Valvoline (NYSE: VVV)

Is there a great business behind the iconic "V" logo?

Valvoline (NYSE: VVV) is a car and engine care business known by many for its iconic “V” logo. Per p.1 of the 2021 10-K, “Valvoline has consistently led the way in innovating and reinventing its services and products for changing technologies and customer needs, including leading the world's supply of battery fluids to electric vehicle manufacturers. Valvoline operates a fast-growing, best-in-class network of service center stores, which are well positioned to serve evolving vehicle maintenance needs with Valvoline's iconic products. In addition to its quick, easy, and trusted quick lube oil change services and the legendary Valvoline-branded passenger car motor oils, Valvoline provides a wide array of lubricants, chemicals, fluids, and other complementary products and services designed to improve vehicle and engine performance and lifespan.” The business is headquartered in the mean streets of Lexington, Kentucky. Per the most recent 10-Q (2022 Q1), the business recorded $87 million in net income, a 31% increase in sales and returned $54 million to Valvoline shareholders via dividends and stock repurchases.

Why Valvoline Might Not Be for You

The stock chart doesn’t look great – Per TIKR, the stock price has compounded at ~5% since the business went public back in 2016.

Debt load – Valvoline has approximately $1.7 billion in long-term debt. Current assets sit at just over $1 billion with cash and cash equivalents only being $152 million.

Underfunded pension plan – The business’ pension plan as of the most recent 10-K had benefit obligations of $2.203 billion while the fair value of the plan assets was $2.055 billion meaning it was underfunded by $148 million. The business also has “other postretirement benefits” that are unfunded to the tune of $49 million bringing the grand total to $197 million in total unfunded obligations.

This is a boring business – Valvoline has two business segments. The first is Retail Services which includes their quick lube (aka Valvoline Instant Oil Change) business and the second is Global Products which sells their branded automotive products.

“Adjusted EBITDA” – The business plays the “adjusted EBITDA game” which I will talk about more in the “Executive Compensation” section of this writeup.

History of Valvoline

Per Wikipedia, Valvoline was founded on September 6, 1866, as the Continuous Oil Refining Company by Dr. John Ellis who invented a petroleum lubricant for steam engines. Per Wikipedia again, the company moved to Brooklyn sometime in the late 1800’s. The invention of the car was a boon for the business and Valvoline was the recommended motor oil for the Ford Model T in the early 20th century (Willoughby, 2016). Valvoline was the purchased by the Ashland Oil & Refining Company, now known as Ashland Global Specialty Chemicals Inc., in 1949 (Thompson, n.d.)  and operated as a subsidiary until it was spun out in 2016.

CEO

Valvoline lists eight, yes eight, named executive officers in their 10-K and proxy statements. I think listing all of them and their accomplishments doesn’t provide a lot of added value for you, the reader, so I will focus mainly on the CEO and red flags that I come across in proxy or 10-K filings going forward. I may single out an executive officer if I think they’re exceptionally qualified or if the list all named executives if the list is short, maybe less than four people. Sam Mitchell is the CEO of Valvoline and has been so since the company went public in 2016. Per the business’ IR website, Mr. Mitchell joined Valvoline in 1997 as a marketing director and has moved up ever since. Prior to joining Valvoline, Mr. Mitchell worked at Clorox for eight years. He has an undergraduate degree from Miami University, an MBA from the University of Chicago and is a graduate of the Harvard Business School’s Advanced Management Program.

Executive Compensation

Reading about executive compensation at Valvoline was particularly interesting because executive compensation now versus when the business went public is noticeably different. The 2016 Proxy statement tied long term incentives and bonuses to Ashland’s business, which I didn’t think was fair to compare to Valvoline’s current compensation structure. I compared 2017’s executive compensation to the present instead as that was the first year that long term incentives and bonuses were tied solely to Valvoline’s performance. Valvoline uses Deloitte Consulting LLP as their compensation consultant. Total compensation for named executive officers is made up of an “Annual Incentive Plan” and “Long-term Incentive Plan”. The “Annual Incentive Plan” which, from what I could gather, is made up of a base salary and a base salary incentive bonus. The “Long Term Incentive Plan” is made up of stock appreciation rights (SARs), restructured share units, (RSUs) and performance share units (PSUs).

