Transitioning Business Model Creates Buying Opportunity

Businesses want connections. Providers are starting streaming services and brands are moving online. It is easier than ever with the rise of Big Data, and for companies to reach customers directly, that connection is more valuable than ever.


This spin-off that is current is currently transitioning from a business model that sells through third party retailers to one which possesses the customer relationship to customers. This transition creates volatility at the short term, but it is going to make the company more rewarding. Valvoline is the week’s Long Thought.


Increasing Focus on Quick-Lube

Valvoline, based in 1866, was the first trademarked motor oil brand in the U.S. Historically, the business has focused on selling its branded products to consumers through third-party retailers such as NAPA Auto Parts, AutoZone (Advance Auto Parts, and OReilly Auto Parts.

However, this business faces pressure on account of the decrease of”home improvement” (DIY) car upkeep and the growth of”do-it-for-me” (DIFM). A variety of factors, such as complexity of automobiles and an increasing consumer preference for advantage, have led consumers to opt for professional service rather than altering their oil or performing other car maintenance.

Valvoline targets this growing group of customers through its Quick Lube segment, which owns franchises ~1,300 service locations throughout the U.S. and Canada. Since its spin-off from Ashland (ASH) in 2016, Valvoline has rapidly grown this section to offset the decrease in its third party retail business (which it calls”Core North America”). Figure 1 shows that operating income for the Quick Lube segment surpassed Core North America for the first time.

Figure 1: VVV Segment Operating Income Considering 2015

Operating income for the Quick Lube segment climbed from $95 million in 2015 to $153 in 2018, or 17. Lube operating income is up to $162 million TTM. By 2015 into the TTM period, the share of segment operating income of Quick Lube has increased from 26% to 41%.

GAAP Earnings Mislead Investors

Transitioning from a 3rd party retail model to the Quick Lube version has been challenging for Valvoline. In particular, the Core North America segment has fought due to the decline of the DIY customer base as well as increasing competition from private label motor oil manufacturers.

But, GAAP earnings exaggerate the extent of the company’s challenges. Figure 2 demonstrates that GAAP net income declined by 45 percent in 2018 although net operating profit after tax (NOPAT) rose by 59%. TTM GAAP whilst NOPAT is up 15% over precisely the exact same time, net income is down 18% from 2015.

Figure 2: VVV NOPAT and GAAP Net Income: 2015-TTM

The disconnect in 2018 comes in $77 million (3% of earnings ) in non-recurring charges because of tax reform. In addition, 2017 earnings were increased due to $138 million (7 percent of revenue) in non-cash pension gains.

Because of this, Valvoline’s GAAP net income tells the story of a company that’s struggling. Valvoline has missed earnings expectations in 6 out of the past 8 quarters, leading to a 15% decline in the stock price over the previous two decades.

My adjustments, on the other hand, imply the organization’s profits, over the past year, have grown despite current volatility.

Steady Increase in Demand

The strength of the business of Valvoline could be understood in the long-term increase in quantity of lubricant sold. Figure 3 displays the total gallons of lubricant sold by the company has increased from 159 million in 2012 to 182 million in 2018, or 2 percent compounded annually.

Figure 3: Millions of Gallons of Lubricants Sold: 2014-2018

No matter the station it sells , consumer demand is increasing, and Valvoline has shown an ability to continuously increase the entire sales of its products.

Advantages of the Quick-Lube Model

On the long-term, the transition to a more Quick Lube-focused model will create Valvoline a much safer and more profitable business. Fast Lube has Benefits over the 3rd party retail model, including:

Direct Customer Relationship: As mentioned above, Quick Lube allows Valvoline possess the relationship with its customers. It can collect data to customize service and promote more effectively, and it gets the chance to upsell greater value products and services.
Vertical Integration: As both the manufacturer and distributor of its products, Valvoline can earn higher margins than when it has to split profits with the retailer.
Higher Barriers to Entry: It’s relatively easy to start a motor oil manufacturer to market through retailers or online. By comparison, the Quick Lube model requires significant property investment and also the ability to attract and train employees to deliver an adequate level of service.
Due to these advantages, the Quick Lube segment of Valvoline has a working margin of 22 percent compared to 15% to the Core North America section.

Valvoline doesn’t break out its resources by section, so I can’t analyze the yield on invested capital (ROIC) of these lines. But over 60 percent of the company’s Quick Lube locations are franchised, which suggests the capital requirements for this segment are relatively low, and also the ROIC is fairly high. A recent business presentation said that fresh investments make 2x their cost of capital (WACC), which the business general earns an ROIC above 20%. This latter number matches my data and calculation which shows VVV total ROIC is 20.4percent for the TTM period.

Gaining Market Share

Valvoline isn’t just shifting sales from DIY customer to DIFM. It’s also rapidly gaining market share in the DIFM oil change market. Consumers are already shifting more towards quick lube operators in the DIFM segment, and sales by oil change and lubrication shops increased by 4 percent in 2018, according to data in the Auto Care Association. Valvoline’s Quick Lube places grew same-store earnings by 8 percent, or twice the industry rate, as shown in Figure 4. During the first six months of 2019, same-store earnings grew by 10% year-over-year.

