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In a world where under-valuation of listed securities — to the...

  1. 450 Posts.
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    In a world where under-valuation of listed securities — to the extent that provides enough of safety buffer for me — is rare, it comes as a bit of a surprise to me that I have in recent weeks discovered an investment opportunity, not among the normally disregarded, under-researched population small to micro-cap stocks, but right under my nose in the form of a large-cap, $5bn company: Caltex.

    In the past I have ignored CTX as a potential investment opportunity, deeming the stock to be sub-investment grade due to its history of acute volatility in earnings, the punishing capital-intensity of the refinery operations and the inability of the company to be the architect of the its own destiny given its earnings have largely been a function of what the Singapore Weighted Average Refining Margin is doing on any given day/week/month.

    So the long-term sustainability of refining petroleum products in a country like Australia has always been highly questionable, in my mind:

    Producing a range of commoditised products within the constraints of:

    • Stringent environmental requirements,
    • Punishing compliance regimes, and
    • High fixed cost structures

    … does not provide for a good investment outcomes.

    And when the price received for converting inputs to outputs is determined by extraneous factors outside of Australia’s borders over which management has absolutely no control nor influence, then the investment prospects sound especially woeful.

    But when management announced in July 2012 a strategy to shut down its refining operation in New South Wales (Kurnell, south of Sydney), and to convert the existing infrastructure to a terminal that will serve to import refined petroleum products, I had made a mental note to monitoring company developments surrounding this strategy a lot more closely than I had in prior years.

    Because this restructuring exercise is a very significant undertaking that carries significant technical, market and capital budget risks, I wanted to see things proceeding to plan before I could consider the company at a sufficiently de-risked stage worthy of investment consideration.

    That point of comfort for me was largely achieved following the webcast of the company’s interim result in August.

    The plan to shut down unprofitable refining operations is on budget, and on schedule, for completion in Dec Half, 2014, after which the company will become an importer of refined products, which it will market through its established distribution infrastructure.

    The effect of this transformation exercise is to reduce near-term earnings by a few points, but to significantly increase the value of the company due to a change in its definition: from a capital-intensive business with volatile refinery earnings, to a capital-light, much more stable, infrastructure-style business that garners a distribution margin against the backdrop of a relatively benign competitive landscape.

    The closure and rehabilitation costs of Kurnell are $450m, plus $250m in costs of converting the site to a refined product import terminal. At the same time, the company’s more modern Lytton refinery in Brisbane (which produces 40% of its output as diesel, compared to Kurnell’s mere 25%...recall that diesel is the fastest-growing refined product in Australia, which is one of the reasons why Lytton is continuously profitable, and Kurnell not) is undergoing a series of modernisation upgrades, which will cost around $80m. These projects, together with Stay-in-Business Capex of around $280mpa will see CTX spend around $1.5bn between 2013 and 2015.

    Despite the bulk of this capital ($1.2bn) being spent in 2013 and 2014, the impact on the balance sheet is minimal: According to my modeling, NIBD-to-EBITDA and EBITDA-Net Interest will remain largely unchanged over this capital-intense period, before improving rapidly in 2015 once the project is complete. (Note: Upon conversion of Kurnell to an import terminal, over $200m of cash will be liberated, which softens to capex hump to some extent.)

    NIBD-to-EBITDA
    2011: 0.93
    2012: 0.84
    2013: 0.98 (f)
    2014: 1.01 (f)
    2015: 0.67 (f)
    2016: 0.51 (f)
    2016: 0.35 (f)

    EBITDA-to-Net Interest
    2011: 9.7
    2012: 9.1
    2013: 9.4 (f)
    2014: 9.0 (f)
    2015: 10.1 (f)
    2016: 11.9 (f)
    2017: 13.1(f)

    When a business undertakes a once-in-fifty year complete re-design of itself requiring a capital investment equal to almost one-fifth of its current Market Capitalisation, then that is a very serious transformation.

    But – and this is the key takeaway for me – that this very significant exercise can take place without the balance sheet even flinching, then that I find to be a very big statement about the cash-generating capability of the business.

    Which is what has attracted me to CTX as an investment opportunity.

    Once the company emerges from the ugly cocoon that is refining of crude oil, and into the colourful butterfly that is distribution, then it will satisfy all the “investment grade quality” criteria for me, namely:

    • Difficult-to-replicate assets - Virtually impossible in NSW (I mean, where would potential competitors possibly site a new refinery/import terminal infrastructure in Sydney?)

    • No extreme customer concentration – Last year CTX lost a supply contract with Rio Tinto, one of its largest customers, and it barely registered in terms of profitability (CTX has subsequently re-signed Rio, as Rio struggled to establish security of supply from CTX’s competitor(s))

    • Competitive Positioning – CTX is number 1 or 2 in all sectors which it services/supplies. Scope for radical change in the competitive landscape is considered negligible. Australia has 7 refineries, two in NSW (Shell’s Clyde and Caltex’s Kurnell, which are both being shut), two in Brisbane (CTX’s Lytton and BP’s Bulwar Island), two in Melbourne (Shell’s Geelong – also likely to be shut - and Exxon’s Altona), and one in Perth (BP’s Kwinana). In Fuel Distribution, CTX has a 35% national share, BP and Shell each have ~25%, and Exxon around 15%) but it’s really highly region-specific, i.e., in NSW, CTX has about 60% market share.

