Description

Summary

We are recommending a long on Valvoline as the Company’s announcement on October 13^th, 2021 that it would separate the Retail Services and Global Products businesses is a pivotal event that will unlock significant value. We will not dive deep into Valvoline’s businesses in this write-up as it was well covered by darthtrader’s June 2018 Valvoline write-up. Instead, we will present the situational dynamics of the stock and make the case that it is an even better investment, on a risk / reward adjusted basis, today, than it was back in June 2018. With the stock at ~$36 per share (~12x ’22 EBITDA), we think there is significant upside over the next 12-24 months and believe the stock is worth over $50 per share once the separation occurs.

Situational Overview

Valvoline has two businesses, one of which is primarily a wholesale motor oil business (“Global Products”) and another which is a quick lubes retail business (“Retail Services”). These two businesses never really made sense under a single Company as they have vastly different growth and capital intensity characteristics, and there are almost no synergies to speak of between the two.

Global Products is a high free cashflow generating business, requiring very little capital expenditures and generates ~$200mm of discretionary FCF per year, but with very little growth. The business sells motor oil to retailers like Advance Auto Parts, Walmart, and others, as well as to “do-it-for-me” (DIFM) vendors like independent mechanics. The business had 19% EBITDA margins in FY21 and, more importantly, 12% FCF margins. This is a business with staples-like margins and growth, throwing off significant FCF that can be returned to shareholders. It is also a “counter-cyclical” business that typically sees significant margin expansion during cyclical downturns and recessions as raw material prices decline. During the GFC, margins for the business expanded by over 1000bps as price can largely be held flat while raw material prices (base oils) go down. As evidenced in FY20, one can see that this business grew FCF vs. FY19 despite an 8% decline in volumes, implying that FCF per gallon grew by 11% y/y during the year.

The Retail Services business, on the other hand, is a fast-growing retail business that has averaged same-store sales growth of over 9% over the last 6 years and has had 15 consecutive years of same-store sales growth. The business generates 30%+ margins at maturity and 30%+ cash on cash returns and has grown revenues at a high-teens rate over the last 5 years. These metrics are off-the-charts relative to virtually any other retail, and we believe that Retail Services is one of the highest quality retail concepts we’ve ever encountered as it has consistently generated strong growth through a multitude of economic environments. 

Since darthvader’s write-up on Valvoline in 2018, several major events have occurred that improves the situational dynamics of the stock moving forward. First, on an EBITDA basis, Retail Services is now the majority of the business (54% versus 34% in 2017)

Second, and more consequential, is Valvoline’s October 12^th, 2021 announcement that it intends to separate the two businesses.  Since this announcement, shares have traded up ~10% but we believe continues to dramatically undervalue the value of the Company on a sum-of-the-parts (“SOTP”) basis. While some were concerned that management could potentially backtrack on their pledge to separate the businesses, we are further convinced that the Company is going forward with the separation in good faith as it has formalized its intention to separate through significant language changes in its 10-K. The announced separation of the businesses was mentioned over 10 separate times in the 10-K, including language on the risks associated with the separation. Management also discussed the separation extensively on their FY4Q21 earnings call, and noted that this current team has experience with separating businesses as Valvoline itself was separated from Ashland in 2017, thus likely mitigating any potential surprises:

“We’re the product of a separation ourselves. We separated from our former parent, Ashland, 5.5 years ago. And so we’re well aware that there can be cost dissynergies created through a separation.” (VVV CFO Mary Meixelsperger, VVV FY4Q21 earnings call)

To understand how the separation is likely to occur, we believe the most likely scenario is for Valvoline to sell the Global Products business and retain Retail Services as a public Company. On Valvoline’s FY4Q21 earnings presentation, management released a slide that noted Global Products’ tax basis was $0.6-1.3bn, which, compared to the likely transaction value of Global Products or Retail Services suggests a much lower tax impact to sell Global Products than to monetize Retail Services. It is not an accident that management disclosed the estimated tax basis of each business segment.

Finding Value in the Separation

To value the SOTP, we compare VVV’s Global Products and Retail Services businesses against publicly traded companies that share similar characteristics. There are nuances to how the separation will occur, particularly with respect to how Valvoline will manage the volume of motor oil Global Products currently sells to Retail Services at cost. While we initially believed that there could be a purchase agreement in place that would transfer the volumes (and considerable profits) from Retail Services back to Global Products, it’s since come to our attention that management, during their most recent post-4Q meetings with sell-side analysts, plans to create a structure where Retail Services will retain the brand rights and charge Global Products a licensing fee to offset the impact this reallocation of profits could have on Retail Services. This would likely keep the profits of each segment roughly as presented by management so far, which makes sense since Retail Services will get a significantly higher multiple than Global Products. Management has also noted that it believes there will be a 50/50 split of corporate costs between the two segments.

