On 30 September 2019, United Global (SGX:43P) announced that Spain’s oil major Repsol (BME:REP) will purchase a 40% stake in one of their subsidiary, United Oil Company, for up to US$46.5mil.
While selling a huge stake in their core business does not sound like good news, I felt otherwise. After understanding Repsol’s ambitions in the lubricants market, I feel that the alliance will provide huge growth opportunities in the long term.
Business Overview
United Global (SGX:43P), is a lubricants manufacturer with their own in-house brands such as “United Oil” and “Ichiro” as well as manufacturing for third party principals. They have 2 manufacturing plants in Singapore and Indonesia. The Group is also involved in trading of base oils, additives and lubricants.
Repsol (BME:REP) is a global energy company present throughout the whole energy value chain. They are principally engaged in the production and marketing of oil derivatives. The company has upstream activity in 25 countries, produces 715,000 barrels of oil equivalent per day and has one of the most efficient refining systems in Europe.
Who Bought What?
Repsol will purchase 40% of the paid up share capital of United Oil Company Pte Ltd (UOC), a subsidiary of United Global for and initial consideration of US$36.5mil and deferred consideration of US$10mil.
The deferred consideration will be paid if UOC achieves a contribution margin that exceeds US$34.2mil for FY2023. (I will be touching on this later)
After the purchase, UOC will be accounted as a joint venture in their financial statements and their share of the profits will be reported in the income statement under “Share of profits of joint venture”.
Good Deal?
UOC contributes about 97% of net profit attributable to Unitel Global. Retaining only 60% of UOC’s stake would mean that their performance (ie EPS) for the subsequent years will be affected. On the other hand, having Repsol as a partner could be beneficial in the long run. Overall, I feel that it is a good deal for United Global.
Show Me The Money
Once the deal is completed, United Global will receive US$36.5mil (minus 40% of UOC debt), putting them in a net cash position of 11 US cents per share, strengthening their balance sheet.
Besides a gain on disposal of the sale, United Global will also record gains on re-measurement of the remaining 60% stake of UOC. Hence, they will record a profit and increase of NTA of US$70mil from the deal.
I think that management has done well in unlocking the valuation of its core business and realizing part of the investments which will allow them to further grow their business.
Repsol’s Ambitions
With Repsol on board, it is no longer business as usual for UOC.
Under Repsol’s strategic plan for 2018-2020, they target to double their sales volume of their lubricants business, with 70% from outside Spain. The company also expects to invest € 1.5b for expansions in the downstream segment. (source: https://www.icis.com/explore/resources/news/2018/06/06/10228470/spain-s-repsol-plans-downstream-capex-of-nearly-7bn-for-2018-2020/ )
The purchase of UOC is part of Repsol’s plans to expand its downstream footprint in Southeast Asia, especially in the Indonesia market. UOC will manufacture and supply Repsol’s brand of products in Singapore, Indonesia, Malaysia and Vietnam.
There are also plans to upgrade UOC’s manufacturing plant in Indonesia. Due to the complementary nature of both companies’ products, Repsol would be able to gain immediate access into new customer segments. At the same time, the joint venture will be expanding their network of dealers and distributors through a sales and marketing drive.
From this deal, Repsol aimed to be a “top 5 player” in Indonesia in the lubricants market.
Been there, done that
This is not the first time Repsol has expanded their business using this strategy. In 2015, Repsol entered the India market by entering into a JV with G.P. Petroleums Ltd (BSE:532543) (GP), a local domestic lubricants brand. Under this agreement, GP will manufacture and sell Repsol’s line of products. Sounds familiar?
Since the JV, Repsol’s sales in India delivered double digit growth every year and in 2018, they signed an extension of the JV which licenses GP to distribute Repsol’s lubricants in neighbouring countries Sri Lanka, Nepal and Bhutan. (Source: GP Petroleum Annual Report 2018)
MotoGP to help create brand awareness
In one of GP’s CEO’s interviews, he once said this;
“We have been selling Repsol lubricants in India without advertisement. Repsol is associated with Honda racing team and has won several races recently. [Due to this] interest in the product has picked up.” (source: https://www.thehindu.com/business/repsol-eyes-5-market-share-in-10-years/article19699666.ece )
Coincidentally, it was recently announced that MotoGP would be returning to Indonesia in 2021, this should help create brand awareness for Repsol in Indonesia. (source: https://www.motorsport.com/motogp/news/indonesia-street-circuit-2021-calendar/3207647/ )
With this business model tried and tested, I’m confident that the JV between Repsol and UOC would reap similar results. There is also the potential of expanding their business to other SE Asia countries like Myanmar or Thailand.