The changes to the 2017 Compensation Program are shown in the screencap below:

The changes to the 2021 Compensation Program are shown in the screen cap below:

Valvoline’s management is now solely incentivized to hit their “adjusted EBITDA and EPS” targets. I went and looked back at the “adjusted EBITDA” figures for Valvoline since it went public. As you can tell from the first screencap below, “adjusted EBITDA” has managed to go up every year except in 2017. With that being said, “adjusted EBITDA” has only CAGR’d at 7.04% per year since 2014. Per the 2021 10-K, the business defines “adjusted EBITDA” as “as EBITDA adjusted for certain unusual, infrequent or non-operational activity not directly attributable to the underlying business, which management believes impacts the comparability of operational results between periods. The “adjusted EBITDA” calculations for 2020 and 2021 are shown in the second screencap below.

After researching the compensation structure, I believe that Valvoline has shifted from an incentive structure that was okay, but not great for the business to one that is absolutely good for management. The reason I say this is because “adjusted EBITDA” can include just about anything to make the numbers increase year over year. I’m not saying Valvoline will start adding frivolous items in their “adjusted EBITDA” calculation, but they have the ability to given the subjectivity in what “certain unusual, infrequent or non-operational activity not directly attributable to the underlying business” can be on a year to year basis. Don’t forget that management is now incentivized to do so given that their performance is based on “adjusted EBITDA” and “adjusted EPS”. This is a red flag 🚩. This doesn’t apply solely to Valvoline, but I find it interesting that businesses have added the “Why We Did It” section to their compensation changes. The reasoning is usually that it’s “good for shareholder and/or shareholder value”, “good for long term success”, “a way to motivate management”, etc., but no evidence is provided as to why the changes themselves are inherently “good for shareholders” or “promote long term success” or “motivate management”.

One last thing about management is their ownership of Valvoline’s stock; Named Executive Officers, directors and director nominees collectively own less than 1% of the business’ stock and have never owned more than 1% since it went public. This is another red flag 🚩.

What Does Valvoline Do?

As I stated above, Valvoline is a boring business. Their Retail Services (formerly Quick Lubes) segment is lesser known than their global products segment but has grown rapidly since the business went public. Retail Services operates under the Valvoline Instant Oil Change brand which provides customers with oil changes and recommended/preventive maintenance services. The most popular service is the “Stay In Your Car” oil change which claims to get you in and out in approximately 15 minutes. This segment has grown through a mixture of company owned and franchised locations. Express Care centers are also included in Retail Services. Express Care locations are independent gas stations and or automobile repair shops that use Valvoline products to serve their customers. I couldn’t find out why the business chooses to operate both a significant number of company-owned and franchised locations. Investor presentations nor management offer any insight in to why this is the case. Valvoline currently has 1,594 retail locations. Company owned stores have increased from 342 locations in 2016 to 719 locations as of fiscal year-end 2021. Franchised locations have increased from 726 locations in 2016 to 875 franchised locations as of fiscal year-end 2021. The 2021 10-K states that there are nearly 300 Express Care Centers. Retail services operates in 47 states and 5 provinces in Canada. Per the 2021 Annual Report, same store sales have increased for 15 straight years. Retail Services sales have CAGR’d at 16.1% since 2014 from $370 million to $1.221 billion in 2021. Per the 2021 Annual Report, Valvoline believes there are approximately 10,000 quick lube locations operating within the United States and Canada which gives them significant room to grow.