For Global Products, as we noted above, we believe the most likely outcome would be that the business will be subsumed by a strategic or cash-flowed by a buyer, likely a private Company / entity. An overview of comparable, publicly traded companies with similar financial profiles to VVV Global Products would suggest a range of around ~11x NTM EBITDA, or 21x EV / NTM FCF:

We acknowledge that VVV Global Products likely faces more terminal value risk given it is exposed to internal combustion engines (“ICE”), even though current industry estimates by IHS suggest that only 13% of cars on the road in the US will be electric, and, as such, discount the EBITDA multiple on Global Products by 25% to arrive at a 7.5x NTM EBITDA multiple for Global Products. Given the superior FCF generation of Global Products, a 7.5x EBITDA multiple would imply a ~11.5x EV / FCF multiple, or nearly a 50% discount to publicly traded comps. Under these assumptions, we estimate that Global Products is worth ~$2.2bn (assuming allocated corporate expenses are fully absorbed) to $2.4bn (assuming Global Products is subsumed under a larger strategic / financial buyer and won’t need to absorb allocated corporate expenses): 

For Retail Services, this is where we believe there is substantial potential upside to valuations once the market begins to appreciate the growth potential of the standalone business. When we compare Valvoline Retail Services to publicly traded comps, it becomes clear this is a business that should trade at a high teens EBITDA multiple at the very least: 

As can be seen above, Retail Services is near best-in-class in terms of same store sales, EBITDA margins, and expected forward revenue / EBITDA CAGR across the board. In fact it sits at #2 across all those metrics when compared to the peers above, and given the distraction of Global Products on Valvoline’s management over the last several years, as well as the likely windfall of close to $2bn of capital from the sale of Global Products for management to deploy, could imply estimates for VVV Retail Services are likely conservative. However, we do acknowledge that Valvoline’s Retail Services business faces unique risks and threats as compared to some of the most companies above in the form of EVs (arguably the Auto Parts and Driven Brands face similar risks), so we discount our implied valuation for Retail Services to 18x EBITDA even though it would likely trade at a higher multiple than that just purely based on its financial metrics and consensus expectations. Based on the assumptions above, we believe Retail Services is likely worth at least $8.7bn, in addition to the ~$2.2 (low-end) valuation for Global Products.

This leads us to a 9/30/2022 price target of over $53 per share for Valvoline, or 48% higher from today’s prices of around $36 per share.

We want to discuss the long-term threat posed by EVs to Valvoline’s Retail Services business and how that could impact the market’s perception of the business. First, we’d note that the population of ICE vehicles (including hybrids) in the US is expected to continue to grow for the foreseeable future as EVs today continue to make up only ~3% of new vehicle sales and the higher age of vehicles continues to expand the addressable market for Retail Services. Second, Retail Service is still only 4% of the total oil change market so even if the overall market begins to shrink, Valvoline Retail Service still has ample runway to take market share from other competitors like Jiffy Lube and smaller mom-and-pop operators who offer an inferior experience. Third, once Global Products is spun off, Retail Services will be infused with a significant chunk of capital that it can deploy to evolve the business model for a drivetrain agnostic world. Management has already indicated that it has been looking into opportunities to expand services to EV vehicles and believe there are ample services that can be offered to EVs at its Retail Services location. Valvoline’s most recent 10-K highlights significant language changes that suggest the Company is already actively engaged in “future proofing” the business. We’d also note that Valvoline today is already the largest supplier of battery fluids to electric vehicle manufacturers in the World. Given the points above, we think there is more than sufficient time for Retail Services to evolve into a world class service model for both EVs and ICE vehicles.

An additional point we’d like to make regarding Valvoline currently is the poor state of analyst coverage, which will likely be solved by a separation of Global Products and Retail Services. Valvoline is currently covered by analysts with primary coverage of chemicals, consumer retail, CPG, and auto retail. This has led to very spotty coverage of the Company and a “to a hammer everything’s a nail” attitude to valuation. For example, we’d note that Driven Brands is covered by well-known JPMorgan analyst Chris Horvers while Valvoline is covered by JPMorgan’s chemicals analyst, Jeff Zekauskas. This horrible coverage has caused Valvoline to be ignored by analysts who might otherwise want to own a best-in-class retail business. 

Risks

 Separation doesn’t occur

-          Global Products and Retail Services are valued at much lower valuations than we expect

-          EV penetration increases significantly faster than projected

-          Competition for Retail Services ramps up due to low cost of capital for competitors like Driven Brands 

Catalyst

Spinoff