Will pending growth-by-acquisition strategy re-rate Caltex Australia?

Having flagged to the market that growth-by-acquisition is his number one priority, following the $4.73 billion exit from Caltex Australia’s (ASX: CTX) share register of US energy giant Chevron back in March, CEO Julian Segal recently revealed plans to buy out its partner Woolworths (ASX: WOW) from its petrol joint venture, and has already advanced plans to pull this off. 

While this is only one of many acquisitions Caltex Australia – now Australia’s leading supplier of transport fuels – is currently eyeballing, including BP’s local retail business, the timing for Woolworths, which only earns 1% of its earnings before interest and tax (EBIT) from the fuel business, to consider a deal with Caltex Australia couldn’t be better. 

Given Australia’s pending supermarket wars, Woolworths – which has a long-term funding gap close to $1 billion – needs to free up cash to refocus on its struggling food and liquor division that’s responsible for most of its group earnings. 

Best estimates suggest that Caltex Australia could allocate around $600 million to acquisitions and capital management initiatives and still maintain its BBB+ credit rating. Segal is expected to announce a formal review of growth opportunities late this year or early 2016 and in addition to cash on balance sheet may use new equity and debt to consider deals of up to $3 billion. 

Assuming this growth strategy excites analysts and the market alike, it could provide the badly need kicker to a range-trading share price. 

It’s understood future deals will focus on “step-out” acquisitions that enable Caltex Australia to leverage off its expertise in infrastructure, supply and distribution – which is where the primary battle within Australia’s fuels market is being fiercely fought. 

Assuming Woolworths is a willing seller of its fuel business, Caltex Australia is by far the most obvious choice, especially since it will want to retain the supermarket bundle agreements to avoid being broadsided by either Coles or Aldi. 

Strategically, Caltex Australia’s purchase of Woolworths’ fuel business would complement its plans to expanding its fuels retailing presence in Australia by adding new petrol stations. Caltex Australia has worked hard to transform itself from being a major refiner of crude oil – characterised by low, volatile margins and dismal returns on capital, and zero pricing power amid intense competition – into an integrated oil refining and fuel retailing and convenience store operator.

Having converted one of its two remaining refineries to an import terminal, Caltex Australia is relying more heavily on its Ampol Singapore operation to source oil and fuels for imports to improve efficiency of supply. 

Ongoing changes to Caltex Australia’s business model enable it to capture opportunities to further optimise its integrated value chain. Given its extensive network of terminals, pipelines, depots and service stations, Caltex Australia is morphing into an infrastructure-like play rather than a retailing or refining play per se, and this should excite investors. 

In line with its pre-released numbers, the company reported a 45% first-half core profit to $251 million. Most of Caltex Australia’s earnings growth has come from the expansion of retail petrol margins which have doubled over a decade, driven by less competition and a structural shift to higher profit premium fuels. 

While Caltex Australia is on-track for a very strong full year performance, it’s important to note that a weaker A$ is successfully masking weaker volumes. The first half saw a 4.4% dip in sales volumes of transport fuels on the loss of a major diesel supply contract, while jet fuel sales sank 8%. 

Assuming we do see a continued downtrend in fuel volumes – due to alternative fuel sources, better public transport within capital cities and cars with greater fuel efficiency – margins are likely to come under greater pressure. In light of these challenges, management has already signaled difficulty achieving a previously stated 5% earnings growth target. 

Growth by acquisition aside, watch closely for plans to distribute the $1.1 billion in franking credits that Caltex Australia as capital returns, plus any regulatory issues that future acquisitions may create, and the impact of future acquisitions on shareholder value. 

Despite having a long-term funding gap of $159.2 million, Caltex Australia has an investment grade balance sheet with strong long-term cash flow relative to reported profits, and very modest net debt-to-equity of 26.03%.

While earnings per share (EPS) has been very weak over the past five years, exceptional EPS growth is forecast; from $2.11 in 2015 to $2.17 and $2.22 in 2016 and 2017 respectively. Return on equity (ROE) has averaged 15.73% since 2005, it and is forecast to deliver 21.41% ROE in 2015; then 19.91% and 18.74% in 2016 and 2017 respectively. 

Based on these numbers, the company is forecast to deliver (fully franked) dividend yield of 3.37% in 2015, and 3.81% and 3.98% in 2016 and 2017 respectively. And based on a 2016 price to earnings (P/E) ratio of 14.48%, the stock doesn’t appear to be excessively expensive, especially given its commitment to future growth-by-acquisition. 

Further share market weakness, ideally around $29.00 would make for an attractive entry point.