Caltex's star rises

On 16 February 2012 Caltex Australia wrote down the value of its refining assets by an astonishing $1.5bn; reducing what’s left on the books to just $340m. That followed a warm-up writedown of $67.7m, made four months earlier.

Caltex’s accounting bloodbath recognises an issue your analysts deduced many years ago – free cash flow was typically well below the profits being reported to shareholders. That meant nothing like the amount of reported profit was truly available for distribution to shareholders (even if directors had wanted to pay it out). Slowly though, that situation seems to be changing.

The company’s ‘marketing’ business has become increasingly profitable in recent years but its huge refineries – at Kurnell in Sydney and Lytton in Brisbane – required tremendous spending on capital works and inventory requirements (when oil prices rise, the cost to replace sold inventory rises with it).

February’s writedown paved the way for bold action in July when management announced a move to close the Kurnell refinery and transform it into an importing terminal. This caused investors to look at the group afresh. Judging by the subsequent share price rise, they like what they see.

Lucrative division

The main attraction is the company’s lucrative marketing division. It sells fuels, lubricants and convenience store goods through a national network of Caltex, Caltex Woolworths and Ampol-branded service stations. This division also deals with resellers and a number of direct corporate buyers.

When Caltex announces its 2012 profit in a few weeks (it has a December financial year end), this division should produce a hefty profit of around $740m – not bad for retailing a commodity product, and one that is becoming more profitable at that.

Petrol retailing in this country has ‘rationalised’ substantially over the past few decades. My hometown of Wellington in rural NSW has a population of a few thousand people. When I was young, it boasted no fewer than eight petrol retailers. Today, there are three.

That typifies the national experience; the number of outlets has fallen from 18,890 in 1970 to less than 6,400 today. As competitive tension has reduced, petrol retailers’ profit margins have expanded, with the switch to more premium fuels and the mining boom assisting the trend. In short, conditions have been great for fuel retailers in Australia over the past few years.

Is this a ‘new normal’?

It could be. With Woolworths and Coles moving into the industry, more ‘rational’ pricing is probably here to stay. And the switch to premium fuels may well be permanent, too.

On the other hand, the trend towards smaller cars and hybrid vehicles could soften future demand growth, as would higher oil prices. The demand for Caltex’s products is also somewhat hitched to the overall health of the economy that, after a couple of decades of growth, could turn.

But, at the right price, this industry is one we could get interested in, especially if it involved investing in the number one player – Caltex.

So what might the company be worth if all goes to plan? If the Kurnell project remains on schedule and on budget, and we assume the Lytton refinery operates at breakeven, then virtually all of the value will be in the marketing business. If profits grow by 20% from the $740m expected this year, then the business would be producing Earnings Before Interest and Tax (EBIT) of $890m in three year’s time.

Table 1 shows high and low valuations for 2016 based on that number. With a valuation range of $20-$32 per share (in today's dollars), it looks enticing compared with today’s price of $19.75.

What that figure doesn’t encapsulate is the company’s strategic starting point (refining). In economist-speak, Caltex stands at the left-hand side of a four-year J-curve. The risks of the ‘dip’ being deeper and/or longer than anticipated are substantial. Management told it straight in July (albeit on page 33 of a 34-page investor presentation):

‘The conversion of a refinery to an import facility is a major capital project and involves significant costs and will be completed over several years. There are risks to operations, schedule and costs in the execution of this project, potentially resulting in cost overruns and operational disruption, including unplanned shutdowns, early closure and or supply disruption.

‘Whilst Caltex believes that it has adequately provided for these costs, some of these are early estimates and the actual cashflows could materially differ from current estimates. Caltex’s reliance on imported transport fuels will also increase following the Kurnell refinery closure.’

This highlights two key issues. Firstly, without Kurnell’s refining capacity Caltex’s supply chain will be more fragile. It should be more profitable overall to operate as a majority importer of refined product rather than a processor of crude, but any bottlenecks or hold-ups associated with an increased reliance on imported inventory could prove problematic.

Potential problems

Secondly, while substantial costs for transforming Kurnell have already been provided for and expectations are that the project will be broadly ‘cash neutral’, those estimates could be way off. And management’s actions over the past six months show that it is – sensibly – steeling itself for potential problems.

That explains why the dividend is to be slashed from a payout ratio of 40%-60% of profits to 20%-40%. The intention is that this will revert in the second half of 2014, although there are no guarantees. The launch of Caltex’ hybrid issue in July targeted $300m but was eventually increased to $550m for similar reasons. Caltex is hoarding cash in anticipation of problems.

Again, that’s sensible; projects of this size rarely go to plan. The problem is that investors have already priced in a lot of the benefit of the company’s strategic redirection, assuming it will go to plan. The share price is up over 40% in the past six months and the risk/reward balance isn’t quite right.

If the project’s progress disappoints the market at some stage – a very real possibility – then we’ll consider buying into that pessimism. The share price is up 8% since 3 Dec 12 (Avoid – $18.30) and, while that remains our view, Caltex is no longer the economic sinkhole it once was. In fact, it is on our radar if future disappointments present a buying opportunity. AVOID, but watch carefully.