28 May 2019
Reach Markets publish the notes from our analyst meetings with company management. They should be read in conjunction with the research we’ve completed. Reach Markets endeavour to provide self-directed investors a seat at our investment meetings. We publish these notes in a conversational format to get these out as quickly as possible for your consumption.
We recently had a one-on-one meeting with Dale Koenders from Caltex Ltd (CTX). The meeting was used as a refresher on the CTX story as well as to reassess our investment thoughts on the Company. The key points were:
Asset optimization review
Mr. Koenders began our meeting by providing an overview of CTX’s asset optimization process. Three points are worth noting.
- Sale and lease back does not make sense especially with considering AASB16. On which Mr Koenders noted (in words to the effect of), “it was ﬁrstly about does the sale on lease back create value on the balance sheet and this is where the market went wrong, the perception was if you sold a certain billion dollars’ worth of property and then lease it back then you had a billion dollar of spare capacity in your balance sheet so you should release it back in terms of market buyback and there was a complete misunderstanding of that…lease liabilities are still debt in the eyes of credit rating agencies…we went through the review and bucket 1 didn’t create value [in our view]…the answer really comes around AASB16 and the Australian accounting board is changing the way lease liabilities have been treated, the S&P uses 7% discounting rate and probably had very generous terms around how you treat the duration of these leases…means that you have got a generous value of your lease liabilities when talking about the debt value…so if you are able to sell your asset at 4% yield and realise that the liability on it is 7% yield you have created a capacity on your balance sheet and that’s what lot of companies have been doing for decades…now what’s happening at the moment is that AASB 16 sets a framework around ﬁnding the discount rate premised on your marginal cost of debt based on your individual lease site so you are kind of stuck with your corporate rate which is around 4.5%…because the difference between using a 7% discount rate on current leased liabilities which are $150m and a rate of 4% could be another half a billion dollars of lease liabilities, so it’s a debate about what’s that rate and we said total will be about $1bn but there is uncertainty around it of a couple of +or – $100m which could be all the difference between sale of lease back and creating increment liability on the balance sheet…we think the value creation is not a key driver and there is uncertainty around it.”
- Potential for re-rate. on which Mr Koenders noted in the words to the effect of, “people keep telling us that retail should be valued at 12x, refining should be on 5x…the issue is when you get to the returns that these companies would require to buy the assets from us you kind of get into a range of 8%-13% by IRR on acquisition premised on the amount of flexibility and control that you give up…if you give up all the control you are impacting the base value of your business and you get back to lease rates which are around 6.5% when the marginal cost of debt is 4.5% so then you think about the earnings impact and its actually earnings dilutive so are you really going to re rate the business or are you going to de rate business because your earnings are going down, so it’s not clear either and we looked at global examples of this and there were just as many cases of companies going down as they were up…what we did identify is that we have not provided a lot of disclosure on our property business and in the future when we do a deal around propco the property optimization joint vehicle we will provide REIT like disclosure and we will give market all the information they would have got if we had done a sale on lease back anyway…not convinced if it’s going to create a value on standalone basis but we will provide the information just in case.”
- Optimization of active management of real estate. On which Mr Koenders noted (in the words to the effect of), “at the moment we are going through due diligence to go and look at all the individual sites to see if liabilities may or may not exist and the expectation is that it is going to be low…we are going through a standard [tendering] process with two partners [being considered] and that is progressing and the expectation is you get to something where like the Bunnings vehicle where you bring in the partner to optimise the use of land like if we have a site location with our pumps and our shop and we buy the land next to it and putting multiple shops on it so you are actually creating a destination for convenience shopping…CTX used to focus on just volumes through the retail network but on the run the focus is on returns of the infrastructure and maximising the return on capital that goes into them and that is the mindset change that is carrying Caltex at the moment and property is the key focus of that process…we need to join with a propco JV partner to get experience, connections and internal resources to actually make that happen and the partners will bring premium size opportunities with them.”
Mr Koenders did not disclose much about the WOW transaction and how it works but noted in the words to the effect of, “We did not disclose a lot to the market because there was too much sensitivity around the information…what we have signed up to is an exclusive right to the metro format across our P&C network…woolworths will continue to own the metro network on the high street like Pitt street but if any there is any metro at a service station it’s going to be a Caltex service station…the WOW fuel co. will not have access to metro…what we pay Woolworths is effectively a licencing fee which is very low percentage of earnings…we put all the cost in and we take all the proﬁts post royalty…Caltex has ﬁnal say in the process when required but ideally we are taking the best of both company’s learnings to create a successful format…there is a sales supply agreement that comes with it where Woolworths rolls out 250 metros across Caltex network plus they supply groceries to the entire network…We get a competitive wholesaling margin which gives us a guarantee in cost reduction…with the deal we get access to their loyalty program 11m customers straight away which also connects us with Qantas frequent ﬂyer points…all these things will help us strengthen the entire retail network…in terms of synergies on propco we have seen a 5% increase in fuel sales on an average…we have seen people coming for metros and staying for fuel…there is 4% increase in average margin as well…we are looking at rolling out a labour optimization platform…on strategy day we are planning to provide an update on capex.”
Transition to franchise sites + underpayment issue
Mr Koenders noted in the words to the effect of, “2-3 years ago we had 90 company operated sites and 700 site locations that were franchised…we found out that underpayment of employees was happening in our network so we appointed an independent expert to undertake an audit through 2017 and about 150 franchise sites were taken back…under the franchise agreement if there is any illegal practice they lose the right to the franchise and we get the store back for free…they pay a certain amount of fee upfront for a 5+5 year term and if the store performs they get next 5 years for free and pay Caltex a royalty of 5% on shop sales and we pay them 2-3 cents incentive fee for selling fuel…they cover all the costs and take all the proﬁts beyond 5% royalty…from the time we rolled out the audit the amount of breaches have been minimal and under the new lease laws, Caltex has to pay if the franchise is underpaying…so taking over company operations removed that risk…we now have company owned and operated about 450 sites and the expectation is that about 80% of the network would be company operated by 2020… when we get through transition the proﬁtability will be the same as when we started in 2017.”
Lytton oil reﬁnery – a cash cow
Lytton oil reﬁnery – a cash cow. We were curious to know if the company would be holding the Lytton reﬁnery business or disposing it on which Mr Koenders noted in the words to the effect of, “it’s got a break-even price of $US 5-6/bbl and when you look at the volatility of the reﬁning margins, on average over last 5-10 years has been $US10-12/bbl…90% of the time, the margins is above $US7.16 and 99% of the time, the margins are above $US6.08…we have ﬁxed the liability issues and now it’s a cash cow.” The company has changed the maintenance cycle where the company had a liability to spend $200m every 5 years to spending $50-70m every year now, which has guaranteed Caltex to at least recover its money in the worst- case scenario, with respect to its current production of 40m barrels per annum. In regards to why Kurnell was transitioned, Mr Koenders also noted in the words to the effect of, “Kurnell’s breakeven was $US12/bbl so when you think about the volatility, the swings from 6 to 16 and margins of 10-12, on average we were making losses on Kurnell…it creates a platform for growth by optimising and integrating value chain from procurement to supplying in the petrol stations it’s actually a very competitive integrated network that no one else in Australia has… wholesale margin that we make on Lytton is premised on import price parity so the wholesale fuel prices in Australia are based on what the cost is to buy from Africa or Asia and import it into Australia.”