Is Petron Malaysia a value trap? (Part 2 of 2)

Value Investing Case Study 05-2: Investment thesis of Petron Malaysia. This post focuses on top management performance, risks, and valuation.

Petroleum products are commodities.

To win in this environment, Petron Malaysia has spent considerable efforts to

Improve its refining operations,

Expand its distribution and logistics infrastructure,

Expand its service station network,

Establish its Petron brand.

With its current price of RM 3.26 (1 Oct 2020) compared to its NTA of RM 5.93 (as of 30 June 2020), you may wonder why the market is not recognizing these efforts.

Has the market overswung on its way down or are there management issues and other risks that the market has inferred into the price?

In Part 1, I have shown that despite the Malaysian economic environment and the excess capacity in the global oil market, Petron Malaysia has managed to grow its physical sales volume.

In Part 2, I will argue that Petron Malaysia has the financial resources and track record for long-term profitability. It is not a value trap. Rather it is a bargain.

There is now an update that was published on 10 Oct 2021.

Now as to whether you should go and buy - see my Disclaimer.

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How well did Top Management Seize Opportunities?

Is there a great Buying Opportunity?

Will Shareholders’ Value continue to be created?

How to minimize risk and secure your Investments

How to Gain from the Case Study

How well did Top Management Seize Opportunities?

There are 9 directors on the current Petron Malaysia’s Board.

There are 3 executive directors who have been seconded from Petron Corp

There are 5 independent directors. 4 of these were appointed after the entry of Petron Corp

One is a non-independent non-executive director who is currently the CFO, Treasurer, and CIO of San Miguel Corporation

The 3 executive directors have been with Petron Malaysia since the acquisition by Petron Corp.

I would classify Petron Malaysia as an owner-managed group as:

San Miguel/Petron Corp owns about 73% of Petron Malaysia

The 3 executive directors are from Petron Corp

The CEO and an additional 7 executives were featured as members of the Management Committee in the 2019 Annual Report.

The CEO and the CFO are from Petron Corp

The 6 other members are Malaysians who have been with the company before the entry of Petron.

The executive directors and management committee have Malaysian refining and marketing experience.

What have they achieved?

Petron Malaysia has managed to reduce its SGA expenses from 3.3% of revenue in 2012 to 2.4 % in 2019 while expanding its sales and distribution network.

While the crude oil price has remained depressed, it has managed to improve its gross margins. This could be because of lower unit costs due to either the increased volume or the investments in the distribution and logistics infrastructure.

In terms of branding, it won the Putra Brand Silver Awards five times over the past 8 years

Currently, there are two Bursa listed company involved in the marketing, sales, and distribution of petroleum products

Petronas Dagangan Berhad which operates in same the market segments as Petron Malaysia.

Boustead Holdings Berhad which operates the BHP petroleum retail network. However, Boustead is reported to be seeking buyers for its BHP petroleum retail business.

Boustead Holdings do not provide a separate report for its BHP operations. Rather it is reported as part of the trading segment operations which included building materials.

As such, I only benchmarked Petron Malaysia’s performance against that of Petronas Dagangan.

In 2013, Petron Malaysia’s revenue was 34.3 % of that of Petronas Dagangan, the industry leader in Malaysia. By 2019, Petron Malaysia has grown its revenue to be 38.0 % of Petronas Dagangan

I estimated that from 2012 to 2019, Petron Malaysia sales volume increased by about 24%. In comparison, Petronas Dagangan's sales volume increased by about 4% during the same period.

However, Petron Malaysia’s gross profit margins and ROE are lower than those of Petronas Dagangan

Chart 1: Petron Malaysia vs Petronas Dagangan Performance

In 2013, there were 532 Petron service stations in the country. This grew to 700 by 2019. In contrast, the number of service stations under the Petronas brand remained about the same of over 1,000 during this period.

In fact, as can be inferred from the chart below, among the top 3 petroleum retail networks in Malaysia, only Petron Malaysia seemed to have increased the number of stations aggressively.

Chart 2: Number of service stations in Malaysia

Source: Statista

Growth in the number of stations can be inferred by comparing the chart with the following statistics:

a) Petronas Dagangan 2013, 2016, and 2019 Annual Reports - more than 1,000 station

b) Shell website in 2020: 950 stations

c) Caltex website in 2020: 500 stations

What about capital allocation?

From 2012 to 2019, Petron Malaysia generated RM 2,430 million in cash from operations. Of these

RM 378 million was paid out as dividends

RM 1,428 million was invested into Property, Plant, Equipment, and Long-Term Asset

At the same time, its loan was reduced from RM 900 million in 2012 to RM 130 million in 2019.

It looks like a very effective use of its funds

At the same time, it generated RM 1,234 million of PAT over the same period with about 31% dividend payout.

Consider it from the San Miguel/Petron Corp perspective.

