Qantas, oil, Caltex, Westfield

The old adage says you "can't own oil stocks and airlines". The theory is that a rising oil price is an insurmountable headwind for the airline industry, and the only way you can make money is by owning upstream oil producers and downstream refiners.
Well, we don't think this is the case today. Over the long-weekend I did see the unusual sight of the new A380 Airbus flying over the Caltex oil refinery at Kurnell in Sydney. I thought to myself this next generation of fuel efficient aircraft means you can own oil stocks and airlines and below we are going to explore the investment case for Qantas (QAN) and Caltex (CTX).

Qantas (QAN), all aboard

"There were three in the bed and the shareholders said.."

Thankfully, "The great plane robbery" as we like to call it was foiled by QAN shareholders. There was a little bit of premature celebration in the photo above, but the Chairman has done the honorable thing and taken the fall for the Board who recommended a takeover that 54% of shareholders rejected. The show now goes on, and I actually believe the fact that the deal failed will make management even more determined to deliver shareholder returns and clearly that's a good development. You can see already that the tone of recent announcements from QAN have become more optimistic and focused on growth and capital management.

QF $7.00

Our view was the $5.45 recommended offer effectively "capped" the share price. If QAN had not been under recommended takeover offer the series of earnings upgrades would have seen the share price trading above the offer price. That view has proved correct, with Australian institutions taking out the foreign hedge fund overhang in less than a week. After a series of broker earnings upgrades, QAN is closing in on being the top industrial stock on all-important quant earnings revisions screens. With broader industrial earnings growth slowing, this is a very important development. Have a look at the chart below, its QAN vs. the ASX200 over the last 4 years. It shows huge underperformance, but that is ending. It also shows you the Board recommended a takeover over at pretty much the low point of relative performance vs. the benchmark ASX200 index, and ahead of a period of extended double-digit earnings growth.

QAN vs. ASX200 last 4 years

Capacity remains very tight

We all remember the post 9/11 images of commercial aircraft being parked at the Mojave Airport in the California desert. According to a recent article in Fortune Magazine (June 11, 2007), that Mojave Airport is nearly empty as global aviation sector capacity tightness has seen most of those planes de-mothballed and returned to service.

Flipping 737's

What has happened is that hedge funds and private equity have got involved in the airline leasing market. Aircraft were previously financed based on the creditworthiness of the airlines, rather than the value of the actual planes. Hedge funds have stepped in, and have begun trading 75-ton Boeings and Airbuses. With Boeing and Airbus basically sold out of new aircraft until 2010, the hedge fund lessors can often name their price for popular aircraft such as newer, single aisle Boeing 737's or Airbus A320's, as well as some twin-aisle planes favoured for lucrative long-haul routes.

To put this in context, recently certain models have brought in as much as 1.5% of their market value in monthly lease payments, the high end of the industry scale. Monthly rentals for newer generation 737's are up almost 20% over the last years, while rates for 767's have doubled. Fortune reports that recently two relatively new 737's were returned from a European airline, and a bidding war started between five airlines.

The new demand for these aircraft is from emerging markets like China, India and Latin America. It is interesting, every time an old economy industry is caught short capacity it's always these emerging economies which are driving it. This is about demand from emerging economies.

Listen to Boeing

Boeing can be accused of talking their own book, but if they get forecasts wrong they will have pretty serious earnings ramifications. Boeing expects worldwide demand for air travel to increase by 260% by 2025, while the number of planes flying will just double. As US carriers begin to replace their fleets, demand for new aircraft will only increase.

Here are some facts about US airlines that nervous flyers should NOT read. Right now US domestic carriers own 126 planes that are 25 to 40 years old. Without new orders, that number is expected to grow to 384 airplanes in 2012, and up to 840 by 2015. They will modernize their fleets. Do you drive a 25 year old car?

Yields remain very strong

QAN's April traffic and capacity statistics that were released yesterday reinforce the effect tight global capacity has on yield. QAN group passenger numbers were 4.6% vs. pcp, revenue passenger kilometers were up 6.4%, while available seat kilometers were up just 2.4%. This all resulted in Revenue Seat Factor (yield) rising from 77.9% to 80.8% in April

For the financial year to date, QAN group passenger numbers are 7%, RPK's are up 7.5%, ASK's 3.3%, and revenue seat factor up by 3.2% to 80.7%.

