Description

Quick Investment Case

I would buy Valvoline, the (relatively) recent spin of Ashland’s motor oil business.  As a recent poster wrote on the ADNT message board on VIC, when it comes to spin offs, the halcyon days of Greenblatt’s book where one could almost close one’s eyes and pick a spin off at random and make 20% in year one seems to be in the rear-view mirror now. Companies have cottoned on, and will frequently spin off the turds that they own, often with more than their fair share of group debt, with the SpinCo’s management trotting out a few clichés about more focus, proper incentives, being able to invest for growth, etc, etc, only for the SpinCo to sink into the doldrums and the RemainCo to make new highs.

This is *ahem* exactly the setup here. Valvoline was spun with a reasonable amount of debt on the balance sheet, all the clichés were duly trotted out, Valvoline now on the lows, Ashland on the highs, so the market appears to have voted. Some chance I am yet another spinoff sucker, but I lay out the case below.

They are a producer of motor oil. They sell product into retail outlets and installers in the Core North America division, while they also operate dedicated oil change facilities through both owned retail outlets and franchisees via the Quick Lubes division. Finally, through their International division, they have a “junior” version of the Core US business – the differences between International and Core US would be profitability (International is lower due to route to market used), sales growth (International far higher as end market growth is higher and Valvoline are a smaller part) and end market exposure (US tends to be more consumer, International more heavy industry). The company has about $2bn of sales, $850m of gross profit and $420m of operating profit. The balance sheet is about $2bn also. Ashland saddled Valvoline with quite a bit of the group debt, so the gross debt this year should end up at about $1.5bn (including the ~$300m pension underfunding), net debt around $1.2bn.

As mentioned above, Valvoline now trades near the lows after derating since listing. Patchy operational performance on gross profit per gallon of fuel sold, I think mainly driven by factors out of their control (crude volatility, refinery shutdowns which temporarily caused spikes in base oil utilisation rates), seems to have driven pessimism over the quality of the business, which has in turn driven the derating, which I think is a bit unjustified. I would also add that a general fall from grace of “consumer-y” names over the last year as rates have risen (see EPC, SPB, COTY, NWL, CLX, CL, PG, for example) has hurt a bit on the derating side.

I think that the company will be able to restore confidence via:

• Fuel margins stabilising as per management commentary, as they put through their third price increase of the year and they fully benefit from the lagged impact of the other two, confirming their pricing power and the earnings stability of the Core North America business

• Further growth the Quick Lube business through a continuation of the well-established combination of mid-single digit LfL growth in their stores and the rolling up of weaker competitors who are still a meaningful part of the market

• Continued strong growth in the International business, which is lower quality and less profitable than the rest, but does at least (along with Quick Lubes) give the company a growth angle

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I think that once it is confirmed that this is not an ex-growth, structurally-challenged company in most of their business areas, that was spun off from Ashland with a load of debt close to peak profitability, the shares will recover. There is no hard catalyst that I envisage, it is more just earnings showing continued stability and then continuing to grow with the top line.

They are guiding for 10%-12% top line growth this year. They did 11.5% in Q1 with a 1.4% currency tailwind and 10.7% in Q2 with a 2.3% currency tailwind. I have them growing about 10.7% this year and then about 7% next year as currency moderates, and 5%-6% CAGR over the next few years. I think earnings will grow a bit faster than that, mainly driven by mix (Quick Lubes will grow the fastest and enjoys gross margins above the group average) and buybacks (company guide to 45%-60% of FCF being returned to shareholders – I think that will be slightly weighted towards buybacks – should allow them to reduce share count about 2% per annum). When one combines ~10% earnings growth into the medium-term with ~20% ROIC, I would say that the ~14.6x 1y forward P/E makes the risk/reward look favourable. The guidance for 2018 FY EPS (Sep19 year end) is $1.31-$1.38, so ~$1.35 at the midpoint. They did $0.58 in H1 so it will be back end-loaded but achievable as price increases they put through in H1 to offset base oil price increases drop through to the bottom line while some investments they made in H1 stop weighing on the P&L. I think with the top line growth, that $1.35 in Sep 18 grows to $1.98 by Sep 22. A conservative (to my mind) 14x 1y forward P/E would drive a Sep 21 price target of $27.7; $1.6 of cumulative dividends would get you total upside of ~41% and an IRR of about 10%.

