Oil Price Volatility Will Grow Again And You Can Profit With An Oil Stock

| About: World Fuel (INT)
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Summary

Thanks to its scale and financial strength, World Fuel Services enjoys huge competitive advantages.

The company should be able to grow revenues organically and through acquisitions for a long time to come.

The market ignores that growing oil price volatility actually benefits the company and boosts profits.

This provides distinct "antifragile" characteristics in difficult market environments.

Introduction

If you've been following World Fuel Services (NYSE:INT) for the past few years, you will have read about the company beating Apple's (NASDAQ:AAPL) revenue growth over the past decade. You will have read about the company being asset-light, growing through smart acquisitions, having excellent management, maybe worrisome razor-thin margins and frightening amounts of receivables on its balance sheet. While all these points are important to note and analyze, you probably haven't read about the most important metric to look at and what ultimately drives INT's profits.

In this article, we will also see why World Fuel Services qualifies as an "antifragile" investment. In my article "The Portfolio for Early Retirees," I have commented on why I consider "antifragile" businesses to be a smart choice for retired investors:

"Antifragile" is a concept developed by Nassim Taleb and characterizes objects that actually benefit from being subjected to stress. Not only do they resist, they even benefit. Applied to businesses, this means that there are companies that can profit from recessions, stock market panics or general disorder. As retirees basically depend more on a stable economic environment than other people, investing in antifragile businesses can be a smart way to manage this problem.

Business model, competitive advantages and credit risk

This is how World Fuel Services describes its business in its latest 10-K:

We are a leading global fuel logistics company, principally engaged in the marketing, sale and distribution of aviation, marine, and land fuel and related products and services on a worldwide basis. We compete by providing our customers with value-added benefits, including single-supplier convenience, competitive pricing, the availability of trade credit, price risk management, logistical support, fuel quality control and fuel procurement outsourcing. We have three reportable operating business segments: aviation, marine, and land. We primarily contract with third parties for the delivery and storage of fuel products, however, in some cases we own storage and transportation assets for strategic purposes.

Some 20 years ago, the company's business was done directly by major oil producers. But over the past 15 years, big oil has been selling off terminals and gas stations, moving out of the downstream business. It's not hard to see what INT's moat is made of: scale. The company acts as an aggregator. It buys large amounts of fuel and sells it back in smaller amounts to its customers. So if you wanted to compete with INT, you'd first need to acquire the necessary scale in order to match its bargaining power with the oil majors. However, this would require thousands of customers all over the globe. So it's a nicely protected moat. Over time, INT has acquired other, smaller fuel services companies to further enlarge its customer base and services offer. Thus, the business continues to grow at a fast pace and will probably continue to do so for quite a long time.

Another competitive advantage the company enjoys is its balance sheet. INT has $3.8 billion of current assets compared to $3 billion of total liabilities and only $0.5 billion of long-term debt and can afford to extend credit to its customers. This also explains the enormous amount of receivables, which stood at $2.5 billion at the end of 2013, representing 150% of total stockholders' equity. So investors definitely have to take into account credit risk, which however seems to be managed very well by the company:

($ millions)

2005

2006

2007

2008

2009

2010

2011

2012

2013

Accounts receivable at period end

690

860

1,371

676

951

1,387

2,161

2,194

2,539

Write off

8

2

4

6

9

4

5

6

7

Net provision available at period end

12

14

13

23

20

20

24

24

29

Addition to bad debt provision

9

4

2

16

5

5

9

5

12

Increase in Accounts receivable

199

170

511

-695

275

436

774

33

345

We can see that in 2008, INT managed to quickly reduce receivables by over 50%, increasing substantially its provision for bad debt, which has almost always covered 3-4 times the effective write offs. However, this issue remains and investors can't do anything about it but decide to trust management or not. The company's CEO Michael Kasbar owns about $38 million worth of stock or 1.22% of the company, while all key insiders together own about 2.6% of shares outstanding. These certainly are no huge insider ownership percentages, yet still represent a huge chunk of money. Investors should also consider that INT, differently from banks and most financial services businesses, effectively lends its own money to its customers, which should provide a further psychological incentive for its management to get things right.