Not only are QAN filling more seats more profitably, but fuel costs are also being contained. QAN also announced that 63% of fy08 crude requirements are hedged at a worst case of US$70bbl WTI. It's also worth remembering that the next generation of long-haul aircraft, the A380 and 787, are far more fuel efficient than today's aircraft. QAN has 20 A380's on the way and at least 60 A787's on the way. They will have one of the most fuel efficient fleets in the world by 2010.

This is all occurring before the strategic review

QAN stated at the May 24th investor briefing that its strategic priorities over the next 12-18 months will be;

A review of capital management (should release a few billion)
Further enhancing of the Two Brand Strategy (yield enhancing)
Expanding the Jetstar footprint (expands the marketplace)
Further leveraging the Frequent Flyer Program (you can monetize anything nowadays)
Developing an integrated freight business (they should buy Linfox)
Introducing the A380 and B787 aircraft and product (too easy, it sells itself)
Realising greater efficiencies across all areas of the business (hopefully this is always a goal)

At the August fy07 result, which will be an absolute cracker, you will get news of capital management and the results of the strategic review process. QAN is trading at $5.75 simply on its own fundamentals and any large scale news about capital management will lead to a further re-rating.

QAN will earn EPS north of 50c in fy08, which is 40% growth on the 45% growth that will be delivered this year. I reckon that EPS number of 50c will be a minimum result, and you can easily see QAN earning 55 to 60c EPS in fy08 as current operating conditions persist. The ordinary dividend should be a minimum of 30c ff in fy08, but that doesn't include capital return/release initiatives.

QAN is cum large scale capital management, cum another year of 40% earnings growth, cum capacity increases, and cum further yield improvement. It is also cum a fleet of next generation fuel efficient aircraft. It is also the most leveraged large cap industrial company to the rising A$. All this for a 50% discount to the ex-bank industrial market and a sustainable dividend yield of 5.5%. QAN remains a strong buy and its destination is $7.00 on an 18 month flight.

Rising bond yields

We firmly believe that rising bond yields are a reflection of continuing strong global growth supporting very positive fundamentals for commodities. As a result we expect a period of outperformance for resource stocks and industrials leveraged to the strength of the global economy. In this context the BRIC economies are driving a massive increase in global demand for oil products. In a relatively short period China has become the world's second-largest oil consumer at 7.2mbpd compared to the US at 20.5mbpd.However, Chinese oil consumption per capita is considerably less than the US. Currently there are 3m registered vehicles in Peking and an estimated total of 17m in China. This compares to more than 200m light vehicles in the US which incredibly consume 11% of the world's oil production. If Chinese oil intensity equalled the US, then Chinese demand alone would consume OPEC's entire daily production of 34mb.This is a scary prospect, but in reality it could occur before 2020.

Refining capacity shortage

In addition, against a backdrop of an unprecedented increase in current and forecast demand, there is a structural shortage of global refining capacity. The fundamentals for the global refining industry, particularly in the US, are remarkably similar to the mining sector. The capacity constraints in both industries are the result of decades of underinvestment in future production. There has not been a new refinery built in the US since 1976.The massive industry overcapacity of the 1970s and 1980s severely depressed refining margins providing no incentive for investment in future production. Over the last 25 years, the number of refineries in the US has fallen by 50%, and refining capacity has decreased by 10% from a peak of 18.6mbpd.At the same time, gasoline consumption has risen by 45%.

As a result there has been a significant loss of spare capacity which has supported high US utilisation rates by historic standards. The US is now a net importer of refined products with refinery output of just 17mbpd compared to demand of 20.5mbpd.US refinery utilisation rates are now regularly over 90% on average, compared to an average of 75% only 2 decades ago. Consequently there has been a big increase in refiner margins and industry profitability. However despite the significant increase in profitability, US capacity has increased by just 0.8% over the last 2 years. In an attempt to encourage new capacity, US Congress passed legislation in 2005 streamlining the permitting process for building new refineries.

Barriers to entry

However, only one new refinery is planned in Arizona. The proposed 150k bpd refinery is expected to be in production by 2011 at an estimated cost of $US3.5b.The major hurdles to developing greenfield refinery capacity in developed economies continues to limit new projects. The American Petroleum Institute estimates its members have spent $US50b over the past decade complying with environmental regulations and changes in emission standards regulations, which is roughly the cost of building 10 large refineries. The replacement cost of building a new refinery is simply prohibitive in Western economies.

