Challenges Ahead For Caltex

This story features WOOLWORTHS GROUP LIMITED. For more info SHARE ANALYSIS: WOW

Caltex is undergoing significant change in its business and this has weighed on the share price and earnings. Yet, amid the challenges, there are positives going forward.

-Transport fuel margins should support the core business amid rational industry competition
-Is the market underestimating medium-term earnings growth?
-Outlook for capital returns now appears limited
 

By Eva Brocklehurst

Brokers were disappointed that Caltex Australia ((CTX)) failed to provide capital management in the first half results but find plenty of positives going forward. First half results revealed operating earnings (EBIT) of $443.4m, at the lower end of guidance, and the market is now dissecting the outcome of the asset review and the future look of the business.

Ord Minnett observes Caltex is undergoing significant change and the fuel supply agreement with Woolworths ((WOW)), alliance sites and food sourcing have all weighed on the share price and earnings multiple. Meanwhile, the transition from a franchise to corporate operating model remains somewhat unclear, although most of the costs have been well flagged. Transport fuel margins should support the core business amid rational industry competition, the broker suggests.

Morgan Stanley, on the other hand, envisages continued pressure on earnings, as the Woolworths contract is re-priced, along with difficult retail conditions and higher costs. While the case for changes to infrastructure have been neutralised, the broker believes there are challenges from emerging fuel consumption trends across Australia.

Earnings may have been flat at the headline level but the fuels & infrastructure division grew by 9% and this includes a reduction in the Lytton earnings of -30% because of a lower refining margin. Hence, Macquarie considers the core division high quality and defensive and somewhat under-appreciated by the market.

UBS remains confident that the business is well-positioned to deliver an earnings uplift from the roll-out of its retail strategy. The broker considers the -30% discount applied to the stock, ex-refining, does not adequately reflect the convenience opportunity and the high barriers to entry.

Credit Suisse incorporates new retail assumptions which set a lower underlying earnings base for the stores that are moving to corporate ownership. The broker was always of the view that the pre-existing franchise profitability base was unsustainably high and, by implication, the profitability of the comparable company-owned store will be somewhat lower.

Credit Suisse suggests this should be closely watched in the second half, as the costs of the transition are not particularly clear as yet, and downgrades to Neutral from Outperform.

The company intends to divest around 15-20% of the existing freehold site portfolio. Citi suspects the partial sale and lease-back of retail sites is slightly dilutive, given a full sale was not pursued by Caltex. The broker agrees the market will need more disclosure on the scale of the opportunities and associated expenditure before being able to ascribe any value.

The broker considers the stock is undervalued and the market is underestimating medium-term earnings growth, albeit there are few catalysts in the near term.

Woolworths

The partnership with Woolworths has been extended and expanded to include the co-creation of a convenience offering as well as long-term wholesale grocery supply, loyalty and redemption arrangements. The first Woolworths Metro convenience store is to be opened in early 2019.

A partnership with Woolworths on the retail strategy is right but it will take time for the earnings to materialise and be difficult for investors to assess in the early days, Morgan Stanley suggests. The broker maintains an Underweight rating.

Capital Return

The asset optimisation review has been completed and infrastructure assets are to remain under company ownership, while Caltex will sell some retail sites into a partnership. Ord Minnett is pleased with the development, although disappointed this has not enabled the hoped-for capital management. Credit Suisse suspects the prospect of capital management has been de-emphasised and this reflects the little headroom available in existing debt levels.

Macquarie also finds the reduced likelihood of a capital return a negative, although envisages valuation support remains. The broker had anticipated a capital release from the divestment of service station freehold but this was not forthcoming, while a sale of infrastructure assets was never considered likely.

With a strategic partnership being incorporated for just a minority of the freehold portfolio and the release of proceeds being impeded by capitalisation of rent charges, the outlook for capital returns appears limited to the broker.

UBS suggests capital management will still be considered in the absence of growth initiatives after 2019. An off market buyback is viewed as the preferred form of capital management given the franking balance. Citi applauds management for not committing to a sale of retail sites or infrastructure for a short-term capital return, particularly if long-term value outcomes are unclear.

FNArena's database shows four Buy ratings, one Hold (Credit Suisse) and one Sell (Morgan Stanley). The consensus target is $33.73, suggesting 10.5% upside to the last share price. This compares with $36.27 ahead of the results.

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