A range of pressures are weighing on Z's earnings. Photo / Dean Purcell
ANALYSIS
Shares in Z Energy, one of the key downstream players in the Kiwi fuel market, have literally been under the pump in recent weeks, following a $60 million earnings downgrade, coming soon after a Commerce Commission report which essentially accused industry participants of making "excess returns" for much of the past decade.
Renewed fears over the stability of the world's oil supplies following the drone attacks in Saudi Arabia have only added to the mix.
With the shares down more than 20 per cent from their mid-August highs, a natural question may be whether Z Energy offers value relative to a broader market which itself is up around 20 per cent so far in 2019.
This is reasonable on the face of it, with Z a dominant player in the Kiwi fuel market, and a history of very strong dividend pay-outs. On the other side, cash-strapped consumers are becoming increasingly price-conscious, and with an 'X' painted on its back, the industry may see regulation intensify.
The strength of Z's market positioning is hard to quibble with. Following the 2016 acquisition of Caltex, Z supplies around 45 per cent of the New Zealand fuel market. Whether we are being 'fleeced' at the pumps as Jacinda Ardern claims, is another matter.
ComCom argues that the infrastructure sharing arrangements of the big three fuel retailers (Z, along with BP and Mobil), gives them "an advantage over any other potential rival importers, as their costs to deliver fuel are lower."
Z Energy has come out swinging, citing "material inaccuracies" within the draft report (BP has also pointed to significant 'errors'). Management claim that profitability (a key driver of the 'inquest') is mispresented, with the regulator's view that Z's 2016-2018 rate of return was 22 per cent, around double management's independently reviewed calculations of about 11 per cent.
The ComCom, they say, is also comparing 'apples with oranges,' in looking at returns of companies in other markets and overlooking currency impacts.
Z has some fair points even if some are to perhaps muddy the waters. Management ask why the regulator should be worried about how much Z Energy makes on 'pies and coffee' when their mandate was to look at fuel pump prices.
The company though has extended some olive branches as it understands the need for Kiwis to get a fair deal. This includes a willingness to display prices more clearly, provide spot pricing for independent petrol retailers, and being open to an industry code.
So, does Z and the other big players make supernormal profits? And if so, to what extent is this at risk from facing tougher regulation? A forecast yield of over 8.5 per cent for the 2020 financial year (FY20) suggests the stock market harbours some concern, although this is also likely due to other earnings headwinds outside the control of the regulator.
Z energy claims that its rate of return has fallen to around 10 per cent, and has flagged further earnings pressures recently. A few weeks ago, the company noted that the first five months of FY20 had been negatively impacted by "unprecedented levels of discounting and price competition" in its retail business.
The company also noted that the gross refining margin during the period had been below forecast.
Z revised its EBITDAF guidance for FY20 to a range of $390m to $430m, down from the earlier range of $450m to $490m.
The top end of its dividend guidance range for FY20 was also pared, with the earlier range of $0.48 to $0.54 revised to between $0.48 and $0.50.
The exit of Caltex from the AA Smartfuels Programme to join the new "Pumped!" loyalty programme alongside the Z brand has evidently increased competitive 'intensities.'
Margins for both brands have been impacted, while volumes have also declined at the Caltex business as customers have considered whether to switch loyalties. Pressures here are set to weigh on earnings to the tune of $50m.
Refining margins from Marsden Point (Z owns 15 per cent of the operator) have also generally been "weak," with an expected negative earnings impact of $10m for FY20.
Z however expects a moderate uplift here down the road due to the implementation of regulatory changes.
It therefore is very possible that ComCom (whose final report is due in December) has come late to the party. Earnings perhaps have certainly been strong historically, and this has benefitted shareholders (Z has paid out over $700m in dividends since listing in 2013).
But as most economic textbooks will tell you, super industry profits also encourages competition until the situation normalises – which it has with the entrance of the likes of Gull and Waitomo, during a period where overall total fuel consumption has remained fairly flat. A move against the fuel companies could arguably see a reaction capacity the other way.
Added to the mix is that the increasing advent of electric/fuel efficient vehicles and the consequent earnings headwinds to Z and others, should they sit still. While EVs account for just a few per cent of the country's vehicles, this percentage will accelerate. The Ministry of Business, Innovation and Employment has forecast this will see petrol sales almost halve by 2050.
Nearer term, it is also not like Z Energy (which has no upstream business to really speak of) stands to benefit from higher oil prices should geopolitical tensions ratchet higher or OPEC+ (now there is a cartel) decide to turn the taps tighter.
In fact, petrol consumption is somewhat elastic, and while much of the populous accept higher prices through gritted teeth, many others do adjust their consumption habits (ride-sharing, taking the bus/train instead, or opting to buy that Blue Pearl Nissan Leaf).
Whether ComCom's findings in the energy sector are therefore 'on point' remains to be seen. However, the reality is that elevated prices at the pump are more a reflection of events going on outside of these shores mixed with a bit of currency impact.
Nonetheless, whatever happens with ComCom's final report it does seem likely that current retail pricing pressure is here to stay, and particularly if you believe the Reserve Bank's still fairly sombre assessment of the economy.
Z Energy's juicy dividend yield, while attractive at first glance, could well prove vulnerable in the years ahead, unless funded by divestment/moving assets off balance sheet, which wouldn't bode particularly well for the share price either. I think Z Energy therefore will stay under the pump.
- Greg Smith is the Head of Research at investment research and funds management house Fat Prophets
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