Global phenomenon

However this is a global phenomenon.During the period from 1990-2000, when refiner margins were lower and less volatile, global refining capacity was on average 9% more than global oil demand. However, since 2000 this percentage has dropped to as low as 3% above global demand in 2004.The IEA estimates that global oil demand in 2010 will be about 93m bpd, an increase of nearly 12m bpd over 2004.This increase would require the addition of 30-40 world scale refineries just to keep pace with oil demand. This is a big ask even with the planned capacity increases. However, in order to maintain the 9% surplus capacity of the 1990-2000 period would require 50-70 refineries of world scale size. This is highly unlikely in our view.

Demand outstripping supply

Caltex highlighted an industry study last year where the results revealed that since the early 1970s, over 30% of planned capacity increases failed to be commissioned. In a recent interview, Chevron's head of global refining Jeet Bindra expected the shortage of refining capacity to persist until 2015, due to rising costs and delayed projects. He confirmed approx 7mbpd of refining capacity was expected to be commissioned before 2011.However, 50% is coming from India and China, where the growth in capacity is expected to merely satisfy the increase in demand. Bindra expects China to be a net importer in 2015 despite the planned capacity increased.

We think the fundamentals of the global refining industry are no different to base metals. Analysts are blindly focusing on the expected supply response, while totally underestimating the structural increase in demand.

At present global oil refining capacity is approx 83.5mbpd.This represents a capacity increase of under 2mbpd over the last 2 years, compared to an increase in demand of almost 4mbpd.The International Energy Agency projected worldwide refining capacity would have to increase to 93mbpd by 2010 just to meet the expected increase in demand.

India is expected to provide the majority of the projected increase in global refining capacity over the next few years. However, recent figures released by the Indian Govt reveal plans to expand refining capacity by 62% or just 4.8mbpd over the next 5 years. In China the majority of planned capacity increases are expected to just satisfy the growth in internal demand. Despite the expected increase in future capacity, clearly the world remains structurally short refining capacity and this is expected to continue over the medium term. In the meantime the International Energy Agency(IEA) is forecasting annual global oil demand growth of 1.8% until 2010.

S.E.Asian capacity shortages

The IEA is forecasting that the Asia Pacific region is expected to experience the highest rate of product demand growth in the world.The region's share of global demand is projected to increase by 30% by 2015.The S.E. Asian region in which Caltex(CTX) operates, reflects the same global structural supply shortages in refining capacity.

The S.E.Asia refinery constraints are highlighted by the structural shift in the regional refiner benchmark, the Singapore Refiner Margin (SWAM).In 2002 the SWAM averaged 2.3%, in 2003 the average rose to 3.9% and then 5.7% in 2004.Over the last 2 years it has averaged 5.5%.In the year to date the SWAM is currently averaging 7.2%.

Domestic clean fuels premium

Again we think this is similar to our "higher for longer" view of base metal prices. CTX expects regional capacity additions to remain limited for the next few years allowing high utilisation rates to continue. However, the fundamentals for the Aust industry are even more positive, with the introduction of the federal Clean Fuels Standards.

Asia is short the refining capacity required to supply the unique nature of the new Aust petrol specifications. As a result, the new cleans fuels legislation has resulted in a long term structural change in the domestic refining industry. The new standards have reduced imported product, protecting the Aust industry from dumping.

Consequently, Aust is structurally short product, with 1 in 4 barrels of oil consumed being imported. This has created a "quality island" for the domestic refining industry which has reduced the volatility of the benchmark Singapore Refiner Margin (SWAM).This is supporting a structural uplift in domestic refining margins resulting in a premium price for "Aust spec" fuel. The current Caltex Refiner Margin (CRM) is averaging between $A 2-3c above the regional Asian benchmark SWAM. We expect this to lead to a long term increase in margins and profitability.

