Woolworths Fuels Value

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This story features WOOLWORTHS GROUP LIMITED.
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The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

A new deal with Caltex prepares Woolworth's fuel business for sale, but broker responses are mixed.

-Expanded joint venture locks in better wholesale fuel prices for Woolworths Petrol business
-Caltex stations will join loyalty scheme and offer discounts on Woolworths dockets
-Caltex will open Metro brand convenience stores and buy Woolworths wholesale food

By Nicki Bourlioufas

Woolworths ((WOW)) and Caltex ((CTX)) announced on July 5 they have sealed a 15-year strategic alliance that will expand five aspects of their joint venture: fuel supply, convenience stores, wholesale food, docket discounts on petrol and loyalty rewards. Analysts’ reactions were mixed, noting that the deal strengthens Woolworths’ Petrol business in readiness for a sale but Caltex has paid handsomely for greater certainty over medium-term earnings.

Woolworths closed at $30.66 after the announcement, in which the company said it would continue to pursue an IPO or sale of its Petrol business. Citi raised its price target to $32.90, but cut its rating from Buy to Neutral given the stock’s recent performance. Ord Minnett maintained its Accumulate but raised its target from $31 to $32.50. Morgan Stanley was most pessimistic, rating Woolworths Underweight with a target of $23, arguing that the petrol division could be less attractive as the 15-year term “will limit a future owner’s flexibility” and its operating performance “may suffer as the future ownership remains unclear”.

Caltex closed at $32.60. Citi maintained its Buy but cut its price target from $37 to $36. Ords maintained its Hold but increased its target slightly to $27.38. Morgan Stanley was again noticeably bearish, rating Caltex Underweight with a target of $26.

Caltex hands over $80m a year to keep fuel supply deal

Woolworths will pocket about $80m a year from the lower margins Caltex charges it on fuel. Caltex will also pay $50m to re-write the deal, which will be amortised over the life of the contract. In return, Caltex gets the removal of “change of control” clauses, which formerly allowed Woolworths to cancel the contract if it sold the business.

Citi says Woolworths’ Petrol division is now worth about $2.4bn, compared to the $1.8bn offer that BP abandoned at the end of the 2017. For Caltex, Citi says, the deal is essentially “an expensive insurance policy” that maintains a competitive position in both the wholesale and retail markets. While Caltex will sacrifice $80m a year in wholesale margin, this is less than the $150m loss that was expected if it lost the supply contract.

Convenience stores and wholesale food a neat fit

The joint venture will establish 250 convenience stores at Caltex sites under Woolworths’ Metro banner over the next six years, starting with 50 sites over the coming two years. Caltex will fund and operate the stores, and pay Woolworths a royalty for use of the Metro name. Citi estimates the royalty at $20,000 per store per year. Woolworths will supply wholesale groceries to the 250 new stores, as well as Caltex’s non-Metro stores.

Citi estimates the sale increase from supplying wholesale groceries to Caltex stores at a relatively small $10m. “The supply chain economics of a convenience store network are more challenging on a unit cost basis due to a higher share of tobacco in the sales mix and smaller delivery sizes to each store.” However, the addition of the 700-plus Caltex stores will improve economies of scale at Woolworths Food division, and this will be felt “materially” over time.

Fuel discounts and reward cards entice shoppers into Woolworths’ orbit

The deal will add 125 Caltex petrol stations to the network of sites giving a petrol discount of 4 cents per litre. With Woolworths already operating 534 petrol stations, this brings the network of stations offering discounts to 658 sites compared to 1,008 Woolworths supermarkets. This is closer to the ratio enjoyed by Coles, which had 712 petrol stations and 806 supermarkets in the first half of 2018.

The benefits of the fuel discount are also expected to flow through to the Food division, as more motorists fill up at a Caltex station then shop at a Woolworths-supplied convenience store. Citi estimates sales will rise about 3% at the supermarkets located near a petrol station that redeems discounts. The Woolworths loyalty scheme will be expanded to give Rewards points to motorists buying fuel and merchandise at more than 700 Caltex stations across Australia.

FNArena's database shows three Buy (or equivalent), ratings for Woolworths, three Hold and two Sell. The consensus target is $28.48, suggesting -7.1% in downside to the last share price. Targets range from $23 (Morgan Stanley) to $32.50 (Ord Minnett).

FNArena's database shows five Buy ratings for Caltex, one Hold and one Sell. The consensus target is $36.29, suggesting 13.2% in upside to the last share price. Targets range from $26 (Morgan Stanley) to $40.80 (Credit Suisse).

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