Time to sell Caltex

The investment case for Caltex was a simple one: what appeared, in aggregate, to be an average business was in fact a combination of a great business and a lousy one. The announced closure of the lousy business would lift the good one from obscurity and transform Caltex for the better.

With the business's transformation now complete and the share price more than doubling in a little over a year, it's time to sell and look for the next opportunity.

Banishing a stock from your portfolio – especially one that has been so generous – is always hard. That is particularly true in this case because Caltex is a much better business today than at any time in its history.  The company's full-year result confirms that there have been no gremlins in the change from a refiner to a retailer and that a decent business is now in place.

Profit adjustment

Caltex reported headline profits of just $20m but that number needs adjustment to accurately reflect changes in the business. Caltex holds billions of dollars of fuel as inventory, typically two months' worth of supply. That supply has been bought at one price and sold, after several months, at another. Movements in currency and crude oil prices impact profits but don't reflect underlying business performance.

Caltex, like all refiners, adjusts for movements in oil prices to report profit on a replacement cost basis. On this measure, net profit rose almost 50% to $493m helped by a stronger refining margin as a result of lower oil prices. This was the refining division's final hurrah because refining revenue will all but disappear and, from next year, Caltex will be a fuel marketing business. That being the case, it's useful to examine results from the marketing business alone.

Marvellous marketing

Here, earnings before interest and tax rose 6% to $812m. As they have for many years, fuel volumes fell 1% but the drop was more than offset by a seemingly never-ending rise in sales of premium fuel which now makes up 29% of total fuel sales.

Margins continued to march higher, rising from 4.4c per litre to 5.1c per litre. Some of this increase was a result of petrol stations withholding the impact of lower oil prices. Eventually, competition will force petrol stations to pass on savings so we expect margins to fall slightly.

Although these appear to be excellent results, they match our forecasts almost exactly. We expect the marketing division to make about $890m by 2016 and then grow modestly with inflation. Today's share price, however, implies an EBIT multiple of over 12 times which translates to a likely PER of about 18. That's a rich price for a business with limited growth prospects.

This highlights a key risk. Having succeeded in turning the business around, management is keen to grow it. The only way to do that is by acquisitions. With limited room from regulators to buy fuel stops, Caltex has hinted it will look at other types of retail, away from fuel. Stepping away from its core competency could be dangerous.

The counter argument is that, having improved the business substantially, management now deserves the benefit of the doubt. Perhaps future acquisitions will generate strong returns. The other point to note is that Caltex will pay 40-60% of profits as dividends and, with $1bn of franking credits to use, the business could distribute a lot of cash to shareholders.

Let's say Caltex sticks to a 50% payout ratio on future profits. That implies dividends of about $1.15 per share, up from 70c today. That still equals a yield of just over 3% at the current price, not enough to get excited about.

The case for selling

Whichever way you cut it, Caltex is fully priced today and important risks remain. Foremost among them is the structural shift in fuel demand. With engine efficiency increasing every year and car ownership rates falling the world over, it is possible that fuel sales have already peaked and electricity, rather than petrol, will power ever more vehicles. We don't want to hold Caltex at premium prices whilst an existential threat hangs over it.

Margins have doubled over a decade to support growth but they won't double again. High petrol margins have been driven by growing premium fuel sales which, we suspect, rely on regulations supporting ethanol fuels. If regulations were to change, a substitution from premium to regular fuels could lower margins again. We fail to see why diesel fuel margins remain so high and they are vulnerable to falls. 

We're willing to accept those risks at a lower share price but not at the current one. We would, however, revisit the business at lower prices or if management can establish revenue growth. A growing dividend and steady cash flows should deliver returns of about 5–6% from here. For some, that will be enough.

For the risk involved, we don't think it is. Just as we exhibited prudence with the buy call, we should likewise show prudence when selling. Caltex is now a decent business but everyone knows it. It wasn't quite dear enough to sell when we last looked it (see Caltex: A fuel's errand (Hold – $29.79)) but, at today's price, we'd prefer to deploy cash elsewhere. It's time to SELL.