Target 2023
As part of the deal, there is a deferred consideration of US$10mil if UOC is able to exceed contribution margins of US$34.2mil in FY2023. I shall assume that this is the target that Repsol has set for UOC for the JV to succeed.
The definition of contribution margin as stipulated in the agreement is;
Contribution Margin = Total Sales – COGS – Selling & Distribution Expense + Amortization + Depreciation of PPE.
According to their FY2018 results, United Global’s contribution margin is about US$18.5mil ( Disclaimer: My calculations could be wrong). I am only using this as a estimated reference as the actual contribution margin should be taken from UOC and not the United Global’s financial statements.
Aside from all that, after deriving the current estimated margin and the target margin, using a period of 4 years (2020-2023), the target growth rate is about 16% CAGR growth. This is about the same as their gross profit growth since 2014.
Hence, I feel that this target is achievable and I expect UOC to exceed this contribution margin target.
Industry Outlook
According to an article by McKinsey & Company on lubricating oil growth, lubricant volume growth will continue to grow at a rate of about 3-4% for Southeast Asia countries. The opportunities lie in Non-OECD countries like Indonesia, Vietnam and Malaysia (where UOC has business dealings in) where the gross margins are the highest. United Global’s gross margins are also somewhere between high-teens and low twenties.
However, the industry is exposed to several potential disruptions which could affect demand and margins of lubricants.
I guess the most likely disruptions are the introduction of EVs into the market. With more efficient batteries, this could reduce demand of internal combustion engines which would lead to lower demand of lubricants.
A risk that would reduce gross margins would be the switching away from personal vehicle ownership to ride-sharing (Go-jek) that would encourage fleet ownership. Fleet owners will have a higher bargaining power and would have less inclination of using premium brands. That would then lead to commoditization and product margins would suffer.
Business Risk
There are 4 key risk factors for United Global.
- Foreign Exchange Rate Volatility – A depreciation of the currency which United Global operates in relative to the US Dollar will be negative. This is because the company sells largely in the respective country’s currency but the consolidated financial statements are reported in US Dollar.
- Raw Material Cost – Raw material cost spikes could drive margins down. However, I feel that United Global’s margins are quite consistent so far hence, should not be a significant issue.
- Competition – There is 2 parts to this. The first is the concern that expansion of Repsol’s business could affect the sales their own brand products. However, looking at their JV with GP, I think the two brands are able to co-exist. The second part is Repsol’s late entry into the lubricants market in SE Asia. There are many well known brands like Castrol and Mobil which might stifle Repsol’s growth. However, Repsol can leverage on its association with MotoGP to build their brand. Their contribution margin target also show that they are confident on becoming one of the top players in Indonesia.
- Diversification Risk – United Global intend to use the sales proceeds to expand their business by acquisitions, mergers, JVs as well as establishing new businesses. The major risk is the lack of acquisition targets and overpaying for businesses. The management has yet to reveal their plans following the deal.
Valuation
Stake in UOC Repsol JV
Assuming that UOC exceeds the contribution margin target at US$35mil in 2023, putting the margin at 17% (est. contribution margin/revenue), that would mean that UOC have to generate about US$206mil of revenue.
The 5 year average net margin is 7.3%. So with that assumption, the net earnings of UOC would amount to US$15mil. With their 60% stake, that would become US$9mil, or US$0.026 EPS (S$0.04).
Assigning a forward PEx13, which I felt is fair due to their targeted double digit growth, United Global’s stake in the UOC Repsol JV would be worth about $0.52 in 2023, very near to the current share price (Rest of the business and cash comes free).
Catalyst to come from new acquisitions
With a huge war chest available, we will be looking at new acquisitions or businesses for catalyst for re-rating or share price. One space which I’m anticipating is United Renewables Company. They have incorporated a subsidiary in Australia to engage in recycling of rubber tyres. However, they have yet to disclose anymore information.
Conclusion
I find that the JV with Repsol offers alot of growth opportunities in the lubricants market. Due to the success Repsol had in India, it makes me more confident that Repsol could emulate the results here too.
Not including the fair gains on re-evaluation, United Global will still be receiving a large sum of money once the deal is completed. This will allow the management to look for more opportunities to expand their business.
In terms of valuation, I feel that current share price is fairly valued. However, catalyst such as new businesses or JVs could enable United Global’s share price to re-rate. A surprise special dividend could also offer some upside (They do not have a formal dividend policy, so we can only hope and pray it happens).
Repsol has a 5 year plan to successfully be a top 5 lubricants brand in Indonesia and reap the rewards of their investment. Similarly, investors in United Global should take a long term approach and trust the management to make the right decisions to create more value for their shareholders.
Cheers
The Moss Piglet is vested in United Global at $0.485.