I don’t think the assumptions I am making are that heroic. The company have done a good job keeping gross margins per gallon sold consistent over the last few years, and I am not assuming any kind of ramp up in those margins. Most of the earnings growth comes from Quick Lubes, where the company have done mid to high single digit LfL growth for about the last 10 years, and I am just assuming more of the same and continued roll ups. I go over how they achieve that below, but they are pretty confident this continues, and the rationale seems logical to me. There’s also a substantial runway for investment in this part of the business, so (famous last words), I think the earnings growth I am assuming is not overly optimistic. Until oil started to really rally in the middle of last year, putting question marks over the per gallon margins, the stock enjoyed a multiple of 16x-19x, reflecting the mid-single digit medium-term top line growth runway and the attractive returns on capital. At the midpoint of that P/E range, you would have a /~$35 Sep 21 price target with $1.6 of cumulative dividends for a total value of $36.2, ~75% upside with an 17% IRR. That is leaning into the case slightly, but not wildly optimistic.

Company In Brief

The company is made up of three related but quite different (in terms of top line dynamics, growth) businesses. I go through the business lines in more detail below, but the group will be about $2.3bn of sales, with about half of that Core North America (motor oil mainly into the consumer market), with the balance evenly split between Quick Lubes (also called Valvoline Instant Oil Change or VIOC), where they own and franchise dedicated oil change locations, and finally International, which is, as the name implies, an international version of the Core North America business, just with a slightly different business model. The group has 37% gross margins currently (varies quite a bit with the oil price so better to look at gross profit dollars per gallon) with Core North America and Quick Lubes around 40% and International around 30%. On an EBIT margin basis, Quick Lubes is actually the most profitable at 25%, followed by Core North America (20%) and International (14%). The company has a large but manageable amount of net debt ($1.3bn or 2.9x EBITDA at FY17) but should generate ~$250m of FCF per annum. The high level summary is as follows:

Core North America

The largest division, with about $1bn of sales $400m of gross profit and $200m of EBIT in 2017. The market size is ~700m gallons, which is about $7bn (will vary depending on where base oil is, so probably best to think about it in terms of volumes). The main drivers of volumes are miles driven and frequency of oil changes. Miles driven in the US on a LTM basis was 3.2trn as of March 2018, which was up about 1% YoY. That number went negative during the financial crisis, but since then has averaged about +1.1%, though it has rolled over recently as oil has rallied:

Average frequency between oil changes is currently about 4,500 miles driven, but it should gradually grow a little from there, related to more efficient cars and better oil going into them. All in all, market volumes are likely to be flat +/-0.5% over the medium-term, I’d say. They have a market share of about 14%, I believe (99.4m gallons in 2017). Private label is the biggest part of the market at 25%, then divisions of some of the IOC’s (Shell, Exxon and BP) have about 45% combined (Shell the largest), with the rest split between various players. While it is not the idea competitive situation, competition is in fact highly rational, bordering on collusive oligopoly. There have been three rounds of price increases this year, and all of the major players seem to have participated. The competitive situation markedly improved during the financial crisis, when the industry seemed to find religion on pricing. I do not have divisional data going back beyond 2013, but looking at Ashland’s financial statements, Valvoline’s group level gross margin and operating margin averaged 23.6% and 3.4%, respectively from 2005-2008. From 2009 until 2017, those margins have averaged 32.6% and 16.6%, respectively.

In terms of the channels the sales are split into, it is DIY, DIFM (“Do-It-For-Me”) and then Commercial & Industrial. I believe that the first two channels are about 45% each of the division, with Commercial & Industrial about 10%. I am not sure how profitability varies between the channels, but one thing to note on the profitability is that, overall, branded sales are 75% of the division and 90% of the EBIT.

The company provides a summary of the types of accounts by each channel. They should not have all that much pricing power in the DIY segment given their relative size compared to Autozone, Walmart, etc, but I guess Shell, Exxon, BP etc would have much more bargaining power, and the industry does seem to collude as noted before, so Valvoline seem to be able to piggyback on this dynamic.

