Morningstar | Refiner Margins Head in the Right Direction; Now for Alliance Volumes. No Change to AUD 3.00 FVE. See Updated Analyst Note from 13 Jun 2019
No-moat Viva Energy’s share price has taken tentative steps toward a recovery following a rout precipitated by a corrected dysfunction in the Coles alliance, and exacerbated by the collapse of regional refining margins. At AUD 2.30, the shares are 35% above December AUD 1.70 lows, although they remain below 2018’s AUD 2.50 IPO price and even further below our unchanged AUD 3.00 fair value estimate.
Regional refining margins fell sharply from the second half of 2018 because of an oversupply of gasoline. This was driven by softer regional demand and the higher production of gasoline-related products as more lower density crude was supplied. But the Geelong refining margin for April improved to USD 7.80 per barrel, from a March year-to-date average of just USD 4.60. Geelong’s refining comprises approximately one third of our Viva fair value estimate overall, where we assume an unchanged midcycle refining margin of USD 10 per barrel in 2023.
Recovery in regional margins favoured the April result, but refinery operational performance has also been strong with record production rates achieved in March and April. There is still some way to go to get back to the approximately USD 10 per barrel levels prevailing over the three years prior to 2018. But continued focus on lifting production, improving operational performance, and increasing productivity and efficiency are good counters regardless. During 2018, Viva successfully completed a planned major maintenance turnaround at Geelong, which lifted crude intake and reduced energy costs.
The other element of the nascent recovery focuses on the Coles Express retail alliance. However, there is no confirmed evidence of a recovery yet. In February, after a near breakdown in the alliance, the partnership was extended through to 2029, but under new arrangements, with Viva responsible for retail fuel pricing and marketing while Coles Express is responsible for operating the stores and providing the convenience offering.
Viva’s most up-to-date publicly available information for the first few months of 2019 show there are continuing challenges for retail, because high oil prices affect margins. But, as in 2018, we expect strength in the commercial component to somewhat counter issues with Coles Express on the retail side of the business. This highlights an innate strength in Viva’s integrated business model, where temporarily weaker volumes through the alliance can potentially be offset through growth in other channels. Not all the retail and marketing relates to Coles, with about 4.5 billion litres or one third of total volumes comprising jet fuel, marine and other specialities, and about 20% of the remainder going to sites operated by non-Coles dealers/agents, including Liberty. In 2018, the retail, fuel and marketing segment reported a 2% increase in underlying EBITDA to AUD 933 million despite the Coles alliance issues.
Overall, we estimate that about one third of the retail business relates to Coles, which is still meaningful, but Viva does need to get the relationship right. The new Coles alliance structure will make this easier: the deal provides better alignment and delivers Viva the right to price of fuel with additional convenience margins. It will now be able to optimise volumes and pricing better, and arrest decline in retail sales volumes.
Our Viva fair value estimate equates to an unchanged 2023 EV/EBITDA multiple of 8.4, high enough we think given the risks. It equates to a 2023 P/E of 15.2 times and dividend yield of 3.0%. We continue to view long-term earnings potential as attractive, including the retail margin improvement, assuming Viva keeps a closer watch on marketing than was the case under the Shell umbrella, in addition to the new V-Power diesel offering. In nominal terms we assume the marketing margin will improve mid-cycle to AUD 0.068 cents per litre versus AUD 0.052 in 2018. This supports five-year EBITDA CAGR of 9.1% and underlying EPS growth of 11.9% over the same period, from a challenging start to 2018. We believe a AUD 2.30 share, prices in a too low five-year EBITDA CAGR of 4.2% to AUD 729 million, versus our AUD 915 million base case. If progress is made restoring Alliance volumes to 70 million litres per week in the near term, and then to over 75 million litres in the long term, as new programmes mature, then it could be a key catalyst for share price appreciation toward fair value.