Caltex restructure fuels interest

Long regarded as one of the ASX's most volatile large industrial companies, CTX is transitioning to a more mature, GDP-style business that should appeal to a broader investor base.

CTX is Australia's leading transport fuels marketer, with market-leading positions in diesel (31% market share) and petrol (34%). It is number two in jet fuel (31%), lubricants (22%) and convenience stores (24%). CTX supplies one in every three litres of petrol, diesel and jet fuel in Australia through the use of its infrastructure assets such as terminals, pipelines, depots, and barges.

For many years CTX shares were a punt on oil refiner margins, which reflect the cost of crude oil, the cost of refining, wholesale prices for various fuels, and currency. These margins are cyclical and were typically unpredictable, which triggered share price swings in response to positive and negative surprises. Get your timing right and you could make large returns in a short time.

The variability in margins and profitability is evident in the chart below. Earnings before interest and tax (EBIT) margins have been small but fluctuations have caused disproportionate volatility in return on equity (ROE) and dividends.

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Source: StocksInValue

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Source: CTX

The volatility continued in the most recent reporting period, FY13, when the refining and supply operations recorded an EBIT loss of $171 million, down from an $88 million profit in the prior year. The realised refiner margin averaged US$9.34/barrel (bbl), comparing unfavourably to the prior US$11.76/bbl margin. Company guidance for 1H14 (the result is due on August 24) refining and supply earnings is for another EBIT loss of $65 million-$85 million, greater than the $43 million loss in the previous corresponding period (pcp). In contrast, the steadier marketing business should deliver EBIT of $390 million-$395 million, an 8% increase on the pcp.

The volatility and lack of visibility limited the stock's appeal to traders and speculators and the company's board eventually realised Australia did not have a competitive advantage in oil refining. This is a scale business dominated by refineries much larger and more modern than in Australia. For example, Singapore is the world's third-largest export refiner and dominates the Asia-Pacific industry.

Strategic shift away from volatile refining business

Finally, in mid-2012 the board decided to close the lossmaking Kurnell, Sydney, oil refinery and transition the facility to an import terminal for fuels refined elsewhere in Asia. The refinery is on track to cease final operations in 4Q14 (the December quarter). Brisbane's Lytton refinery will continue as CTX's sole refinery and CTX will continue to pursue yield and cost efficiency initiatives at Lytton.

The costs of closing the refinery should be broadly offset by one-off and recurring cash benefits. There is ample product supply in the region to replace Kurnell's production and meet CTX's requirements for volume.

The shift from refining and marketing to mainly marketing will substantially reduce earnings and cash flow volatility. Previously around 65% of sales were from refining. In the new model, with only the Lytton refinery online, less than 25% of sales will be from in-house production.

The transport fuels market is becoming increasingly competitive, however CTX's competitive strength is its distribution infrastructure, which includes port terminals, inland terminals, airport terminals and pipelines, all of which enable efficient and reliable delivery of fuels.

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 about 3%. The 47 billion litres per annum market is diversified across different segments.

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Diesel is Australia's most significant transport fuel product by volume at 21 billion litres per annum. Petrol and jet fuel are 19 billion litres per annum and 7 billion litres per annum respectively. The longer term demand outlook for transport fuels remains favourable, with growth in diesel and jet fuel more than offsetting the decline in petrol.

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The shift from refining to mainly marketing transport fuels will transform the business model into a mature business with largely predictable earnings that grow in line with the broader economy. Retaining the Lytton refinery will still provide some exposure to the volatile refiner business, though despite currency depreciation and an unplanned outage the Lytton refinery has been profitable and cash flow-positive over the last two years, delivering FY12 and FY13 EBIT of $178 million and $95 million respectively.

Valuation reflects improvement in profitability

Our adopted normalised return on equity (NROE – includes franking credits) of 18% (red below) reflects continued growth in the marketing business, underpinned by CTX's market-leading position and increasing demand for transport fuels. Our adopted NROE is well above the five-year average of 7% because we expect less volatility as the company diversifies away refining.

Valuation growth of about 9% in FY14 and FY15 (green below) reflects the high proportion of reinvestment (RI below - blue) of 10% in NROE of 18% and the premium of NROE to our 12.5% required return (RR - purple). Reinvesting earnings increases intrinsic value where NROE is more than RR. CTX has lowered its payout ratio during the capital-intensive transformation of Kurnell to an import terminal.

Our low RR of 12.5% reflects large market capitalisation and the defensive nature of the marketing business. We derive an equity multiple of 1.79x and FY15 (December 31, 2015) valuation of $20.57.

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Source: StocksInValue

The shift in business mix to less refining and more marketing will reduce NROE variability, but with no plans to close Lytton the company remains partly exposed to fluctuating refiner margins. Business risk will be lower but not as low as the likes of Woolworths, for example. For WOW we would recommend buying at a 5-10% discount to value; for CTX we recommend a 15% margin of safety. This implies a buy price of $17.50, which is at a discount to the share price. The market likes CTX's transition and the stock has become very popular.

By David Walker, Senior Analyst StocksInValue, with insights from Adrian Ezquerro of Clime Asset Management.