In 2012, it acquired a controlling stake in Petron Malaysia from ExxonMobil for RM 598 million

From 2012 to 2019, RM 1,428 million was reinvested into the operations. Considering its 73% stake in Petron Malaysia, its share of the reinvestment is more than what it paid to acquire its controlling stake

I think it demonstrates the “owner-operator” commitment to the business.

Is there a great Buying Opportunity?

The chart and table sum up Petron Malaysia’s valuation.

The Earnings value is greater than the Asset value. This is not surprising as the return on capital employed is greater than its cost of capital.

Over the past 5 years, there have been instances when Petron Malaysia’s share price has been higher than both the Asset value and Earning value.

Chart 3: Petron Malaysia Valuation

Chart 4: Petron Malaysia comparative values

At its current price of RM 3.26 (as of 1 Oct 2020), it is even trading below its Book value of RM 5.93 per share (as of 30 Jun 2020) and Earning Power value of RM 6.87 per share.

In deriving the Earnings value, I have assumed that its past 8 years' average performance represents that of the future. This means that

If you believe that the future is better, then Petron Malaysia’s Earnings Power value will be higher than RM 6.87 per share

However, if you think that it will be worst, then the RM 6.87 per share is over-estimated

The Earning Power value assumed zero growth. With the growth component, the value increases to RM 8.09 per share equivalent to an additional 18%.

I would conclude that there is an ample margin of safety for the Earning Power Value.

Will Shareholders’ Value continue to be created?

If you have been following my blog, you will know that a high-quality company is one that has a good chance of increasing shareholders’ value.

With Petron Malaysia’s Earning Value > Asset Value, it appears that it will be able to create shareholders’ value.

Over the period from 2012 to 2019, if you assume that no dividend has been distributed, the shareholders’ funds would have increased by a compounded annual growth rate of 12%

I estimate that Petron Malaysia’s weighted average cost of capital (WACC) to be 9%.

With the growth in shareholders’ funds higher than the WACC, the shareholder value would grow as the business expands.

Over the period from 2012 to 2019, Petron Malaysia paid an average dividend of RM 0.175 per share.

At the current price of RM 3.26 per share, this is equivalent to a dividend yield of 5.4 %.

This is quite attractive for any shareholder.

Chart 5: Petron Malaysia Q Rating

Petron Malaysia has an overall Q rating score of 0.59 placing it in the top quartile ranking of the panel companies.

The rating reflects the strong positions in all the rating factors, with the growth standing out.

I will interpret the rating to mean that Petron Malaysia would be able to continue growing its shareholders' value.

How to minimize risk and secure your Investments

The 2 main risks that you have to be aware of when investing in Petron Malaysia are

Privatization risk

Disruption in the fuel retail industry

Privatization

You have to worry about privatization under the current economic environment. This is because the share prices of many Bursa Malaysia listed companies are trading below their fair values.

You may think that you would be able to invest in companies at a significant discount to fair values. And gain when the market eventually comes to its senses and re-rate them based on the fundamentals.

However, this investment thesis assumes that these companies would not be privatized.

The history of privatization exercises in Malaysia over the past year is that

The offered prices are definitely above the market prices,

But they would be below the intrinsic values.

As mentioned in my previous case study, there were 13 Bursa Malaysia privatization offers during 2019 - 2020. Of these, 12 were offered at discounts to their fair values.

You should not rule out privatization here as

In its General Offer in 2012 following the purchase of Petron Malaysia from ExxonMobile, San Miguel has stated that it does not intend to main the listing status if there is a shortfall in the public spread. Note that the offer price then was RM 3.59.

It would cost San Miguel/Petron Corp about RM 238 million to acquire the remaining 27% of the shares it does not own at RM 3.26 per share.

This is a small sum for the parent company. Recall the amount that has been reinvested into the business. Also, over the last 8 years, the parent company has received about RM 276 million for its share of dividends declared.

Beware!

Disruption of the fuel retail industry

In its July 2019 paper titled “Is There a Future for Service Stations?” the consulting group BCG opined

“A number of far-reaching trends are disrupting the fuel retail market. Among the most powerful of these are the rise of alternative fuels (particularly electricity) for mobility, the emergence of new models in mobility, and the evolution of heightened consumer expectations around convenience and personalization.”

BCG went on to add that

A significant portion of the fuel retail network in some markets could be unprofitable by 2035

In a market environment in which electric vehicles (EVs), autonomous vehicles, and new mobility models take off rapidly, up to 80% of the fuel-retail network as currently constituted may be unprofitable in about 15 years.

Another consulting group, Arthur D Little also painted a disruptive future for the industry

“The traditional forecourt model is at its inevitable end. Electric vehicles (EVs), autonomous cars, data analytics, and the Internet of Things (IoT) are only a few of the emerging technologies threatening the classic fuel-station customer experience.”

