Thursday, June 7th, 2018
When we look back at our best investments, buying well was always key. Buying cheaply or even just inexpensively takes so much downside risk out of an investment. Whether a stock’s appeal is growth, quality, cyclical recovery, a turnaround or restructuring potential, minimise the downside and the upside should take care of itself.
One place to find stocks where the downside is already largely or fully priced in is a list of stocks at year-lows. Value investors often go hunting here, seeking stocks where the problem is temporary or the market doesn’t understand the upside. This approach is particularly relevant with large-caps, as they usually eventually revert higher due to cyclical recovery, changes in macro drivers or a corporate turnaround as long as there are not structural problems in the industry. In contrast small-caps trading at 52-week lows could be headed for deeper decline or failure.
One large-cap stock that recently traded at year-lows is Caltex Australia, the oil refiner, owner of petrol stations and land, and retailer of petroleum products and convenience foods. This stock has received little attention lately amidst the optimism in oil markets and consequent rallies in large explorers and producers of oil and/or gas like Woodside Petroleum, Oil Search, Origin Energy and Santos. These stocks are already popular and therefore have less upside but Caltex is out of favour and screens as inexpensive. Is it an opportunity?
To answer this question we need to appreciate how far Caltex has come in its transition to an investment grade business conservative investors can consider. Caltex used to be one of the most cyclical large industrial stocks due to the volatility in oil refiner margins, the difference between the cost of importing a standard Caltex basket of products to eastern Australia and the cost of importing the crude oil required to make that product basket. Fluctuations in crude oil prices, the Australian dollar and the market prices of Caltex products used to generate profitable trading opportunities if you got your timing right. The stock was unsuitable for long-term portfolios however.
All this changed when Caltex closed its oil refinery at Kurnell, Sydney, in 2014 after the 58 year-old facility became uncompetitive with larger, more modern and efficient Asian refineries. Today the site is an import terminal for already refined fuels ready for market and Caltex’s profitability is now more consistent. The firm retains its Lytton refinery in Brisbane but in 2017 the operating earnings from refining crude oil were less than half the earnings from selling fuel. Profit margins from the latter vary with the mix of sales (diesel, premium and jetfuel vs ULP/E10) but supply is a steady business that grows with the economy. Since 2014, return on equity (ROE) has ranged between 16 and 19 per cent, a marked contrast to earlier years of strongly positive or negative returns.
The convenience retail strategy should further raise and stabilise ROE. 50-60 new Foodary (food retail at the petrol stations) sites and 5-10 new Nashi (high street retail) sites are planned for 2018. As of late February there were 27 Foodary sites, where early financial returns and customer acceptance were encouraging. Execution risk in the rollout seems low given the shop models are not difficult to replicate and Caltex has long-term knowledge of foot traffic and customer spending patterns at each petrol station. The convenience theme suits today’s time-poor customers.
In December 2017 the ACCC announced its rejection of Woolworths’ proposed sale of its fuels business to BP. Caltex, which supplies Woolworths, stood to lose 3.5 billion litres of fuel sales and $150 million of operating earnings if the sale went ahead. Caltex will continue to supply Woolworths until any decision to change suppliers, and has already acquired other businesses and reduced costs to replace the potential loss of earnings, but there is a discount in the share price for the uncertainty.
Caltex is reviewing its retail, import and distribution infrastructure and promised the market an update by the end of this month. On 31 December there were $2.8 billion of land, buildings, plant, equipment and capital projects on the balance sheet. Some of these assets would probably be valued more highly in a retail energy property trust but a sale or demerger of the real estate and infrastructure could be deferred until the convenience offer has reached maturity and Caltex has certainty on fuel volume sales if it divested some of its infrastructure. A growing market consensus Caltex will defer rationalising its assets is probably the main reason for the stock’s fall this year from a peak over $37 in late February to below $30 today.
Caltex also forecasts sales growth of higher-margin products like premium petrol, diesel and jet fuel to slow, so the margin benefits from earlier faster growth in these lines will taper. Meanwhile refiner margins at Lytton can probably revert lower from the US$12.87 realised in 2017 towards the 10-year average of US$10.53. These themes are two more possible reasons for the stock’s decline to a recent 52-week low of $28.44.
Caltex has several attractions: a strong brand and one third share of Australia’s petroleum products market, high barriers to entry because its nationwide network of sites and infrastructure would be hard to replicate, a retail rollout, a conservative payout ratio, surplus franking credits, low gearing and the ability to fund a buyback, and resilient earnings. We can value the stock at $36 if the Woolworths supply contract continues and $31 if it doesn’t. The best time to buy Caltex would be on bad news about the Woolworths contract, deferral of asset sales and falling Lytton refiner margins. In our view the downside is minimal at a $28 share price.
Originally published in The Australian, Tuesday 5th June 2018.