Description

Company Overview: World Fuel Service (ticker: INT) makes money by buying fuel from refiners and selling it to the end user (e.g. container and tanker fleets, airlines, corporate fleets, governments, etc).  It either makes money by marking up the fuel it resells or by acting as a broker and charging a commission. It can provide fuel and related services at 2500 locations around the world and does business from 23 countries.

INT basically allows its customers to use its balance sheet (think unsecured credit) as a financing vehicle to procure their fuel needs. Its suppliers, however, often demand letters of credit and/or collateral.

INT operates in a fragmented and highly competitive market.  Competitors range from the integrated oil giants to smaller brokers and oil traders.

The business is often looked at on a gross profit per unit basis given that it is largely a spread/reseller business model.

Investment Thesis:   INT's earnings and multiple has greatly benefitted from an unusual set of circumstances over the past 4 quarters that are about to end and this will result in a significant deterioration in cash flow and cash balances as working capital intensity dramatically escalates and ultimately earnings revert back to historical/normal levels.  While rising commodities pressure working capital intensity, so too will aging receivables from a weak customer base.  I expect cash balances to effectively go away and earnings to settle in closer to $2 than $3.  The street is at $3.30 for 2009. For what is effectively a financing business with little barriers to entry I expect the multiple to approach 10x as it has several times in the past and most recently in the 1H08.

Variant Perceptions: (1) Cash balances are a function of movements in the underlying commodities. While INT earnings don't have direct risk to commodity price movements, the capital intensity of its business model is driven entirely by commodity moves. (2) INT has woefully under-reserved for receivables and adjusting its current reserves and levels of bad debt expense reduce its earnings significantly (3) The spreads that the company has made for the last 4 quarters are not a run-rate but rather a function of a unique sets of circumstances that allowed INT to temporarily earn abnormal profits.

Key Considerations:

• Working Capital Intensity:

Essentially, INT buys fuel from fuel suppliers and, simultaneously, sells fuel to its customers. As such, from an income statement perspective what is important is the gross profit or markup (or in some cases commissions) that it receives.  However, it gets more interesting from a balance sheet perspective. The working capital intensity correlates directly with the direction that commodity prices are moving. This is because receivables grow faster than payables when prices are rising and receivables shrink more quickly when prices are falling.  So as crude collapsed last year, the company enjoyed a cash windfall as working capital was freed up. I believe the reverse is happening now just as it was in the first half of 2008. The following chart makes the point as it shows how volatile the cash on balance sheet is against the delta between receivables and payables.  Clearly, INT was bailed out by the crude crash in the second half of 2008 as its cash balance was quickly deteriorating.  This company does have a history of sudden and violent moves in its working capital situation. This is not new...

                        Q207    Q307    Q407    Q108    Q208    Q308    Q408    Q109    Q209

Cash                 $220     $142     $44       $84       $62       $167     $322     $394     $366

AR-AP               $118     $190     $304     $305     $420     $239     $127     $69       $69

Another way to make this point is to look at the extremely high ratio of Receivables to gross profits.

                                             2005     2006     2007     2008     2Q09

Receivables/Gross Profits          3.8        3.9        4.0        1.7        1.8

I believe that this ratio will mean revert back.

From the 10Q: Increases in oil prices can negatively affect liquidity by increasing the amount of cash needed to fund fuel purchases as well as reducing the amount of fuel which we can purchase on an unsecured basis from our suppliers.

Inventories are also an issue but a different one than above.  Inventories are primarily used in the company's aviation segment. In this segment, the company does take inventory risk for a week or so at a time to give it a "competitive edge."  In the first half of 2008, this benefitted INT as prices for jet fuel were steadily rising giving INT a gross profit benefit against its averaging costing methodology.  Smartly, management effectively liquidated inventory beginning in the 3Q08 and so didn't get hurt by the drop in the prices.  They have started to rebuild this inventory level and so this too should be a drag on cash, though could support gross profit in the segment to some extent.

                        Q207    Q307    Q407    Q108    Q208    Q308    Q408    Q109    Q209

Inventory          $85       $113     $103     $118    $134     $78       $29       $46       $73

• Receivables/Credit risk:

INT basically allows others to use its balance sheet instead of their own; and provides unsecured funding to tanker owners, commercial airlines, regional jets, container ships, etc., so that they can fund their day-to-day operations.  INT, however, buys product from relatively strong suppliers and often has to post collateral or letters of credit.  As such, I think there is an ongoing credit issue here; or at the very least an aging issue of receivables relative to payables.  You would think the company is adequately reserved. However, here is what their bad debt expenses look like (% of AR uses the quarterly expense annualized).