The Global Product segment is the more well-known segment of Valvoline. It is responsible for the sale and marketing of Valvoline’s motor oil, antifreeze/coolants, transmission fluid, grease, gear oil, heavy duty and performance chemical products. Valvoline products are sold in 140 countries around the globe. You can find them here in the United States at your local automotive parts store which the business calls “Do It Yourself” (DIY) locations. You can also find Valvoline products at dealerships and repair shops which the business refers to as “Do It For Me” (DIFM) locations. The business sells their premium branded Valvoline products along with cobranding and private labeling services. Valvoline used to break out this segment in to “Core North America” and “International”, but has since consolidated them. Sales for this segment have CAGR’d in the low to mid-single digits since the business went public. This segment is facing long term headwinds in my opinion. The first one is obvious. It already sells its products in 140 countries and they’re already operating in all the ones with large populations. Per p. 6 of the 2021 Annual Report, Valvoline estimates that the international market for lubricants is more than 3.5x the size of the North American market. This business segment has room for growth, but it isn’t a vast runway. The second headwind are electric cars. Electric cars do not need nearly as many lubricants as cars with internal combustion engines. More and more of these cars are coming to market every year which isn’t good for long-term lubricant sales.

Underfunded Pension Obligations

That’s right, Valvoline has underfunded pension obligations to the tune of $197 million between their pension obligations and “other postretirement benefits” which collectively have $2.252 billion in obligations and $2.055 billion in assets. To their credit, Valvoline has done a fair amount to help themselves with their pension obligations. The number of obligations is down from $3.138 billion when the business first went public. The unfunded status of the plan at that time was $831 million. Valvoline has frozen the pension plan since September 30, 2016. Less than half of their pension assets were in corporate debt instruments in 2016 whereas now that figure is right at 2/3rds of the pension assets. The business has also transitioned out of relying on private equity and hedge funds to make up their deficit. Per the 2016 10-K, private equity and hedge fund assets were valued at $726 million, roughly 31.5% of total pension assets, whereas now that figure is down to only $11 million. Per p. 96 of the 2017 Annual Report, Valvoline used pension assets to purchase non-participating annuities from unnamed insurers on September 15, 2016 and August 29, 2017 which transferred $378 million and $585 million respectively for pension trust assets whose value approximated the liability value. Per pp. 96 of the 2017 Annual Report, the insurers will pay and administer benefits to 20,800 participants in Valvoline pension. Per p. 96 of the 2017 Annual Report again, “The insurers have unconditionally and irrevocably guaranteed the full payment of benefits to plan participants associated with the annuity purchase and benefit payments will be in the same form that was in effect under the plan. The insurers have also assumed all investment risk associated with the pension assets that were delivered as annuity contract premiums.” In my opinion, expectations for returns on plan assets are reasonable too. In 2016, the expected long-term rate of return on plan assets was 6.77%. For 2021, that figure was down to 4.34%. The screencap below from the 2021 Annual Report shows the benefit payments which the business believes it will have to pay in the next five fiscal years.

Debt

As stated above, Valvoline as approximately $1.7 billion in long term debt. The precise figure is $1.677 billion of which $1.610 billion is made up of two notes and term loan. The notes and term loan will be the focus of this section. The description of the notes below are taken directly from p. 94 of the 2021 Annual Report:

“The Company's outstanding fixed rate senior notes as of September 30, 2021 consist of 3.625% senior unsecured notes due 2031 with an aggregate principal amount of $535 million (the “2031 Notes”) and 4.250% senior unsecured notes due 2030 with an aggregate principal amount of $600 million (the “2030 Notes” and collectively with the 2031 Notes, the “Senior Notes”). The Senior Notes are subject to customary events of default for similar debt securities, which if triggered may accelerate payment of principal, premium, if any, and accrued but unpaid interest. If a change of control repurchase event occurs, Valvoline may be required to offer to purchase the Senior Notes from the holders thereof. The Senior Notes are not otherwise required to be repaid prior to maturity, although they may be redeemed at the option of Valvoline at any time prior to maturity in the manner specified in the governing indentures.”

Per p. 94 of the 2021 Annual Report, the 2031 Notes were used along with cash and cash equivalents on hands to redeem 4.375% senior unsecured 2025 Notes with an aggregate principal amount of $800 million. Again on p.94, the 2030 Notes were used along with cash and cash equivalents to redeem 5.500% senior unsecured 2024 Notes with an aggregate principal amount of $375 million. A portion of the 2030 Notes were also used to prepay $100 million on the business’ term loan facility with the remainder being used for general corporate purposes.

