Changes Afoot At Caltex

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Caltex has outlined significant changes to retail operations, expected to deliver 10-15% growth in earnings within five years.

-Costs related to the transfer of retail operations to corporate from franchisees expected to weigh near term
-Unclear how much of the growth target is coming from food or fuel
-Value of assets a key uncertainty, any capital return likely to be a driver of the share price
 

By Eva Brocklehurst

Caltex ((CTX)) has thrown the market a bone, outlining strategic initiatives it hopes to accomplish over the next five years. An asset optimisation review is underway amid several options to drive shareholder returns.

The company will move to ownership of its retail operations and away from franchised sites by the mid 2020's. This will require capital expenditure of $100-120m over the next three years.

The company calculates the conversions, in addition to the rolling out of Foodary sites and Nashi stores in 2018, should yield a net sustainable uplift of $120-150m in convenience store operating earnings (EBIT) over the next five years. Earnings contributions are expected to be net positive from 2020.

The optimisation review is designed to determine whether attracting market multiples for the retail and infrastructure assets will be greater than keeping the company together. The review is canvassing all options, including an A-REIT structure, and the outcome is expected by the end of the June quarter.

The first phase of the review has identified cost savings of around $60m per annum which should go towards offsetting inflationary pressures, Macquarie suggests. Deutsche Bank expects Caltex will be able to deliver the bulk of these savings through 2018.

Morgan Stanley believes the move away from a franchisee model is a sensible strategy but has several questions regarding the near-term earnings impact and how Foodary earnings will grow over time.

The broker would not be surprised if non-fuel income declines over the next couple of years, because of lower rent and franchise income while the strategy for Foodary takes shape.

Foodary

The sales uplift from new Foodary outlets is now around 35%, with 26 new stores operating under the format. The company intends to launch a further 50-60 sites in 2018. Deutsche Bank suspects the conversion of franchise sites will be erratic, given varied terms across franchisee arrangements.

Credit Suisse questions just how much of the growth target of $120-150m is coming from Foodary and how much from fuel. Either way, despite a recent re-rating, the broker continues to believe the stock is cheap and there is an opportunity for shareholders. Outperform maintained.

Ord Minnett considers Foodary an attractive long-term opportunity too, provided the execution risks are well managed. In the meantime, costs relating to the transfer to corporate from franchise are expected to weigh on earnings.

The broker downgrades to Hold from Accumulate, expecting earnings declines in the near term, and because the share price performance already incorporates some multiple expansion.

Asset Divesment

Asset ownership, or otherwise, remains key, as Credit Suisse asserts a break-up scenario offers potential upside that is hard to beat. Nevertheless, the broker accepts that there may be strong reasons that emerge as to why more value is on offer by not selling assets.

UBS envisages capital returns resulting from any asset divestment will be a driver of the share price but the lack of detail regarding the asset book value makes an estimate of how much capital could be unlocked next to impossible. The broker suspects some assets could be put up for sale, with any potential proceeds likely to facilitate growth and further buybacks.

Citi is not convinced the share price will re-rate after the asset optimisation review is completed. If the focus is on delivering long-term shareholder value then the risks centre on reduced competitive advantage, supply cost inflation risk and accounting-related downgrades, and this may make it hard to instigate large-scale changes.

Risks arise around the the Woolworths ((WOW)) wholesale supply contract, if the decision by the ACCC is challenged by BP, or around the conclusion of the asset review after which the broker believes large changes are unlikely.

Uncertainties

The prevailing uncertainties cause Citi to downgrade to Neutral from Buy, despite the solid fundamentals in the business. While the outlook is uncertain, disciplined strategy and prudent capital allocation by management has consistently delivered top returns and the broker suspects the market may still be under estimating the outlook for earnings growth in the medium term.

Deutsche Bank adds six months of earnings back into estimates for the second half of 2018, in anticipation of a response from BP regarding the transaction to acquire the Woolworths fuel sites, which failed to materialise because of ACCC opposition.

The positives have offsetting factors, in Macquarie's view, and new initiatives are arguably required to counter the headwinds. Uncertainty continues for the Woolworths fuel volumes and the benefits of a shift in mix to premium fuel are likely to taper off as a driver of margins while some reversion in refining margins is expected.

Morgan Stanley is also concerned about margin degradation in the base business and, while infrastructure and asset sales could be exciting, suggests these are too difficult to forecast.

The broker will look at the first half marketing and supply performance for a clue as to whether there is any more degrading of earnings in this segment. Supply and marketing were down around -10% in the second half of 2017 versus the first half, excluding acquisitions.

The company has outlined higher capital expenditure in 2018 based on spending in the Foodary business and additional capital requirements at Lytton refinery. The broker finds it unclear why the company is moving to smaller annual turnaround at Lytton but suspects this provides greater flexibility in regards to potential changes to Australian fuel standards.

There are two Buy ratings, four Hold and one Sell (Morgan Stanley) on FNArena's database. The consensus target is $36.84, signalling 4.2% upside to the last share price. Targets range from $27 (Morgan Stanley) to $40.80 (Credit Suisse).

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