.66 billion) for 2007.

Valero is the largest oil refiner in North America, one of the largest independent U.S. refined petroleum products retailers, and operates refineries that can process sour and acidic crude oils.

First quarter after-tax operating earnings increased 35%, to $1.1 billion, or $1.86 per share, reflecting widened refining margins due to stronger demand and more limited supply caused by refinery outages. Results fell short of our estimate by $0.06 per share. Refining throughputs were flat with in the first quarter year-to-year, despite increased capacity at the
Port Arthur refinery, on planned maintenance at the McKee refinery, and we expect that second quarter levels will rebound as the refinery returned
to operations on April 15.

U.S. refining margins have been strong of late, partially offset by reduced throughput on refinery outages. While we expect that margins will narrow for the remainder of 2007 as refinery maintenance is completed before the summer driving season, we believe strong demand and limited conversion capacity will cause U.S. refining margins to rebound in 2008.Strong industry fundamentals boosted after-tax operating earnings by 32% in 2006, but we expect declines of about 19% in 2007 and 12% in 2008, on lower projected pricing. Our sell recommendation is based on valuation. As VLO is the largest refiner in North America, we believe its size and ability to refine heavy sour crude feedstocks offer strategic and economic advantages. With the majority of refining costs focused on feedstocks, we think VLO's ability to refine lower quality crudes (about 55% of its 2006 feedstocks were sour or acidic) is a competitive advantage.We estimate that VLO holds an above-average level of conversion capacity (near 1.6 million b/d), and the company is expanding its upgrading capacity at its Aruba refinery and Port Arthur, TX, crude unit. Risks to our recommendation and target price include changes in economic, industry and operating conditions that could lead to a widening of margins or an increase in production. Using a blend of our discounted cash flow (assuming a weighted average cost of capital of 10.1% and terminal growth of 3%) and relative valuations, we derive our 12-month target price of $58. Our target price represents an enterprise value of 4.5X our 2008 EBITDA estimate, a discount to peers.

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