In terms of the economics of the division, what matters are base oil prices (about half of the COGS, with the rest being additives and packaging mainly), and then the margin that they can secure per gallon above these costs. Base oil prices are, unsurprisingly, closely correlated to WTI:

While their COGS per barrel are then very correlated to base oil:

In terms of the gross margin per gallon that they can secure, I only have good data going back to 2013, and only quarterly data going back to Q116, but the summary from the information that I have is that from 2013-2015, the gross profit per barrel on a yearly basis averaged $3.64 with a low of $3.47 and a high of $3.90. On a quarterly basis from Q116 to Q218, the average has been $3.98, with a range of $3.52 to $4.34 (was $3.98 in Q118 and $3.94 in Q218). The margin shows some inverse correlation to base oil prices when there’s significant YoY volatility, but the relatively stable margin over time (~$3.50 to $4.30 range from 2013-2018 with WTI going from $90 up to $110, down to $30, then back up to $70 recently) suggests that there is, in fact pricing power:

The reason for the apparent correlation with base oil is just the lag in passing through commodity price increases. While most of the passthroughs are by formula, there is, on average, a two month lag, which is why you see per gallon margins declining from mid-2017 before finding stability again. Of course, crude and base oil have continued to have momentum, which has generated question marks over what happens to per gallon margins. I think I am being fairly conservative in modelling them declining to about $3.60/gallon (at the low end of the historical range that I have) into perpetuity, and that hopefully leaves some margin of safety. The only other thing worth mentioning is the mix of premium lubricants in the Core US division. The difference between premium and regular products is that the premium products are synthetically made and have less viscosity and are purer. They are better for the engine and carry higher prices and slightly better margins. The current premium mix is in the mid-40% range and has been growing about 300bps per annum in recent years – each 100bps increase in penetration in the mix adds about $2.5m to gross profit.

I include my numbers below, but the division did $1bn of revenues, $400m in gross profit and $200m in operating profit in 2017. This business is pretty much ex-growth, but I think that it can maintain profits around this level. The business generates a lot of FCF obviously (should be a capex = D&A type of business, not much WC investment, would be about 20% tax rate on most of these earnings so probably about $130m-$150m of FCF given a pro forma allocation of interest cost, pension contributions and stock-based comp.

The role of this division is as a stable, cash generation machine that allows the company to invest in the other two divisions, which are profitable, mid-single digit growth businesses.

Quick Lube

The second-largest division by sales, with about $540m, gross profit of $220m and operating income of $130m in 2017. I think that, by the end of the decade, this will be their biggest division in terms of operating income. The business is dedicated DIFM – you drive into one of their dedicated units (either directly owned, of which they have about 450, or franchised, of where there are about 730) and they turn around an oil change in 15-20 minutes without you having to even get out of the car. In terms of market size, there are about 9,000 of these instant oil change units in North America, of which they have about 1200. Jiffy Lube (Shell) are the market leader with about 2,000 stores, followed by Exxon and Valvoline in roughly joint second, Havoline third with about 900, and a very large tail behind that of Mom & Pop type operations.

This business seems to be a classic better execution roll up/share gain story really. The business is driven by ticket size (about $45 for a conventional oil change, $70 for synthetic oil, does not seem to vary much across the industry) and the number of oil changes done per day. It is in this area that the company really excel – the industry average is about 30 changes per store per day, whereas a mature Valvoline-owned store does about 41:

In terms of how they achieve that improvement vs. the industry, it is a combination of:

• Better locations – they have a dedicated internal team that works on developing a pipeline of locations around high traffic areas

• Consistency of experience and investing in the business. I am not going to delude myself that they have some kind of technology advantage, but it is stuff like setting up the store so that you can drive your car in, look at them changing the oil on a screen when they pop the hood on your car (apparently people worry about the mechanics cutting corners when they can’t see what is happening), investing in ecommerce (you can download an app that locates the nearest VIOC stores to you, tells you whether the wait is 5 minutes or an hour), and so on

• Bigger competitors maybe caring less – Jiffy Lube for example doesn’t really move the dial for Shell, so management probably a bit less focused

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They have been growing LfL’s in the mid to high single digits for several years now, taking market share, and have not been shy at conferences to refer to the fact that when they go head to head with better-capitalised peers, they win.