Utilisation rates higher for longer

After the completion of the refinery upgrades to comply with the new Aust clean fuels regulations, CTX refinery utilisation rates averaged a record 85% in the 2H 06.At times the rate exceeded 90%.This compares with rates of 74% in 2004 and 73% in 2005. In addition management's expectation is to achieve a yearly target of 85% utilisation rate, following the the $350m Refinery Performance Improvement Program (RPIP) by the end of 2008.In addition CTX expects to lift production of high value transport fuels from 10.2b litres last year, to 11b litres in 2007, rising to 12b litres in 2008 following the successful implementation of the RPIP.

Replacement cost

In an environment where the costs of greenfield projects and brownfield expansions have significantly escalated we think the replacement costs of "trophy assets" are very underestimated. In addition this significantly raises the barriers to entry of potential competitiors. The high cost of replacement assets is highlighted by the only new refinery currently planned in the US. The proposed cost of the 150k barrel Arizona refinery implies a replacement cost of $US23k per barrel. Applying the same valuation to CTX's domestic production of 240k bpd represents an implied valuation of $US5.5b or $A6.5b for CTX'S Aust refinery assets. Yet the current market cap for CTX $A6.9b including Chevron's 51% stake.

A $3b marketing business for free

We believe CTX is trading at a discount to the replacement cost of the domestic refinery assets. However this implies at current levels shareholders are receiving the marketing business for free. We think the major point of differentiation for CTX relative to the domestic peer group, is the marketing business. CTX has a dominant industry position as Aust's largest petrol retailer with a 38% market share, well ahead of the competiton. Shell is a distant second with 27%, followed by BP 19%, and Mobil 10%.The marketing business comprises a national network of over 1800 branded service stations and more than 60 branded resellers. The Woolworths (WOW) alliance with a discount offer, has been instrumental in raising utilisation rates, and delivering volume growth over the competition.

In addition, CTX is the nation's leading operator of convenience stores with 30% market share.Non-fuel income represents a significant proportion of convenience store income, and importantly now contributes around 10% of total earnings.As a result, the total marketing business represents approx 30% of earnings, and provides the diversification to smooth the volatility of refining margins.We believe the marketing business is conservatively valued at $A3b.I can envisage an opportunity for CTX to buy back the franchisees, float the division, and monetise the hidden value of the marketing business However, the market is ascribing absolutely no value to a $3b business.

Long-term fundamentals

The domestic refining industry is an oligopoly underpinned by capacity shortages supported by the new clean fuels regulations.We think the new domestic petrol specifications have created a "quality island" resulting in a permanent long term positive change in industry fundamentals.This is driving a long term and sustainable increase in profitability.

In addition, the significant increase in industry replacement costs has substantially raised the barriers to entry.The result is genuine pricing power for the domestic refining industry.CTX has the dominant industry positioning and the earnings leverage is generating annual free cash flows in excess of $A500b.We think this will result in a significant increase in future dividend yield driving a further rerating.

We believe current SWAM forecasts are too low and CTX is cum further earnings upgrades. The half-yearly update is expected within the next couple of weeks. However, given the short term focus of the market any trading weakness in CTX should be used as a buying opportunity for long-term outperformance.

Who would you back?

Westfield announced a $3bil capital raising with the intention to pay down debt. Trading on 20x earnings that equates to an earnings yield of 5.00%. The Australian Government 10 year bond is yielding 6.30%. In reality, a strong and diversified company like WDC could borrow at probably 50bp over the risk free government bond rate (6.80%).

The point I am making is that the equity market is prepared to give WDC new equity capital at a 130bp risk "discount" to a risk free government bond, and around an 180bp risk discount to where a financial intermediary would lend them the money.

The Lowy's are rich for a reason; they are smart. They are using the hype in the LPT sector to reduce their funding costs by issuing expensive equity (relative to debt). I find it very interesting that as non-traditional players use debt finance to bid down yields in the LPT sector that the Lowy's are basically doing the exact opposite.

I'd back Westfield over any other stock in the large cap LPT space. They own the highest quality assets and they have the highest quality management. If I owned only one stock in the LPT sector it would be WDC. There is a clear message being sent by WDC today, and for those of you who own some of the companies I would call "listed property timebombs", I urge you to listen to what is implied by this WDC capital raising (i.e. equity is expensive)

We remain aggressively underweight the Australian LPT sector, with our recommendations tilted towards mid-cap trusts and developers (LLC, PPC, AXI, WOTCA, PPI etc). Pay a 100% premium to NTA for LPT's if you like, we'll stick to lower risk ideas like QAN and CTX.