A high-quality, undervalued infrastructure network

We continue to like Caltex Australia. Transport fuel earnings will continue to grow due to the continued shift to premium fuels (i.e. more European cars and the greater penetration of diesel passenger vehicles), growth in non-fuels convenience and a general increase in pricing to reflect a return on the store development programs. We expect fuels volumes to stay largely flat due to lower demand from resources companies, increased vehicle efficiency and the gradual adoption of hybrid and electric vehicles over the longer term.

The business has a high-quality network of infrastructure assets that we believe is extremely difficult to replicate. It also has a well-regarded management team that has driven strong value creation through the cycle as well as a robust balance sheet that sets up the group for growth opportunities as well as capital management to release over $1bn in franking credits.

The strong transport fuel earnings growth story will help offset the well-anticipated normalisation in refining earnings which peaked in 2015. We always expected a reversion in 2016 and our refining earnings are based on very conservative margin assumptions, due to their inherent unpredictability, to ensure our fundamental valuation is not driven by an extraneous factor that is volatile.

The past 12 months has seen Caltex underperform for two primary reasons:

(1) a significant decline in refiner margins early in calendar year 2016 and

(2) expected loss of fuel volumes from its largest customer, Woolworths, after its petrol's business was sold to BP in December 2016.

The first reason was well known by the market, but as has been the case on so many occasions in the past, the market was spooked by lower refining numbers posted in early 2016 and the stock underperformed. Interestingly, the margins recovered throughout the year, up 50% from the low numbers reported early in 2016, yet the market didn’t react. The Caltex refinery produced more barrels, operated more efficient and at a lower cost. But Caltex received no credit. Talk about one sided!

The second driver of underperformance was more out of left field. In December 2016, it was announced that Caltex would lose its large multi-billion litre fuels contract with Woolworths as part of the Woolworths Petrol sale to BP. This is no doubt a negative for Caltex. But again, the market overreacted in terms of the impact on the underlying cash flows. While the volume impact is significant, the Woolworths contract was struck at a very low margin such that we estimate the earnings impact to Caltex is less than 10%. Caltex has actively responded to the potential earnings hit by initiating another cost out program as well as acquiring a couple of bolt-on businesses on the cheap that will provide strong cash flow and returns accretion. We believe Caltex will be able to offset most if not all of the earnings decline if they lose the Woolworths contract which is set to terminate in early 2018. We are saying "if" because the Woolworths contract is predicated on BP obtaining ACCC approval to purchase the Woolworths fuels business. We understand this might be difficult due to the reduce competitive intensity in the retail fuels space and perceived higher prices that consumers might pay for fuel. If the deal is rejected, Caltex might, in fact, retain the Woolworths contract.

Our numbers have Caltex losing the Woolworths volumes and the refining margins reverting to normalised levels. Despite these headwinds, we see significant valuation upside. With a strong balance sheet, we see this business undertaking capital management to release over $1bn of franking credits as well as further bolt-on acquisitions to expand its already robust network footprint. The penetration of premium fuels will continue which will support higher retail margins. The market might currently be focused on the short term, but we remain confident that the quality of the underlying infrastructure asset and strong cash flow generation capability of the business will be rewarded.

Written by Vinay Narsi, Investment Analyst at UBS.