Figure 4: VVV Quick Lube Same Store Sales Growth: 2014-TTM

In addition to its own same-store sales growth, Valvoline is quickly expanding its store count through new store openings and acquisitions of smaller fast lube chains. This rapid growth drove a 22% rise in overall revenue (and 18 percent in reported operating income) for the Quick Lube segment in 2018.

Superior Efficiency Provides Benefits

Valvoline’s vertical integration and highly recognizable brand make its locations more efficient and more profitable compared to independent quick lube operators. The typical quick lube store earned ~$862 million in revenue in 2018, while the average Valvoline quick lube shop topped $1 million in earnings, meaning their stores earn at least 16 percent more revenue than an normal store. According to a recent company presentation, their locations average ~40 oil varies daily compared to ~30 for the fast lube industry as a whole.

This superior efficiency describes Valvoline’s ability to earn a high return on new investments. The company can acquire independent fast lube operators, re-brand, add them to its distribution system, and quickly improve sales and profits.

In addition, the company’s superior efficiency may be linked to its emphasis on promoting from within. According to a Wall Street Journal report by 2018, employees who began as technicians manage nearly all of the company-owned quick lube locations and occupy 83 from the 84 regional manager functions. This emphasis on promoting from inside helps to establish a consistent corporate culture, make sure that management knows the issues faced by technicians, making Valvoline a more appealing alternative for prospective workers.

Bear Case: Amazon Basics Threat Is Overhyped

The bear case for Valvoline supposes that the growth of this Quick Lube segment will not be enough to offset the decline of Core North America. Specifically, the issue is that competition from private label manufacturers can lead to margins in this business to collapse.

This concern intensified last fall when Amazon (AMZN) announced it would start selling private label motor oil under the AmazonBasics brand. In the aftermath of this statement, JPMorgan downgraded VVV to”Underweight”, and the stock fell 6%.

However, AmazonBasics isn’t the kind killer that investors believe it to be. Research indicates that AmazonBasics has gained substantial market share in accessories and electronics, but it has fought to break through in different categories. In particular, there are two Important reasons why Amazon’s personal label motor oil does not represent a major danger to Valvoline:

Oil Recycling: Most DIY oil changers market their used motor oil, and many make the most of the oil recycling services offered by major auto parts retailers. If you’re already going to the shop to market your oil anyhow, it is simpler to simply purchase new oil there rather than online, therefore the normal convenience advantage of e-commerce doesn’t exist in this area. Consequently, e-commerce accounts for just 5 percent of motor oil sales.
No New Value Proposition: AmazonBasics motor oil is produced by Warren Distribution, the identical company that currently produces Walmart’s (WMT) private label motor oil manufacturer, Supertech. With a price point equivalent to other private label manufacturers and no innovation on the manufacturing side, there is no reason to think AmazonBasics motor oil is going to be a substantial disruptor within this space.
Competition from private label manufacturers has been and will continue to be a struggle for Valvoline’s Core North America segment, but Amazon does not represent the threat which bears believe.

Bear Case: EVs Won’t Spell Doom for VVV

Longer-term, the bear situation against Valvoline is the growth of vehicles — that don’t require engine oil and require less servicing than vehicles — will make its business model obsolete. On the other hand, the adoption of EV is further off than many realize, and Valvoline has the capacity, if they are becoming dominant.

Regardless of the hype around EV, they currently account for one in 250 automobiles on the street and 2 percent of auto sales that is new. The most optimistic projections of EV adoption have them accounting for just 32% of the planet’s passenger vehicles by 2040.

Valvoline’s Quick Lube model will enable it to adapt and endure, if gas-powered automobiles are completely replaced by EV. Its bread and butter oil change service may go away, but the company still performs lots of solutions — like tire spinning, air conditioner recharge, air filter replacement, light bulb replacement, and wiper blade replacement — that will still be expected on EV.

As EV adoption develops, in addition, the business could add new services. For instance, it might install rapid charging stations at its places, introduce software troubleshooting, and develop more advanced coolants for batteries and fuel cells.

The substantial backlog in the service centers of Tesla demonstrates as the talk of EV grows, that there will probably continue to be demand for maintenance services. Who knows Tesla or a different automaker/dealer could contemplate Valvoline so as to boost their service capabilities. Surveys show that millennials are significantly less likely to use dealerships for maintenance and support than preceding generations, therefore automakers and dealers might be looking to enter the lube business.

ROIC Analysis Shows Shares Are Undervalued

Case studies demonstrate that obtaining ROIC right is an significant part making smart investments. Feb Figure 5, ROIC explains 61% of this gap in valuation for the lists as coworkers at the area in its proxy statement. As shown below the trend line by its position VVV trades at a discount to peers.

Figure 5: ROIC Explains 61 percent Of Allergic for VVV Peers

If the stock were to trade at parity with its peers, then it’d be worth $31/share — 41% above the current stock price. With Valvoline taking market share it arguably deserves a premium valuation compared to its peers.

Cheap Valuation Creates Buying Opportunity

VVV is down 15% since its spinoff in 2016 in spite of the fact that financial earnings and the firm’s NOPAT have increased since then. As a result, stocks finally have significant upside potential.

