Caltex: The Battle For Woolworths’ Petrol Business

This story features WOOLWORTHS GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: WOW

Speculation is mounting regarding the potential disposal of the Woolworths fuel business and Caltex has thrown its hat in the ring.

-Loss of Woolworths volumes unlikely to be entirely offset in the medium term 
-Opportunities for Caltex, given its competitive infrastructure network
-Concern the company may abandon capital discipline to chase the bid

By Eva Brocklehurst

Caltex ((CTX)) has confirmed its interest in the Woolworths ((WOW)) fuels business, flagging the submission of a conditional and confidential bid. Caltex is currently the exclusive supplier of petrol and diesel to the Woolworths fuel outlets.

The loss of 3.5bn litres in Woolworths fuels volume – the number confirmed by Caltex – out of the 15.7bn litres it sells, would be a significant negative, given the scale this provides to the operation of the infrastructure network, but Ord Minnett is one broker that is confident the company could adapt. The broker notes BP, according to press reports, appears to be favoured to win the business. BP has greater flexibility in its operating model as some operators run the store while BP as the head lessor, retains its branding and supplies the fuel.

Some of the implications brokers consider include the fact that any change of control of Woolworths fuel would take some time. The Australian Competition and Consumer Commission (ACCC) would have a keen interest in assessing the implications for the retail fuel industry and may require sites to be divested if BP wins the contract, which could then provide incremental sites for Caltex. Foreign Investment Review Board approval is also likely to be required.

Ord Minnett notes the Caltex infrastructure network has a competitive advantage, especially in Sydney and Brisbane, and it is unclear how BP would supply Woolworths in these markets. Caltex could also access a new loyalty partner. The broker notes two major alliances, BP and Velocity (Virgin Australia) and Woolworths and Qantas ((QAN)) (Frequent Flyer), are in play.

The loss of the Woolworths volumes is unlikely to be offset entirely in the medium term if Caltex loses but some volumes could be partially offset by growing third party distribution, and transport fuels margin per product is likely to expand while reduce in aggregate, in Ord Minnett's estimates. Moreover, Caltex has well flagged ambitions to expand its convenience operations and this may present an opportunity as key part of its medium-term strategic growth.

A review of Lytton refinery is also possible. The broker notes Caltex has been disciplined regarding the continued operation of Lytton, with a focus on strict financial hurdles. Finally, if Caltex were unsuccessful regarding the Woolworths business, another round of capital management to return some of the $850m in franking credits is possible. Caltex has stated it will be disciplined in its bid but there is downside risk if a competitor such as BP or Vittol is successful, as the fuel supply agreement could be terminated.

This supply agreement represents 22% of annual sales volume and UBS estimates it generates a margin of 2-2.5c per litre. The broker calculates the termination of the supply agreement could negatively impact EBIT (earnings before interest and tax) by $70-90m per annum, which represents 8-10% of forecast 2016 EBIT. Assuming an 18 month to two year delay before any supply agreement is cancelled the broker estimates $2.40-3.00 per share downside to valuation. In the event of success, upside will depend on the price Caltex pays and any further value uplift via synergies.

Credit Suisse cannot envisage any rational way, economically, that BP can outbid Caltex, but accepts the risk exists. Yet the risk to earnings per share is far lower than the actual volumes suggest and can be offset both operationally and through buy-backs, in the broker's view. There are plenty of growth options, too, for Caltex if it loses the Woolworths business. This is not to suggest, Credit Suisse emphasises, that it does not believe the business is a natural fit for Caltex.

The issue is about competitive infrastructure, which BP does not have in NSW and Queensland. BP has a small site in Newcastle and an agreement with Vittol at Parramatta and takes all its retail product from Caltex in south Queensland after closing Bulwer Island. Acquiring the Woolworths assets makes sense for Caltex but Credit Suisse would also applaud the company's capital discipline if it did not chase a deal at any cost.

The broker suspects there is a lot of competitive posturing going on between the seller and potential bidders. In a scenario where no company ends up buying the assets – where BP baulks at the economics and Caltex refuses to bid higher – the broker believes the loser is likely to be Woolworths.

Moreover, BP has been divesting assets aggressively in the past few years and has not allocated much capital downstream, and Credit Suisse considers it would be an unusual strategic step to spend a decent amount of capital on Australian downstream business to buy low-quality retail sites.

Citi believes the announcement from Caltex confirming the bid is an acceptance that it could lose the wholesale supply agreement. The fact that Caltex has also disclosed that the alliance and agreement are dependent on continued ownership of the sites by Woolworths is a signal to the broker that Caltex does not envisage it will successfully acquire the assets.

Citi agrees that losing the volumes would impact earnings, and could be partially offset by supply logistics services to the successful acquirer or by acquiring retail outlets that were forcibly divested by the rival to appease the ACCC.

Macquarie envisages a potential negative earnings impact of 3-12% on group EBIT should Caltex lose the agreement and is also concerned that the company's management may be pressured to overpay to secure the asset. On this subject Goldman Sachs is quietly confident that strong capital discipline will prevail at Caltex.

Questions for the broker centre on whether other bidders are competitive and whether the relationship with Woolworths is damaged by the push by Caltex into convenience retail. Goldman, not one of the eight stockbroker's monitored daily on the FNArena database, has a Neutral rating and $32.15 target.

The database shows two Buy and five Hold ratings. The consensus target is $35.34, suggesting 8.0% upside to the last share price. Targets range from $32.60 (Morgan Stanley) to $40.00 (Credit Suisse).
 

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