Hunting for value in break-ups - Part 2

Statistical cheapness, by itself, does not make an investment case. That was the main thrust behind Part 1 of this series. To recap, we argued that, because numbers are easy to see and exhaustively leered over, they provide little investment edge. Cheapness, on its own, will lead you into traps more often than it will lead you to mispricings.

Instead, investors need to use more subtlety in their quest for value. That means understanding how a business generates cash and whether the odds favour it continuing to do so. In some cases, though, the value of one business can be obscured by another, or by the structure that ties them together. These situations can create opportunities because recognising the value requires something that screens, robots and algorithms can't capture: imagination.

In Part 2 we will examine the case for breaking up two listed blue chips stocks - Caltex and Newcrest - and how such a break-up could release value.

Caltex

We begin with Caltex. The company was once synonymous with poor quality and poor results. For years, it operated a large refinery whose colossal losses obscured profit from other divisions. 

That refinery has now closed and Caltex has changed for the better. The company now houses two distinct businesses: a fuels business that distributes and sells fuel across the country; and a retail business with 800 sites and $1bn in sales, which is expanding to deliver new products and services.

Ownership of both the fuels and retail businesses allows Caltex to capture a larger chunk of the value chain as petrol is refined, distributed, wholesaled and retailed to final users. Petrol links these businesses together and justifies the status quo. That is changing.

Fuel volumes are falling and, as that trend hastens, the case for holding both business units inside the single structure starts to weaken.

Divisions

Caltex only separated the two divisions in its accounts last year. The numbers illustrate that the fuels business is still the largest driver of profit, generating $570m in operating profit although this number is volatile as it includes earnings from refining.

Caltex's last remaining refinery is a classic cyclical asset, generating enormous cash returns when refining margins are high and modest returns when they're not. Although Caltex does not report asset values in the division, capital expenditures of more than $740m over the past two years confirm this is a capital intensive business.

Yet returns should be decent. Caltex moves about a third of all fuel around the country through a large fixed cost asset base. Only BP has the physical assets to compete with Caltex and it moves about 50% less volume. The scale advantage belongs to Caltex. 

We think the fuels business probably generates returns on capital in the low teens - an excellent outcome.

The retail business generated operating profit of $307m last year and Caltex aims to lift that by $120m-150m by selling more non-fuel goods and services. It has poured $180m into the retail business over the past two years to meet this goal. 

The retail arm can potentially grow swiftly but that depends on unwavering management focus. 

Retail requires a specific skill set; the best retailers focus relentlessly on their customers and are nimble in responding to their needs.

The fuels business couldn't be more different. This isn't about service so much as optimising volumes through the network, solving logistical bottlenecks and fighting for prime sourcing. It requires different skills to retail. 

Two fronts

As retail starts to grow and challenge the fuels business for time and resources, we wonder whether the different demands of each business can be adequately fulfilled.

For the moment, while fuel sales dominate retail revenues, there is logic in Caltex capturing wholesale and retail fuel margins inside the same supply chain. As retail outgrows fuel, however, that logic starts to break down. 

Infrastructure investors want to see predictable cash flows that can underwrite dividends. Investors wanting retail exposure will want growth, rollouts and increasing sales density. Neither shareholder base will be satisfied as things stand. 

Caltex says it's exploring ways to lift returns. Over time, a break-up would be a logical, perhaps inevitable, path to follow. HOLD.

Newcrest Mining

A mining business is a collector of individual mines, each with its own economics, production techniques and quirks. That's true of Newcrest Mining as much as any other miner and makes it an attractive break-up candidate.

Newcrest operates four large gold mines in the Asia-Pacific region: Cadia in NSW; Telfer in WA; Gosowong in Indonesia and Lihir in Papua New Guinea. It is also developing a large orebody in Canada and the enormous Wafi-Golpu gold mine in PNG, which is shaping up as one of the best undeveloped gold mines in the region.

In aggregate, Newcrest appears to be a successful, profitable miner. Last year it produced over 2.3m ounces of gold from its mines and a whole lot of copper, too. Production costs after sustaining capital expenditures sit at under US$900 per ounce, already in the lowest quartile of producers, and free cash flow generation is a healthy US$545m while net debt stands at US$1bn. 

Yet these numbers, while decent in isolation, are poor against the wave of capital deployed by the business. 

Newcrest's balance sheet carries about US$7.5bn of net assets which means it generates a free cash flow yield of just over 7%. This is excellent when compared to other major gold miners but that's a low bar; against other large miners, Newcrest underperforms. BHP and Rio, for example, generate free cash flow yields of more than 10%; Fortescue may soon double that.

A model mine

Newcrest can do better, and it already has the asset base to help improve its financial performance. Let's take a closer look at it.

Table 1 shows that the success of Newcrest is driven by the Cadia mine. A large, low-grade mine with significant copper production, Cadia's stunningly low cost of production and outstanding return on assets is driven by Newcrest's expertise in block caving, a bulk mining technique that the company has become very good at.

Rather than digging through lots of barren rock to get to a low-grade orebody, block caving involves getting beneath the orebody and selectively collapsing it. 

This can generate better economics as it utilises bulk mining techniques to lower unit costs and reduces drilling time. Cadia is also a simple deposit with easy metallurgy, while copper revenues help offset mining costs. 

The excellent economics of Cadia is diluted by two of Newcrest's largest mines: Lihir and Telfer. 

The bad boys

Both these mines are geologically complex - they involve refractory ore which means gold must literally be bled from stone with complex and expensive processing techniques - and both have specific obstacles that make mining hard. 

The Lihir mine sits inside an active volcano and requires huge mining volumes to generate modest returns. Risks are high with regulation, geology and metallurgy all confounding miners over decades. 

Although it is one of the largest orebodies in the world, Lihir has never been sufficiently profitable under several owners. 

Telfer is even worse. Isolated in the middle of the WA desert, the mine is geologically complex, requires three different processing techniques and is power hungry. 

It has improved from losing hundreds of millions of dollars a year to now merely losing US$60m but it consumes oodles of capital that could be better deployed elsewhere.

Although Newcrest has improved the financial returns from both Lihir and Telfer, neither mine is likely to ever generate acceptable rates of return. Both assets have attracted billions of dollars of writedowns over the years and Newcrest's insistence of working them is a triumph of stubbornness over sense.

Small is beautiful

Both mines generate large volumes - combined they contribute 58% of group production - but they account for just 25% of operating profit and almost 60% of Newcrest's capital expenditure. 

The cash being poured into these mines isn't generating a sufficient return. Both should be sold.

That will mean a smaller Newcrest but a vastly more profitable one. Without the troublesome two, Newcrest's return on assets would rise from 10% to 25% and its capital expenditure would fall from US$590m to just US$250m.

It could return the spare capital to shareholders, as other big miners have done, or to lower debt and develop better mines at Wafi Golpu and in Canada. Newcrest would be far more valuable as a smaller miner generating higher returns than it is today. Until that happens, though, we won't be adding it to our coverage list.

These examples aren't necessarily ideas to buy, but they're interesting to watch and think about - and they could present an opportunity if the stars align correctly. Gone are the days when value was obvious in numbers and the strength of an idea could be measured by the size of the PER. 

In the ongoing hunt for value, investors must deploy new weapons and none is as powerful as imagination.