Caltex Australia Limited (ASX: CTX) supplies one third of Australia's transport fuel. The company recently converted one of its two oil refineries, the Kurnell refinery in Sydney, into Australia's largest fuel terminal.
Refineries are capital intensive businesses subject to external forces. The refining margin is essentially the difference between the price of fuel products and the cost of crude oil. It dictates the profitability of refineries and depends on the price of oil, exchange rates, regional refining capacity and demand for fuel.
As with any commodity business, it is only the lowest cost providers that can make money in the long term and the Kurnell refinery was far less efficient than its Asian counterparts. Consequently, it was a drag on resources, losing Caltex $69 million in 2014 alone. The remaining Lynton refinery in Brisbane is consistently profitable because it is more modern, and produces a favourable mix of diesel and petrol.
The remainder of the Caltex business distributes fuel across Australia and sells non-fuel items through its network of petrol stations. The company enjoys a dominant position in New South Wales and has managed to build up brand strength through advertising the premium quality of its fuels.
In addition to the Kurnell conversion, Caltex underwent a cost and efficiency review in 2014, which is expected to reduce costs by up to $100 million per year. Here are some pros and cons of the rejuvenated Caltex business.
Pros
- Owner of billions of dollars of essential infrastructure.
- Unassailable market position in New South Wales.
- Defensive revenues due to the nondiscretionary nature of fuel.
- Stable margins and cash flows going forward.
- Reduced capital requirements freeing up cash for higher dividends or to pursue growth opportunities.
Cons
- Risk of adverse changes to government environmental policy.
- Reduced demand due to growth of electric and self-driving cars, although this is unlikely to happen for decades.
- Mature industry with limited room to grow.
- Due to Caltex's dominant position, growth opportunities will be limited by the ACCC.
Valuation
Caltex has $640 million of net debt on its balance sheet which is easily serviceable, since I expect the business now generates around $600 million in cash flows per year after maintenance capital expenditure. This figure takes into account both the impact of the Kurnell project and the recent cost and efficiency review.
Crucially, the cash generated by Caltex has been tied up in recent years by the $270 million conversion of Kurnell. Prior to that, the old refinery was a significant cash drain, and so Caltex will soon be in a position to invest heavily in the growth of the business or to increase dividends. Management has been exemplary in its decision making and execution over recent years, and there is no reason to suspect it won't continue to allocate resources effectively.
As with most stocks in the market currently, Caltex is not cheap, trading at around 16x my estimated free cash flows. Fortunately, the analysts at The Motley Fool have trawled the market and identified one of the few remaining genuinely undervalued stocks.
