Caltex: refined and redefined

Picking a decent business at a decent price is hard. When things work out exactly to your investment case, as they did when we first recommended Caltex in Caltex: A fuels errand back in 2013, it can be tempting to tick the success box and move on. That would be a mistake.

While Caltex is now dearer than our original buy price, the business is also better. The Kurnell refinery, long a sink for capital and a source of low and variable returns, is now closed.

Caltex still operates a small, modern refinery in Queensland – Lytton – which refines mostly premium grade fuels, but it imports most of its fuel from Singapore. No longer a big refiner, the business is largely a distributor of fuel and an operator of petrol stations.

Still sounds dull, doesn't it? That may just be the point. Petrol stations, once maligned as little more than peddlers of gum and source material for comedians have morphed into wonderful businesses.

The improvement in profits has been decades in the making but was obscured for years by Caltex's refining losses. The first time we recommended Caltex it was because the market was ignoring the transformation of the business. We're looking at it again because, even with the transformation complete, the valuation doesn't appear to reflect the improvements.

Who needs a Kwik-E-Mart?

Two big changes have lifted retail profits for Caltex; lower competition and higher margins.

Forty years ago, there were over 20,000 petrol stations to service a population of 12m. Today, there are just 6,000 stations to service twice that many. The car fleet is larger still.

With independents all but gone from the industry, the retail industry is the preserve of consolidated giants and each petrol station is now far more profitable. The same dynamic has occurred along the distribution chain.

Once highly competitive, the petrol distribution business now resembles a cosy oligopoly. The four largest firms account for 90% of industry revenue and high sunk costs along with low margins eliminate the threat of new entrants.

Despite the rise in the car fleet – about 1.2m new cars are sold annually in Australia – absolute petrol volumes have been flat or falling for years as efficiency gains, smaller engines and regulations require less fuel.

Caltex has offset those volume declines with astonishing margin gains. Margins from the distribution and retail of fuel have more than doubled over ten years. This is no mere cyclical phenomenon. Ten years ago, premium fuels accounted for less than 10% of the fuel mix; they are now a third of all petrol volumes and 35% of diesel volumes.

Engines may be more efficient but that improvement comes at a cost as modern motors need higher octane fuel from which Caltex generates higher margins. Distribution and retail margins of less than 2% have grown to well over 5%. That trend is unlikely to reverse and, in fact, appears to be more entrenched as the car fleet modernises. We don't expect margins to rise much but neither will they fall.

A retail story

Protected by high barriers to entry, the distribution business supplies fuel to about 2,000 sites including petrol, diesel and jet fuel suppliers. The end of the mining boom has made a small dent in diesel volumes but the vast bulk – about 70% – of diesel volumes and almost all growth comes from consumers rather than miners.

Caltex also owns or leases 800 sites itself from which it conducts 3m transactions per week. With sales of over $1bn a year, Caltex is a significant retailer in its own right and has barely tapped its potential.

In Australia, just 20% of sales in the convenience sector come from petrol stations. In overseas markets, that share is as high as 60% so there's an opportunity to lift sales. Caltex is aiming to lift non-fuel revenue through its retail sites by offering new services such as mail pickup, laundry and more food and drink.

New format stores a being rolled out and, while this is a source of potential, management has been careful to limit the downside with experimentation and a slow rollout. We view an expanded retail base as an option rather than a certainty.

Even without success from new formats, profits have been growing at about 5% per year and we expect this to continue for some years. Lifting sales through a high fixed cost base should improve profits over time.

Fair value

We expect Caltex to generate EBIT of around $900m this year and perhaps $950m in 2017. In Table 1, we've outlined a base case valuation and a high case. In the base case, an EBIT multiple of 10 yields a valuation of $32 a share, just below today's price.

In the high case, we assume that higher earnings attract a higher multiple to reflect better quality. On 12 times EBIT, Caltex would be worth over $40 a share.

Net debt has risen to $700m but with operating cash flow covering interest by 15 times last year, the debt load remains comfortable. The business also holds over $1bn in franking credits, so higher free cash flow (there no longer being an expensive refinery to maintain) should support higher franked dividends.

Another option for cash is to purchase a competitor. Woolworths is apparently looking to sell its petrol business and Caltex is a logical buyer. In New Zealand, consolidation of retail sites has been tremendously profitable. This could happen here too.

It is tempting to upgrade now. With over $1bn in franking credits, strong free cash flow and a dominant domestic position, this is a better, more resilient business than it appears.

Yet we adhere to strict hurdles and demand a discount to fair value. Below $32, we'd likely upgrade. You might consider building a small position now but an official upgrade must wait. For now, HOLD.