Arthur D Little opined that key trends concerning how we commute, eat, and shop will be the core drivers that ultimately shape the forecourt.

Increased demand for grab-and-go eating

A shift in the mobility energy mix

Demand for eco-friendly outlets

Hyper-connected customers

Quest for easier living

While both reports are in the context of the global fuel retail industry, Malaysia is not immune to them.

The best analogy is how the Malaysian media and taxi sectors succumbed to the same disruption suffered by these industries in the developed countries.

Even Petronas Dagangan has recognized this changing environment and its 2019 Annual Report stated that higher usage of public transportation and push toward EV is leading to waning fuel demand.

If you want evidence of this waning demand look at the chart below. It shows that the vehicular traffic volume in Malaysia has not shown any significant growth since 2015.

Chart 6: Malaysia vehicular traffic
Source: CEICDATA.com

For the fuel retail industry in Malaysia, it is not whether the disruption will occur. It is when.

Taking a leaf from what has happened to the media and taxi industries, there are two possible scenarios

The first is the “traditional” industry being in a secular decline. This is what is happening to the media and taxi sectors in Malaysia

The second is for the existing players to re-invent themselves. A good example of this is the Malaysian food retailers that has adopted online ordering with delivery via Grab

BCG has offered the following scenarios for the service stations:

Move from a vehicle-centric business model to a customer-centric one to capture new product and service opportunities

Transform the service stations network eg changing formats in some locations and divesting locations that will not be profitable

Develop new capabilities including digital expertise and, in some cases, capabilities related to entirely new areas such as last-mile logistics or real estate.

Whether Petron Malaysia will reinvent itself remains to be seen. However, there are 3 positive things for them

It will have to reinvest. Given its reinvestment track record, this should not be an issue

It sees itself as a sales and marketing company. This mindset may give it a first-mover advantage to re-invent the fuel retail network

Petronas is the dominant player in Malaysia and like the taxi industry, there will be political-economic forces to delay the effects of the disruption. This may buy Petron Malaysia time to re-invent itself

Conclusions

You will have to consider the risk of privatization in determining your entry price

Any disruption will be seen/felt in the developed countries first and this may provide some window to plan your exit

Case Notes

There are 3 basic skills that you need to develop to be a successful long-term value investor

How to analyze companies

How to value them

How to mitigate risk

Many investment courses only cover the last item superficially. Warren Buffett has said that risks come from not knowing what you are doing.

That is why I believe that case studies are an important part of the learning process as they illustrate the analytical and valuation issues encountered in real life.

At the same time, I also looked at the investment and business risk as part of the fundamental analysis.

However, you should learn about risk separately and I have provided various risk-related topics in other posts. You must read them,

I am of course assuming that you are interested to learn how to analyze and value companies. What would you do if you are not interested in doing your own analysis and valuation but still want to be a value investor? One way is to rely on other experts to assess and value companies for you. Those who do this well include people like Seeking Alpha.* Click the link for some free stock advice. If you subscribe to their services, you can then just read their analysis and assessment.

How to Gain from the Case Study

Petron Malaysia is in a sector characterized by the following

Commodity in a mature market

Cyclical

Regulated market (for petroleum and diesel prices)

The national demand for petroleum products is likely to experience low single digits growth.

A significant part of Petron Malaysia’s growth will be at the expense of its competitors and there will be limits to such revenue growth.

At the same time, there are limits to operational improvements.

I thus expect that earnings growth will eventually be pegged to the country’s economic growth.

Secondly although prices of its raw material - crude oil - are cyclical, the Automatic Pricing Mechanism (APM) provides some “stability” to its margins.

The APM has not been revised for more than a decade. Any revision to the amount for each of the cost elements would boost the profits of all the oil and gas companies.

The above scenario suggests that Petron Malaysia is not a growth stock. Its Earning Power value is probably a more realistic representation of its intrinsic value.

What is our investment thesis?

A value investment opportunity with the market price at a 48% margin of safety based on the Earning Power value

You have downside protection while waiting for a re-rating.

Petron Malaysia is financially strong with a 0.34 debt-equity ratio (as of 30 June 2020) and RM 262 million cash. It would be able to weather a longer downturn if this happens.

It has a strong track record of growing shareholders value during the past 8 years which covered a period of declining and low oil prices

It has paid an average of RM 0.175 dividend per share over the past 8 years. At the current price of RM 3.26 per share, it is equivalent to about a 5.4 % annual dividend yield. A reasonable recurring income while waiting for the capital gain.

On the other hand, the key risks are

Privatization

Disruption to the fuel retail sector

I worry more about the former than the disruption.

Therefore, if you invest in Petron Malaysia, it should be below RM 4.00 so as to minimize any loss due to privatization.

Furthermore, it has to be part of your portfolio of cyclical and defensive stocks. That way, you’ll be well-positioned to prosper when the economy is growing.