Recent announces from Viva Energy Group (ASX:VEA) indicate an improvement in operating conditions. However, they have provided further details on potential growth opportunities over the medium-to-longer term. Accordingly, we assess the extent to which these factors can support future upside in the shares.
About Viva Energy Group
Viva Energy Group is one of Australia’s leading energy companies. They supply approximately a quarter of the Australia’s liquid fuel requirements. The Company is the exclusive supplier of high-quality Shell fuels and lubricants in Australia through an extensive network of service stations across Australia. There are three operating segments:
1. Retail, Fuels and Marketing – Retail: Comprises a national network of over 1,300 retail fuel and convenience sites which are operated through various channels such as Coles Express (716 sites), Liberty Convenience (293 sites), and sites operated by independent dealer owners. The Retail segment also includes sales to wholesalers and independent retail operators.
2. Retail, Fuels and Marketing – Commercial: VEA is a significant supplier of fuel, lubricants, and specialty hydrocarbon products to commercial customers in the aviation, marine, transport, resources, construction, agriculture and manufacturing industries. The Company’s strong position across many segments is underpinned by national infrastructure and long-standing customer relationships.
3. Refining: The Company owns and operates the strategically located Geelong Refinery in Victoria.
Key Fundamental Drivers
Forecasting Retail Fuel Margins is Challenging
The retail fuel margin, not volume, is the key sensitivity to retail fuel earnings, which account for ~40% of group EBITDA. Average retail fuel margins for the six months to 30 June 2021 (1H21) averaged A13.4c/L, down from ~A20c/L in 1H20. Over the course of 2H21, average retail fuel margins have been impacted at times by sharp increases in oil prices.
Overall, VEA’s retail fuel margin appears to be tracking below expectations. Aside from the impact from higher oil prices, Viva retail outlets are typically priced at a premium to the market, and this appears to be a factor in volumes from the Coles alliance tracking below recent trends. VEA has a strategy to lift Coles alliance volumes to 70-75ML over the next 3-5 years. At present, the market expects alliance volumes to lift to 70ML/week in 2024.
Retail Fuel Business Needs a New Long-Term Strategy
A structural decline in fuel volumes is expected over the long-term, given the trend towards electric vehicles in the passenger car segment. This is set to accelerate given model availability, subsidies and an expanding vehicle recharging network. To this end, convenience retail is becoming an increasingly important offering for the industry.
Historically, VEA has not had much exposure to convenience retail. VEA has been growing the Liberty Convenience network (which is predominantly regional-focused) and was a meaningful contributor to VEA’s overall volume growth in 1H21. The strategic rationale to increase its exposure is borne out of both industry trends towards increasing/enhancing the convenience retail offering as a larger source of value, as well as VEA’s lack of competitive advantage in this space. In comparison to its ASX-listed competitor Ampol (ASX:ALD), VEA appears more vulnerable to the accelerating transition towards electric vehicles given that it doesn’t own the freehold property under its sites and has more exposure to refining operations.
The Company intends to gain more exposure to convenience retail via the Liberty channel and is committed to take full ownership of Liberty Convenience (in 2025) and Coles Express alliance outlets in 2029 (at the expiry of the current agreement). As VEA currently does not manage the convenience offering across its retail network, the Company will need to build out this capability over the next five years.
Earnings from Refining Operations Remain Unpredictable
The recovery in the refining margin in recent years has returned VEA’s refining business back into profitability, with the Geelong refinery now expected to be consistently cashflow positive.
In 3Q21, the refining margin fell significantly, to $5.50/bbl, which triggered the Fuel Security Services Payment (FSSP) and enabled the refining operations to be ‘roughly breakeven’. Refining margins were also lower than expected, as reduced domestic demand meant surplus production was shipped to other markets, increasing operating costs for VEA.
VEA reported refining margin of US$6.8/bbl for November 2021 and assumes US$9.30/bbl for December 2021. Notwithstanding this recovery in the refining margin, a more sustainable improvement from current levels is highly dependent on the recovery in air travel globally, especially as inventories are now at five-year lows.
Strong Balance Sheet Position Enables Capital Management
VEA retains a strong balance sheet with a net cash position of $44.7m as at 30 June 2021, which is a significant improvement from a net debt balance as at 31 December 2021 of $104.2m as a result of strong operating cashflow. Consistent with prior commitment, the Company intends to return the remaining $100m of the proceeds of the Viva Energy REIT divestment in 2021 through a $100m capital return, along with a $40m on-market share buyback.
The recent rally in the share price reflects market expectations that additional earnings from refining (as refining margin improves) has potential to offset weakness in retail fuel margins. However, the rally in the oil price in late December 2021 raises the prospect that the recent recovery in both retail fuel margins and refining margins may not be sustainable.
Our main reservation with the retail fuels business is that the Company is not generating sustainable volume growth (in particular through the Coles alliance) and does not have a strong enough convenience retail offering to support retail fuels margin during periods of strong oil prices.
While the strategy to capture additional earnings for the retail segment from an enhanced convenience retail offering appears sound, there are inherent challenges over the medium term (as noted above) and progress (in terms of profitability) is hard to measure given that the Liberty Convenience business is equity accounted.
Accordingly, we see limited scope for a further re-rating. However, a key risk to our view is the potential use of the balance sheet. To this end, the Company has indicated that it can deploy $500-750m of balance sheet capacity to pursue growth opportunities, whilst maintaining gearing within the target range of 1.0-1.5x (on a net debt/Underlying EBITDA basis).
Since the lows in 2020, we can see that VEA has been in a steady uptrend. The swings are quite large, but it seems to respect the uptrend line very well. In the last couple of weeks we have seen it bounce back off this uptrend line and this means that there is a strong chance that it continues to edge higher from here.
Michael Gable is managing director of Fairmont Equities.
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