Ready to prosper … Caltex changes tack

Operational changes at Caltex rank the group as a long-term buy.

Summary: Oil refiner and distributor Caltex is undertaking a series of transformational changes, including the closure of its Kurnell Refinery in Sydney next year. The company is seeking further growth in its products and margins over time, which should eventually manifest in higher dividend payouts.
Key take-out: Once Kurnell is closed, Caltex should earn a lot more than last year’s $1.70 a share, partly because of the growth rate and partly because of the drag Kurnell had on profits.
Key beneficiaries: General investors. Category: Growth.

In today’s high and rising sharemarket it’s hard to find stocks that the sharemarket has overlooked. But during the week I had breakfast with the managing director of Caltex, Julian Segal, and his finance director Simon Hepworth.

Caltex has always seemed to me to be a company where results have fluctuated wildly on the basis of how global refinery margins moved. It was an oil punting stock.

But Segal and Hepworth explained to me that they are in process of transforming the Caltex business so that it becomes a petroleum product distribution operation with an increase in emphasis on high margin products.

The transformation will be accelerated by the closure of the Kurnell Refinery in 2014. I have always thought that closing a refinery was a very expensive operation and difficult to do. Caltex has explained to me that if you dig deep, the closure will involve almost no cash outlay at all, although the group is investing $250 million in additional funds to convert the site to a distribution centre.

How can you close a refinery and not outlay a lot of money? First of all there is a $309 million after-tax cost in retrenchment and clean-up provisions. The write-down of the asset yields a $120 million tax credit to reduce that $309 million cost. But there is more. To keep Kurnell operating Caltex has to source sweet crude (i.e. low sulphur crude) from Libya and West Africa. Because of the long distances involved, some $200 million in Caltex cash is tied up with working capital. Once the refinery is shut the working capital requirement is slashed because most of the group’s petroleum products will be sourced from Asia.

And in Asia it is very fashionable for nations to erect an oil refinery, so the capital costs of these refineries is being subsidised by governments in the region, and that means there is a lot of capacity and good deals.

One of the reasons why Caltex held onto Kurnell so long was that it needed a deal to gain refined petroleum products at the best possible world price. Segal believes the deal Caltex now has with its 50% shareholder Chevon will deliver excellent petroleum product purchasing prices and protects Caltex in the event of shortages. It will enhance Caltex profitability.

Caltex will retain its Lytton Refinery in Brisbane, which is a more modern refinery than Kurnell and has been profitable.

In the year to December 31 Caltex earned $1.70 a share, so at around $21.40 the stock is priced at about 12.6 times earnings.

Given Caltex’s history of profit fluctuations, that PE ratio probably sounds reasonable, but without Kurnell suddenly Caltex becomes a growth company. Its marketing and distribution operations have been growing well above 5% a year. Because of the fluctuations in profitability the company’s dividend record has been abysmal and the latest year’s payment of 40 cents a share represents the second year in a row that dividend has been reduced (see graph).

The latest dividend cut reflects the fact that as well as its normal expansion Caltex is spending $250 million on a massive Sydney distribution centre at Kurnell.

But once Kurnell is out of the way this is a stock that is going to earn a lot more than last year’s $1.70 a share, partly because of the growth rate and partly because of the drag Kurnell had on profits. Moreover the Caltex growth rate will tend to accelerate as the group modernises its service stations so that it is easier to access diesel fuel and there is the ability to pay at the pump rather than getting into long queues.

There is absolutely no reason why Caltex can’t pay dividends of around 80 cents to $1 a share in, say, two years. I must emphasise that neither the CEO nor the finance director made any forecasts about dividend policy. But in today’s yield orientated world, unless there are continuing special reasons, paying 40 cents a share in dividends out of $1.70 a share in profit is not the way to get sharemarket premium.










EPS growth



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Source: Bloomberg

For the last two or three years Caltex has been spending retained earnings to send up more and more distribution centres to increase its share of the more lucrative oil supply contracts. And that process is going to continue, but it doesn’t require virtually anything like $1.30 a share to fund.

The best way to show the way Caltex is looking at its future business is to look at a series of charts which highlight just what is ahead of this company.

Look at that growth rate in marketing and distribution in chart 2. That growth is likely to continue.

Not many companies have such a strong and consistent growth rate for two of their three main products, and with the third product (gasoline) people are moving to higher-quality higher-margin forms – see graph number four .

I must emphasise that in the year ahead there will be big charges as a result of Kurnell’s closure, and the reduction in stock level is a cash item which does not boost the bottom line.

I can’t see any great immediate joy in dividends, but the momentum is clearly there and this is a stock that could easily move itself up to 15 times current earnings and pay $1 a share in fully franked dividends. 

The gross yield would exceed 6% and, as the graph above shows, this is a company that has grown regularly over a long period of time in its marketing and distribution, but this growth rate has been absolutely masked by the fluctuations in the oil refinery business.

That is about to stop. There are very few companies in Australia that are growing and that are set to pay much higher dividends, albeit in a few years’ time. What can go wrong? It is possible that the majors like Shell and BP and Mobil could suddenly start a price war, but I don’t think that is likely.

The price wars are taking place in the gasoline business, but even there the supermarkets are not as aggressive as they were in years gone by. So Caltex is not a stock where somebody wants to make a quick dollar, but it is the sort of stock you can put in a portfolio and know that once the Kurnell turmoil situation is out of the way it will be a stock that will grow profits and grow dividends with not a great deal of risk. It is one for the oak chest.

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