    • No risk of technological obsolescence or to tectonic shifts in business model – With little doubt, in five and ten and fifteen years time, we will most likely still be overwhelmingly filling our cars with fuel products, notwithstanding the hype around electric cars and/or other funky-sounding alternatives.

    • No over-dependence on critical suppliers - The supply agreement with parent, Chevron, provides for Chevron to secure refined fuel products from third parties for CTX should Chevron be unable to supply from its own regional refineries.

    • Competent, trustworthy board and operational management

    • Prudential and conservative accounting policies – The financial statements pass most of my tests of robustness and consistency, with no sign of accounting liberties flattering profits

    • More stable, easier-to-forecast financial performance – Refinery profitability is virtually impossible to forecast with any degree of confidence. CTX’s refinery operations have lurched in a range of EBIT from $200m in one year, to over $100m loss in another. (And the cause of this volatility lies squarely with Kurnell… the Lytton refinery – being more modern, and better matched with product demand, is always profitable)

    • Surplus capital generation – Even during its life as a dirty, capital-hungry refiner, CTX paid its own way. The company has generated Free Cash Flow in every year (FCF breakeven during the GFC). Over the preceding 12 years the company generated a total of $5.4bn in Operating Cash Flow. It consumed $3.2bn in capital over that period ($3.0bn after PP&E sales). It paid a total of $1.2bn in dividends and never raised capital once. The OCF-to-Capex ratio averaged 1.7x over this period, which is not too bad. But once the company moves to a distribution model from Kurnell, the OCF-to-Capex ratio will almost double, to around 3.3x, according to my analysis.

    Those final two bullet points – of more stable, predictable earnings and of lower level of capital intensity – will have significant implications for the way CTX is valued and the valuation multiple(s) which the market is likely to ascribe.

    Specifically, I think the stock will ultimately end up being valued mostly as the entity it really is: an infrastructure stock.

    The stock is currently trading at around 12x P/E and 6.5x EV/EBITDA, which tells me the market still views it as an industrial manufacturing-type business. Some commentators talk about it being a retail business given its forecourt shop-ettes, but I think that’s flawed given just $200m out of $1.0bn of Gross Margin is derived from Non-Fuel income (i.e, cokes, pies and lollies).

    I think that, post Kurnell closure, CTX will trade closer to 15x/16x P/E (8.5x/9.5x EV/EBITDA).

    Those equate to a $26 share price.

    Viewed another way: Once CTX is overwhelmingly distribution-based, pro forma OCF will be around $700mpa and Stay-in-Business Capex will be around $220m, implying FCF yield of almost $500m.

    That puts the stock on a FCF yield close to 10%. This, clearly, is too cheap, and way out of kilter with other long-duration infrastructure businesses (APA, DUE, GNC, SPN, TCL) which trade close at FCF yields in the 3% vicinity.

    I think that 5% or 6% is far more plausible.
    That, in turn, implies a $30 stock price.

    As such, I think the current share price undervalues the company by about 50%.

    Now, I have to apply a few caveats at this point:

    1. The first being that I might be a bit early in my call given the FCF “fruits” as I see them are only likely to become manifest in 2015.

    2. Secondly, what is happening at CTX is not very well understood by the market, in my view. Typically, largely due to legacy reasons, the broking analyst in Australia who covers CTX also covers exploration and production oil and gas companies such as WPL, STO, and OSH. It stands to reason that the focus is not quite what it should be, which has been my experience when I read what analysts are writing/saying/recommending to their institutional clients in regards to CTX. Case in point, most analysts have cautious investment outlooks on the stock (just Credit Suisse has a BUY recommendation, UBS, Deutsche Bank, Morgan Stanley have HOLDs and Merrill Lynch, Macquarie Bank, and Citigroup have SELL calls), predicated largely on the fact that FY13 and FY14 earnings forecasts are being downgraded due to falling Singapore Refining Margins, despite refining being a minor part of CTX’s business model from about 12 to 18 months’ time).

    3. Thirdly, because of Chevron being a 50% shareholder, the stock is not part of any of the major benchmark indices in Australia, meaning that most domestic institutional investors need to worry about it.

    Of these three, the latter two matter not in the slightest to me, because I have never, and will never, take my investment cues from equity research analysts. For the greater part, I think they are inordinately inept (and I’m eminently qualified to make that assertion, because I once was one of them). In fact I think that the fundamental mis-appreciation of the fundamentals of the stock is what has created the investment opportunity as I see it.

    The first point, however, that of being “too early” could be a valid constraint on the share price, I concede. I suspect the stock will only begin to really move towards its intrinsic valuation once the transformation process is announced to have been completed, i.e. when Kurnell is officially shut down this time next year.

    However, my experience is that finessing things has never served me well in the past, so I have in recent weeks commenced building a position in the stock, and I will continue to buy it on days that the share price is soft.

    But I have little doubt that my level of conviction will keep growing as the next 12 months tick inexorably by.


    Cam




 
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