Old-time banker studies Caltex Notes

Traditional bankers, like the one your grandparents went to church with, didn’t first think of interest rate and fees when considering a new loan application.

Back then, it was about the credit risk of the borrower and the safety of their collateral. Only after concluding the borrower was sound and had sufficient collateral did thoughts turn to risk compensation.

Instead of acting like gold stock speculators, it’s time the typical Australian income security investor took a leaf from the traditional banker’s book. If not, they run the risk of getting sucked in to an offer like this.

From our banker’s perspective, Caltex looks a safe and trustworthy proposition at first glance. At 28%, net debt-to-equity borders on the conservative. The company’s net debts of $617m at 31 December 2011 are forecast to grow to $750m by 30 June 2012 but remain manageable.

Furthermore, cash flow interest cover over the past 12 years has averaged more than an eight times, an impressive result. Operating cash flow also covered its interest bill every year bar one (2000).

Business quality

What about broader measures of business quality? Over the past 12 years, Caltex had cumulative net financing cash outflows of $1.7bn. That might sound bad but it’s indicative of a company that pays out a lot of cash to shareholders rather than constantly taking money from them through new share issuances.

Our banker prefers lending to cash-generative businesses like this. Indeed, he recalls Intelligent Investor’s blog post Business quality: An effective acid test? of 1 July 2011, that confirmed the usefulness of this measure. Tellingly, Caltex hasn’t issued a single new share in more than a dozen years.

What he does notice are the large inventories of crude oil and refined product; $1.7bn worth at 31 December 2011 in fact. The massive and sustained increase in the price of oil over the past decade boosted the value of its inventory, making the above metrics more flattering than they might otherwise have been.

Our traditional banker then examines Caltex’s future debt-servicing capacity in light of this fact. It is not historical cash flow that will repay these notes, he muses, but future cash flow.

The refinery business, an important part of Caltex, is in a state of flux. He knows how massive refineries in Singapore have such a comparative cost edge over local refiners, exacerbated by the high Australian dollar, that it’s cheaper for Caltex and its competitors to import refined product than refine it here.

Plant closures

That’s why Caltex recently announced plans to close its Kurnell Refinery near Sydney. The company, already outlaying $450m on capital expenditure in 2012, will spend some $430m (in 2012 dollars) over the next four years to close it. Our banker nervously notices how the company must spend significant sums of money to reduce operating capacity.

In addition to the raw cash outflow, the plant closure suggests to him that the past may not be a good guide to the future. There’s also the possibility that this closure has been in train for some years. If so, the company would have logically underspent on capital works at Kurnell in anticipation of the closure. That would have further flattered the historical numbers discussed earlier.

He notes how an additional $250m needs to be spent converting and expanding Kurnell’s capacity as an import terminal. Caltex expects savings from the closure and import conversion will offset the outlays over the coming four years. That, our banker notes, remains to be seen. In business reconfigurations like this, surprises are usually negative. At the very least, he anticipates a temporary increase in company debt.

The Kurnell closure might not be the end of it, either. Caltex’s Lytton Refinery in Brisbane is subject to similar cost pressures. The company won’t close both at the same time but he wonders whether management is doing the numbers on an eventual closure of Lytton, too.

His conclusion: Caltex’s balance sheet, currently in good health, is at risk of deteriorating in the years ahead. Indeed, if that weren’t the case, the company wouldn’t need fresh capital from an offer like this.

The company has also signified the urgency of this requirement by announcing a likely cut in the dividend payout ratio on its ordinary shares (to 20-40% of profit) for at least the next three years.

Our banker wonders whether the company considered an ordinary equity raising, but thinks major shareholder Chevron, which owns 50% of Caltex, may prefer not to inject fresh capital or incur dilution of its stake. That’s the reason for this opportunistic subordinated notes issue. His conclusion is that this is a quasi-equity raising needed to fill company coffers.

The banker flicks through the offer document and associated presentation notes. On page 23 of the latter, he examines the comparison of Caltex Notes with Woolworths Notes II, and snorts; Caltex is no Woolies.

What about the compensation for taking on these risks, he wonders? Caltex Notes offer a margin of 4.50-4.75% over the three-month bank bill rate (to be set via bookbuild on 8 August), higher than the 3.25% margin on the Woolies offering. But the difference in credit quality alone demands a higher margin. Caltex needs the money more than Woolworths and has a less predictable business to service that debt, it needs to pay a higher margin.

Then our banker casts his eyes over the fine print for potential stingers. He finds a big one. As with the Woolworths Notes II, Caltex can redeem the notes in five year’s time or leave them outstanding for up to 25 years.

Woolworth’s excellent cash flow and the 1.0% step up in interest rate from 2016 means Woolies Notes II are likely to be redeemed early. Caltex Notes are far more likely to go the full distance. It’s all there, spelled out in the fine print:

‘Caltex intends … to retain Notes in its capital structure in circumstances where Caltex’s credit profile is materially worse than as the date of this Prospectus, unless it elects to replace Notes with a new issue of hybrid or other securities which are ascribed at least an equal equity credit from a ratings agency.’

The banker knows that if the Kurnell Refinery closure goes well, and the company is in solid financial footing come 2017, these notes are likely to be repaid early.

Unknowns

If, however, its finances take a turn for the worse, investors will be stuck with Caltex Notes for 25 years, getting only a miserable 0.25% step up from 2017. This is perhaps telling of the company’s longer-term intentions, concludes our banker. If Caltex is to flog a 25-year security, it needs to offer a far higher margin than a five-year one.

Table 1 highlights the key similarities and differences in comparison with other recently floated non-bank subordinated notes. But for our banker (and us), it’s the unknowns of the Kurnell (and potential Lytton) closure that is the key differentiator.

The best thing one can say about Caltex Notes, concludes the banker, is that it offers non-bank diversity to a portfolio of income securities. That, though, is no justification for taking up this offer. Our old-time banker decides to pass on Caltex Subordinated Notes, and we recommend you do likewise.