They clearly feel that there is a significant growth opportunity here, and refer to that quite a bit in their presentations and on their conference calls. It will be a combination of organic growth (they have a team/pipeline in place that will allow them to grow by probably 40-50 stores per year in a combination of company-owned and franchised), while they also have the capacity for inorganic growth via buying up underperforming peers in the right markets and rolling them into the Valvoline banner. I think that the average industry-wide store has absolute operating profit around 40% below Valvoline, so it is a compelling opportunity

I am modelling them growing Quick Lubes revenue from $541m in FY17 to $1.1bn by FY23, while operating income should more than double, from $130m to $282m. That is driven by company-owned stores growing by 40 units per years, franchised units growing by 20 units, and the company continuing to have ~4% LfL’s:

International

I have less to say about the International division. As I referenced above, I see it as a junior version of the Core North America business. It is focused on industrial rather than consumer (more volume in that part of the market internationally), and it is structurally less profitable. The gross margin is about 30% vs the group at ~37% and Core North America at ~40%. Part of the difference is I believe accounting-related (they go to market via JV’s in some markets and their share of the operating profit is reported as a line item rather than in the divisional operating income in the segment breakdown). Part of it is then that some of the profit goes to their partners, i.e. they team up with engine manufacturer Cummins in a number of markets, who of course take a fee. Premium product penetration has also been much slower Internationally – about 30% vs 45% in Core North America. It could be a source of earnings upside over time, but I have not modelled that, Finally, I believe that there is just structurally tougher competition. As an example, in China they have grown volumes massively in recent years, but they are going up against downstream divisions of state-sponsored oil companies who can do business unprofitably. The gross profit per gallon in the International segment is about half the level they manage in Core North America, and I do not model any change in that. All the same, group sales continue to grow at a mid-single digit clip driven by volumes (faster growing market and they are taking a bit of share) and they are investing in those markets, so volume growth should continue. At 30% gross margin, 15% operating margin, it is still value creating growth.

Financials

The divisional drivers that I have described above should generate the following P&L:

FD EPS should grow very strongly, as laid out above. The share count reduction is driven by strong FCF generation. I think the generate about $240m-$250m per annum for out to FY20, before it ramps up to about $330m in FY21 when some capex they are doing on a new blending facility in China ramps down. They guide that 45%-60% of FCF gets returned to shareholders, so they should be able to retire a couple of percent of the shares per annum, as well as paying a dividend and investing in the Quick Lubes business (one company-owned store is about $1.2m of capex; franchises obviously much less, about 10% of that). Obviously, a prospective FCF yield of 8% on Sep 21 numbers should also be supportive of the shares down here:

They could actually buy back quite a bit more stock, but I have them delivering slightly to get net debt/EBITDA down from 2.9x in FY17 to 1.7x by FY21 – they possibly will not need to do that if they can prove the stability of the Core North America per gallon gross margin, and indeed they do not reference deleveraging in any of their presentations that I can recall.

Valuation

I value the company a few different ways, but to keep it simple and focus on P/E, as referenced above, I have them doing $1.38 of adjusted EPS this year, and I have that growing to $1.98 by Sep 22 FY; 14x that, which I think will prove to be a conservative multiple once they prove that the core business is stable, would get you to ~$28 by Sep 21, 33% upside, and you would get cumulative dividends of $1.6, for an IRR of about 10%.

Using a SOTP-type analysis to account for the fact that the divisional drivers are quite different, one could value the Core North America part of the business on 10x EBIT (about 13x P/E) to reflect the ex-growth nature of that business, then 12.5x EBIT on Quick Lubes to reflect the better growth, and 10x for International to reflect higher growth, but lower profitability and higher tax rate, I again get a SOTP value in the high 20’s a couple of years out:

DCF value would be about $28, 35% upside:

In terms of what can go wrong, the number one thing would be gross profit dollars per gallon in the Core North America business, which is the FCF driver allowing them to invest in the other parts of the business. Competition seems to be quite rational, but, as with most retail business, volumes do appear to be migrating online. I don’t see electric vehicles as a big threat in anything but the very long term, just because ICE cars will remain well over 90% of the US Car Parc mix for at least the next decade. I would say that oil price volatility with an upwards bias is clearly a shorter-term risk, just because there is a lag of a couple of months in passing on base oil price increases, which has a transitory effect on per gallon margins, but over time the company has demonstrated pricing power. If rates continue to rise and the bond proxy stuff continues to underperform, that could be a headwind, but with the earnings growth I envisage, if the shares stay do nothing, the stock will be on a P/E of 11x-12x within a couple of years, and downside risk will be limited.

Catalyst

No specific catalyst in mind