Caltex is undergoing a strategic shift away from its volatile refining business, which has contributed to disappointing and unpredictable returns.
With the closure of the Kurnell refinery in the December quarter 2014, Caltex’s earnings are increasingly leveraged to the stable, more predictable marketing side of the business, which has a positive outlook underpinned by Australia’s economic growth.
Caltex is Australia’s leading fuels marketer. Its competitive strength is its distribution infrastructure, which include port terminals, inland terminals, airport terminals and pipelines, all of which enable efficient and reliable delivery of fuels.
It holds a market leading position in Australia with respect to market share in diesel (31 per cent market share) and petrol (34 per cent). It is number two for jet fuels (31 per cent), lubricants (22 per cent) and convenience stores (24 per cent).
Australia’s demand for transport fuels grows at close to GDP rates. The compounded annual growth rate of the transport fuels market over the last five years has been approximately 3 per cent.
The longer-term demand outlook for transport fuels remains favourable, with growth in diesel and jet fuel more than offsetting the decline in petrol.
Figure 1: Growth outlook for transport fuels]
Source: CTX May 2014 Investor Presentation
In mid-2012, following a strategic review, the board decided to close the lossmaking Kurnell oil refinery and transition the facility to an import terminal for fuels refined elsewhere in Asia.
Kurnell was expected to continue to lose money and was at a competitive disadvantage compared to regional refineries due to shipping constraints and the yield of high value products, particularly premium fuels.
Caltex’s strategic shift from a refiner/marketer to mainly marketing will reduce earnings and cash flow volatility. Previously around 65 per cent of sales were sourced from refinery production. Under the new business model, with only the Lytton refinery online, less than 25 per cent of fuels will be from in-house production. This model provides substantially less exposure to the refining business, where margins are volatile, cyclical and unpredictable.
Volatility in earnings is evident in the below chart on Caltex’s normalised return on equity and earnings before interest and tax margins over time. EBIT margins have been small but fluctuations have caused disproportionate volatility in profitability.
Figure 2: EBIT margins (grey) versus NROE (orange) over time
Following the closure of Kurnell, the Lytton refinery will remain Caltex’s sole refinery. To further strengthen the fuel product supply chain, Caltex has established an Ampol-branded office in Singapore. Ampol has entered into a long-term arrangement with Chevron, to assist with the procurement, supply and shipping of transport fuels. Note Chevron is a majority shareholder of Caltex, owning 50 per cent of the company’s shares.
We adopt a return on equity of 18 per cent and low required return of 12.5 per cent to derive a fiscal 2014 (31 December 2014) valuation of $18.77.
The shift from refining to predominantly marketing transport fuels will transform the business model into a mature business with predictable earnings that grow in line with the broader economy.
However, with no plans to close the Lytton refinery, the company remains somewhat exposed to volatile refiner margins and currency headwinds. We would require a 15 per cent margin of safety before investing.
By Amelia Bott of StocksInValue, with insights from Adrian Ezquerro of Clime Asset Management. StocksInValue provides valuations and quality ratings of 400 ASX-listed companies and equities research, insights and macro strategy. For a no obligation FREE trial, please visit StocksInValue.com.au or call 1300 136 225.