                       Q207    Q307     Q407     Q108    Q208     Q308      Q408     Q109    Q209

Bad Debt Exp    .313      1.29      1.30      1.91      8.15      6.84      .818      .458      .464

As a % of AR      .1%      .5%      .4%        .5%      1.8%     2.1%      .5%      .3%      .2%     

And here is what their overall bad debt reserves have looked like going back a few years:

                                  2003     2004     2005     2006     2007     2008     2Q09

Bad Debt Reserves       11.1      11.2      12.2      14.3      12.6      23.3      17.9

As a % of AR               6.3%     2.3%     1.8%     1.7%     .9%       3.4%     2.3%

Further, at higher fuel prices, INT's customers do become riskier borrowers as fuel is the biggest piece of their variable cost structure.

In the earlier part of this decade (until early 2004), bad debt expenses were mainly in the 2-3% range. I believe those levels were too low as well and that the business today has great credit risk than it has had in years if not ever.  JP Morgan has modeled $4.6mm of bad debt expense for 2009 which comes out to ~.6% of current receivables. If we assume 3% (way too low in my opinion) bad debt expense/receivables, then bad debt expense would be ~$23mm this year. That itself would take JP Morgan's earnings from $3.40 to $2.93.

The company does have a history of bad debts in over-seas markets (Ecuador in 1999 and West Africa in 2000).

• Spreads:

Moving to the income statement, INT has posted very impressive earnings since Q308. The gross profits on a unit basis and an absolute basis have been well above historical norms despite volumes sold being down dramatically. 

                                                            2005     2006     2007     1H08    2H08    1H09

Marine Unit Gross Profit ($/mt)                  5.5        5.3        5.2        7.0     11.4      10.4     

Air Unit Gross Profit (cents/gal)                  4.0        5.0        5.2        6.6      9.4      7.7

I think there are predominantly 3 factors at play here.  First, there was a structural improvement in the spreads due to the greater need for credit at high commodity prices. The industry (suppliers and buyers) were no longer as willing to finance the upfront cost of the working capital with crude going much higher than historical norm and therefore were willing to pay the INTs of the world a larger spread to do so.  So basically, a ship-owner would "borrow" money from INT and pay them back when the ship-owner's customer (cargo owner) would pay them.  INT, meanwhile, has strict payables terms with refiners and other suppliers.  However, as fewer people were willing to finance this arrangement on an unsecured basis due to rising commodity costs, INT was able to raise prices...likely structurally.  However, there should be a commensurate increase in bad debt provisioning. At higher levels of commodities, INT's customers are worse credits.

The second development was the general void of credit availability. Quite simply, as we all know, there wasn't much credit around at all and so INT actually offered a scarce service.  I think this will loosen up as the market settles down and old players and new players come into this market that has zero barriers to entry.

The third development was from the mayhem that the environment created. INT was in a position to buy from people who had to much inventory at discounts and sell at market rates.  Freight rates were also slow to move in some cases as listed prices were held on to for as long as possible giving a brief window for people to earn excess margins.

My belief is that spreads will most likely revert to the mean and take out much of the earnings growth the company has enjoyed as competitors eat way at these excess margins that INT has earned. However, if you take the argument that spreads are higher now structurally because of the greater credit risk in this business, then at some point the bad debt expense will have to rise. This is far too easy a business to enter for excess spreads to be earned for an extended period of time.

• Insider sales:

Very significant insider sales in past several months.

• History of accounting:

There is a history of questionable accounting.

Other salient points:

• Bunker tankers (supply fuel to ocean-going vessels) may eventually be in short supply due to the ban in certain areas of single hull tankers. This would raise cost to INT that it may or may not be able to pass on.
• Better volumes would probably bring in more competitors and be a further drain on balance sheet.
• Company has reduced its hedging costs which have helped gross profits. As jet fuel inventory is rebuilt, I expect this cost to rise as well.

Bull case/investment risks:

The bull case is that this company has gotten lucky and the environment as left it in a much more rational and less competitive space that it has developed a niche in. Many competitors have gone and will be slow to come back. As such and due to the increased value of this service to customers, margins are structurally higher. When volumes return on these new margins, earnings can go a lot higher.

Another bull case for the company would be a declining crude price as this reduces working capital intensity. Ironically, INT's stock price on a short-term basis seems to trade more with crude (or at least independent of it) but fundamentally, I think crude coming down is good for their cash flow. The caveat here is crude coming down is probably bad for volumes and bad debts.

Valuation/Financials:

Below, I give 4 years of historical from 2005 - 2008 and consensus (basically JP Morgan) for 2009. The last column is what I think normalized earnings are based on volumes improving and spreads contracting (though I do have them higher than 2005 - 2007.  I believe this stock will trade back down to 10x area and believe that is probably what it's worth given it's average returns, below average long-term growth, volatile cash flows and weak business model.

Catalyst

Catalysts:

1. 3Q should show sequential deterioration in balance sheet and this should continue as either volumes improve or commodities move higher

2. Potential writedowns from bad debts

3. Mean reversion in spreads earned on business