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Morningstar | Despite Sluggish North American Lubricant Sales, Valvoline's Advantages Leave Shares Attractive

While we plan a high-single-digit percentage reduction in our $22 fair value estimate for narrow-moat Valvoline, we are more sanguine than the market about the firm's long-term prospects (the shares slid more than 20% after first-quarter results were released). Although the North American lubricant unit disappointed, we believe the trading reaction underestimates Valvoline's strength as the market premiumizes, leaving the shares somewhat attractive even after the expected fair value estimate cut.

Valvoline saw 2% sales growth against an 18% adjusted EBITDA margin. Management cut fiscal 2019 guidance to 6%-8% sales growth (previously 7%-9%), adjusted EBITDA of $470 million-$485 million (from $480 million-$495 million), and adjusted diluted EPS of $1.31-$1.39 (versus $1.35-$1.43). Our targets had been on the lower end of the prior sales and adjusted EBITDA ranges, at 7%, $484 million, and $1.42, respectively.

The North American lubricant unit was the culprit as a competitive environment exerted price pressure, leading to a 7.6% revenue dip. Results trail our low-single-digit full-year growth target, but we are encouraged that the competition was concentrated in the lower-margin conventional segment. Valvoline has done well to premiumize, with branded premium products' share of sales approaching 50% in the quarter (up 200 basis points from the same period last year and around 30% in fiscal 2013). We expect the shift to pay off long term as older vehicles are replaced with newer models that require synthetic lubricants. Valvoline said it is targeting $40 million-$50 million in cost savings by fiscal 2020 from restructuring the unit (4%-5% of fiscal 2018 segment sales). We believe that this is a positive step to improve efficiency and that past patterns will re-emerge, with price competition easing as raw material-related inflation stabilizes. We expect low-single-digit segment sales growth against mid- to high teens adjusted EBITDA margins long term.

International lubricant volume also trailed expectations, growing 1% (adjusted for a business model change in Brazil) versus our 4% full-year target. However, we are encouraged that the unit's adjusted EBITDA held steady in the quarter, better than our call for a low-double-digit slide for the year. We continue to expect the unit (which accounted for about one fourth of fiscal 2018 sales) to drive the company's growth, though macroeconomic considerations could result in near-term agita, particularly in China, where Valvoline is building a blending plant.

The quick lube unit (nearly 30% of fiscal 2018 sales) remains Valvoline's strongest, with same-store sales growth of nearly 10% that well exceeded our 6% full-year target (and management's original 6%-7% fiscal 2018 guidance, since raised to 7%-8%). We still believe the segment will drive top-line growth (mid-single-digit long-term forecast) and pace Valvoline's profitability, with our mid-20s long-term adjusted EBITDA margin target in excess of our roughly 20% average estimate for the firm overall. We contend that the unit draws a particularly attractive customer (premium lubricants' share of U.S. branded volume in the mid-60s versus around 50% for the North American product segment) and should serve as an advantage for Valvoline as customers shift away from do-it-yourself oil changes as vehicles become more complex.