Profit drivers

If we look at INT's revenue growth over the past few years and compare it to earnings growth, we can clearly see that revenues alone are not what drives the company's profits:

($ millions)

2009

2010

2011

2012

2013

Revenue

11,295

19,131

34,623

38,945

41,562

Op. Income

154

181

257

257

264

While revenues have almost quadrupled, operating income has grown only by 71%. So the comparison to Apple many financial journalists have made is almost meaningless. However, the explanation provides the starting point for important further insights: Because the price of oil is basically passed through to INT's customers, overall revenue growth is as meaningless as would be a revenue reduction. What really counts is operating income per gallon of fuel sold:

($)

2009

2010

2011

2012

2013

Revenue/gallon

1.16

1.59

2.62

2.70

2.66

Op.Income/gallon

0.0159

0.015

0.0195

0.0178

0.0169

Revenue per gallon more than doubled over the period, but operating income per gallon has remained about stable, with an evident spike in 2011. Compare this to the CBOE Crude Oil Volatility Index over the same period:

Now read the following statements made by CEO Michael Kasbar during the last conference call:

So certainly our services are offering greater value if we're helping to navigate difficult markets. And our ability to add derivative products, we're quite confident at being able to do that.

We thrive on change. And you can call that another form of market volatility. So anytime there is a change in regulations, it's certainly an additional challenge, but for us it's a tremendous opportunity to provide service because we are focused on those changes.

We anticipate those changes. We have the staff to be able to sort out and prepare to provide solutions to our clientele.

As INT provides additional price hedging services to its customers, it actually profits when markets enter the rough path. Regulatory changes, recessions, international crises, wars - that's what ultimately drives profit per gallon growth at INT. Operating leverage due to major scale, synergies and operating efficiencies provides just a fraction of the tailwinds oil price volatility can provide.

In the 2008/9 period, the stock market clearly didn't get it: While the stock lost 60% of its value, earnings per share continued to increase throughout the recession:

($)

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

EPS

0.41

0.49

0.61

0.79

1.11

1.12

1.81

1.96

2.31

2.71

2.64

2.83

At its low in 2008, the stock traded at book value, which by the way undermines the possible argument related to the intrinsic credit risk. If Mr. Market had been really worried about credit risk, INT should have traded far below book value, as receivables were higher than equity.

The obvious question here is: will history repeat itself during the next big crisis and provide another opportunity to pick up a stock with growing profits at a sharply falling price? In this case, potential investors should put INT on their watch lists and wait. On the other hand, if Mr. Market has learnt his lesson, today should be a good time to buy World Fuel Services. Oil price volatility is historically low and is very likely to pick up in the near future:

At this point, INT will almost certainly experience a strong boost to its profits.

Valuation

This brings us to the difficult task of valuation.

We have already seen that Mr. Market doesn't seem to understand INT.

Anyway, history tells us that during the past decade the stock market has evaluated the company at PER multiples between 6 and 21, with the average trough valuation being 11.5 times EPS and the average peak valuation 17 times EPS. Currently, INT trades at 15 times earnings and 1.8 times book value, which seems to be inexpensive for a company that has excellent growth prospects, a stable (or even "antifragile") business model, little need for capital expenditures, excellent inflation protection and a 10-year-average ROE of 17%. In my opinion, World Fuel Services is worth at least $50 per share, representing about 17 times earnings and a bit more than 2 times book value.

With a spike of oil price volatility similar to 2011, INT should be able to increase operating profit per gallon to about 2 cents. The question here is of course when the spike will happen:

($ millions)

2013

2014

2015

2016

2017

2018

Gallons sold

15,600

16,380

17,199

18,059

18,962

19,910

Op. Income/gallon ($)

0.0169

0.02

0.02

0.02

0.02

0.02

Operating income

264

328

344

361

379

398

Net income

198

246

258

271

284

299

Shares outstanding

72

72

72

72

72

72

EPS

2.75

3.41

3.58

3.76

3.95

4.15

Value at PER = 17

46.69

58.01

60.91

63.96

67.16

70.51

CAGR from today's price of $42

38%

20%

15%

12%

11%

In this table, I have projected below average volume growth of 5%/year. If INT makes 2 cents per gallon already during this year, EPS would grow to $3.41, which at a fair PER of 17 would provide investors a CAGR of 38% from today's price. If the increase of profit per gallon materializes only in 2016, investors would still pocket a CAGR of 15% (assuming that they can sell at a PER of 17). Even if we still have to wait 4 years for a strong volatility spike, the CAGR would stand at a more than decent and probably market beating 11%.

As a caveat, investors should remember that I am talking about value and not about price. While it is almost certain that World Fuel Services will increase its value in difficult times, it is far from a foregone conclusion that Mr. Market will value the stock accordingly.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in INT over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.