The term loan is part of the “Senior Credit Agreement”. The term loan had an outstanding balance of $575 million at issuance but because of the $100 million prepayment described above it is now at $475 million. This is a secured credit facility unlike the notes and is due in five years. In addition to the term loan, Valvoline may draw on a five-year, $475 million revolving credit facility which includes a $100 million letter of credit sublimit. Per p. 95 of the 2021 Annual Report, “At Valvoline’s option, amounts outstanding under the Senior Credit Agreement bear interest at either LIBOR or an alternate base rate, in each case plus the applicable interest rate margin. The interest rate fluctuates between LIBOR plus 1.375% per year and LIBOR plus 2.000% per year (or between the alternate base rate plus 0.375% per year and the alternate base rate plus 1.000% per year), based upon Valvoline’s corporate credit ratings or its consolidated net leverage ratio, whichever yields the lowest rate.”

In closing of this section, I’m not exactly a huge fan of a business that does roughly $3 billion in sales having this much debt, but at least the notes are unsecured and at rates under 5%. I also like that the business made a sizable prepayment on their term loan and haven’t drawn upon the revolving credit facility. Overall, I’d prefer that the company have much less debt. I don’t think the debt load deserves a full red flag, but it is something to keep a close eye on.

Valuation

Below is a screencap showing the free cash flow that Valvoline has generated since it went public.

In addition to having almost no growth in free cash flow since going public, revenues have only grown from $1.929 billion in 2016 to $2.981 billion in 2021. That is a CAGR of 7.52%. Total assets as of fiscal year-end 2021 were $3.191 billion while total liabilities were $3.056 billion. Neither the free cash flow, revenue CAGR or assets to liabilities jump off the page to indicate that Valvoline is a great business.

What Valvoline does have are pretty good returns on invested capital (ROIC). Please refer to previous writeups to see how I calculate ROIC. The figures are shown in the screencap below.

In addition to having pretty good ROIC, Valvoline has repurchased $562 million worth of shares since going public and paid $353 million in dividends over the same timeframe. I don’t short stocks, but I’m not sure how this business is worth its current market capitalization of ~$5.5 billion even with its above average ROIC, share buybacks and dividend payments.

I even went ahead and did an estimate on Valvoline’s return on incremental invested capital (ROIIC). Please refer to previous writeups to see how I do this. The screencap below shows the value compounding rate of the company since it went public.

By my estimates, Valvoline has been compounding value by 9-12% per year since it went public. Per TIKR, the stock price over the same period has compounded at ~5% per year indicating a bit of a spread between what the business is actually doing versus what market participants are willing to pay for it. Regardless of the spread, Valvoline hasn’t compounded value at a level that I’d like to see.

What Is So Interesting About Valvoline Then?

What makes Valvoline interesting is that management is pursuing a separation of the two business segments. You can find the press release here. Stephen F. Kirk, the Chairman of the Board, said, "Following a comprehensive review of strategic alternatives by the Valvoline Board of Directors and executive management, we believe that a separation of our business segments will create significant and sustainable value for our shareholders, employees and other stakeholders, and will best position the Retail Services and Global Products businesses for continued long-term success." Sam Mitchell, CEO, added, "Our confidence in separating these two strong businesses reflects the tremendous progress we have made in our strategic transformation. Retail Services now generates more than half of our adjusted EBITDA and is growing at an exceptional pace. The separation will allow Retail Services to continue its growth and focus on leveraging its world class service model. Global Products is a market leading, high cash generating business, which we believe will thrive well into the future with the opportunity to focus and allocate capital to its own strategic priorities." Valvoline is working with Goldman Sachs on the separation and have kept quiet about how it’s going to happen. It is unknown whether each business segment will be publicly traded or if they’ll sell one and keep the other, etc.