In its current price of 22/share, VVV has a price-to-economic book value ratio of 1.0. This ratio means that the market expects no expansion in VVV NOPAT over the firm’s remaining lifetime. This expectation appears too pessimistic for a firm that is steadily growing volume and shifting into a more profitable organization.

If VVV will maintain its present NOPAT margin of 13 percent and increase NOPAT by just 5% compounded annually for the next ten years, the stock is worth $32/share today — a 45% upside down. See the math behind this DCF scenario that is dynamic.

In the event that you think that the rise of EVs will be a long-term headwind, VVV has upside. If I utilize the exact same 10-year prediction from the above scenario, but then assume that earnings will decline by 3 percent yearly and NOPAT gross profits will shrink to 11% over the subsequent 20 years, the stock is worth $22/share. See the math behind this DCF scenario that is lively. Within this scenario, VVV NOPAT declines by 1% compounded annually over the course of the next 30 decades.

Sustainable Competitive Advantages That Will Drive Shareholder Value Creation

Here’s a summary of why I think the moat about Valvoline’s business will enable the company to generate higher gains than the current valuation of this stock suggests. This list of competitive benefits helps VVV offer far better products/services in a lower cost and prevents competitors from taking market share.

Highly recognizable brand with a reputation for quality and reliability
Vertical integration leads to higher cost efficiency for Quick Lube company
Capability to quickly integrate newly acquired locations at a top ROIC
Direct customer relationships create lasting value no matter What Sort of automobile people drive
What Noise Dealers Miss with VVV

Fewer investors focus on locating quality funding allocators with shareholder company governance that is friendly Nowadays. Rather, due to the proliferation of noise traders, the focus tends toward trading tends while research is overlooked. Here’s a quick overview for noise traders when studying VVV:

Understated earnings growth due to the impact of tax reform on 2018 GAAP net income
Despite short-term volatility, transition from 3rd party retail to Quick Lube model will probably be beneficial long-term
Amazon is not as important a hazard in this area as investors fear
Electric cars still require service, and manufacturer support places Cannot meet Present demand
Catalyst: Earnings Beats Can Send Shares Higher

Valvoline faces significant pessimism from analysts because of its history of earnings misses. Five out of the two sell-side analysts covering the stock rate it. Consensus estimates have earnings for the quarter.

As Quick Lube becomes a larger portion of Valvoline’s company, its expansion should become enough to cancel the battles of Core North America. In addition, the company has announced pricing and a cost-saving initiative so as to stabilize its legacy enterprise.

Longer-term, global expansion might be a major growth driver for the company. Valvoline announced a joint venture together with Experts Too earlier this season to develop a quick lube version. If this high-growth company is successfully exported by the company to an global consumer base, the potential is huge.

Exec Comp Should Return to ROIC Emphasis

Owing to its latest spinoff from Ashland (ASH), Valvoline’s executives chose to earn long term awards based on goals set by its former parent company through 2018. These goals contained return on investment (ROI), which will be very similar to ROIC.

However, the new long-term goals set by the business concentrate on EPS and total shareholder return, while yearly bonuses are based on operating earnings and lubricant volume. The company continues to highlight ROIC in presentations and reports, but it will be better if it continued to definitely link executive compensation into the metric that is important.

Dividends and Buybacks Offer 4% Yield

Its dividend has raised in each of its three years as an independent firm. Since 2016, Valvoline has increased its dividend by 47. Its current annualized dividend of $0.42 equates to a dividend yield of 2.1%

Along with dividends, capital is returned by Valvoline to shareholders. In 2018, the company repurchased $325 million (8% of market cap) worth of shares. The business has $75 million remaining on its own buy authorization. If it exercises the rest of this authorization, Valvoline’s dividend and buyback activity provide shareholders with a potential yield that is 4%.

Insider Trading and Short Interest Trends are Minimal

Insider action was minimal over the past 12 months, with 94 thousand shares sold for a net effect of 62 thousand shares sold and 33 thousand shares purchased. These earnings represent less than 1 percent of shares outstanding.

There are now 5.7 million shares sold short, which equates to 3 percent of shares outstanding and 4 times to cover. There does not appear to be much appetite to bet against this stock.

Critical Details Located in Fiscal Filings by My Firm’s Robo-Analyst Technology

Research automation technologies is needed to analyze all of the financial details in financial filings as investors focus on research. Below are details about the adjustments I create based findings in the 2018 10-K of Valvoline:

Income Statement: I made $128 million of alterations, using a net impact of eliminating $122 million in non-operating expense (5 percent of earnings ). I eliminated $3 million in non-operating earnings and $125 million in non-operating expenses. You are able to see of the alterations made to VVV income statement here.

Balance Sheet: ” I made $518 million of adjustments to compute invested capital with a net reduction of $76 million. You are able to see of the adjustments made to VVV balance sheet here.

Valuation: I made $1.8 billion of adjustments with a net effect of diminishing value by $1.8 billion million. In spite of this reduction in value, VVV remains. You can see all the alterations made to VVV valuation here.