My hope is that the Retail Services segment stays public because I think it’s interesting and worth your attention. If you’ve read this far then you have come across some interesting statistics and comments about the Retail Services segment; it has a long growth runway, same store sales have increased for 15 straight years, the segment now contributes more than half of “adjusted EBITDA”, etc. Valvoline also provided a slide deck in June of 2021 titled “Retail Services Key Metrics” which provides more information about Retail Services. You can find the presentation here. The four screencaps below provide most of the relevant information regarding the potential future growth of Retail Services.

The first big takeaway is how much Valvoline expects Retail Services to contribute towards EBITDA over the next several years. This reinforces my opinion that Retail Services has a long growth runway while the Global Products segment is facing headwinds. The industry trends highlighted in the second slide don’t seem unreasonable either. Vehicles are only going to become more sophisticated and require synthetic oil products that Valvoline provides. Being a millennial, I agree that I would rather pay someone to change my oil for me (DIFM) rather than going to a store, buying motor oil and doing it myself (DIY). For full transparency, I currently do not and have not owned a car in several years, but when I did, I never once changed my own oil. The last two slides seem like reasonable growth projections as well because they don’t rely on taking over the world to work. Retail Services seems to have a simple, proven and replicable strategy that could be utilized to compound shareholder value. I do think referring to increasing store count and same store sales as a “Growth Algorithm” is a bit generous, but there appears to be a lot of runway left given that management believes there are over 10,000 quick lube locations in the United States and Canada alone. I have not come across anything about how Valvoline thinks about the growth potential of Retail Services outside of the United States and Canada. One thing to highlight in the final slide that I posted is the growth in average ticket and the non-oil change revenue. The average ticket is up over 16% since 2018 with non-oil change revenue making up about 23.5% of the current total ticket. This combined with the unit growth of 5-7% more stores every year seems like it could be a winning combination. Lastly, the transition to more non-oil change revenue is something you want to see as internal combustion engines are phased out.

You may be wondering about how Valvoline is going to deal with electric vehicles. Honestly, this is a long-term concern for the business. I will not deny that. Management has taken this issue head on though. Per the Q1 2022 Press Release, Valvoline claims to be the world’s number one supplier of battery fluids to electric vehicle manufacturers. The business has also started an electric vehicle service pilot program. Per the Q1 2022 Investor Presentation, the program includes tire rotation, air filter and wiper replacement, 12v batter replacement, key FOB battery replacement and a safety inspection. The presentation also states that additional services will be evaluated during the pilot program. The CEO was asked about the state of Valvoline’s electric vehicle services the Q1 2022 investor call. One interesting thing that he said was, “You know… it’s going to take some time for, you know, the EV market to be significant in size, but what we’re doing now is to prepare for that future…” In regards to the revenues that Valvoline has seen from electric vehicles, he said, “…I would say, you know, based on some of, uh, you know our insights, as we’ve been studying EV’s over the last few years is that it could be that frequency might be a bit less versus an internal combustion engine, but the service offering and the revenue from that transaction, um, you know, might be very attractive for us too. Uh, but we’ll learn, you know, in the coming year and years so, um, that we’re positioning Valvoline to continue grow and thrive no matter how those vehicles are powered. And that’s our approach to EV’s, to the hybrid market, internal combustions engines, the opportunities we have in the fleet market, etc.”

Management only breaks out how much revenue, EBITDA and adjusted EBITDA each segment contributes to the overall business, so I don’t know what the ROIC or ROIIC is for Retail Services. Other unknown figures are the debts and pensions obligations for each business segment, so you must take that into consideration if Retail Services does in fact separate and stay publicly traded.

Conclusion

Do I think Valvoline is a compounder? Not as it currently stands. I’m not a fan of how management is compensated and that they own less than 1% of the outstanding stock. I also do not like the debt load. To be fair, I don’t think these dynamics are detrimental to the business, but they certainly don’t do it any favors. Additionally, the Global Products segment is a drag on the overall business and I think management is right to separate it from the Retail Services segment. My hope is that they decide to keep Retail Services public. I think that business segment is interesting and possibly worth an investment given the right price given all that it has going for it. However, it is not a no-brainer idea. At this time my approach will be to wait and see how things play out with Valvoline and its separation.

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