Kerr-McGee & Pennzoil
Er, we mean Pennzoil-Quaker State

by Jeff Fischer (TMFJeff@aol.com)

ALEXANDRIA, VA (Feb. 16, 1999) -- We spent Thursday and Friday considering our fifth oil contestant, Kerr-McGee (NYSE: KMG), and this weekend Fools posted excellent thoughts on Kerr and its proposed merger partner, Oryx Energy (NYSE: ORX).

To read those thoughts (which show knowledge and insight beyond what we've discussed), visit our Drip Companies message board. Each relevant post has KMG or Kerr-McGee as its subject title. We left Kerr-McGee's fate in the air based upon your vote, and it was great to have your Foolish thoughts. Thank you to everyone who posted.

Before addressing the vote, let's consider the return on capital employed (ROCE) at the company and at its proposed acquisition, Oryx. ROCE is defined as operating earnings divided by the sum of total debt plus shareholders' equity. When an oil company tops double-digits in this category, as Mobil and Exxon do at 10% and 11%, it's a very good thing. Most of our candidates have had low single-digit ROCE results.

Here's how we find Kerr's ROCE:

Kerr-McGee had operating earnings for the nine months ended 9/30/98 (the latest 10-K that we can obtain) of $19.1 million. It had total debt of $1.44 billion ($892 million in long-term debt, $555 million in current liabilities). It had total shareholders equity of $1.65 billion. Adding the debt and shareholders equity we get $3.1 billion. We then divide operating earnings of $19.1 million by $3.1 billion to reach return on capital employed of 0.03%. Obviously small. Going through the same process on Oryx, the return is negative.

Of course, when oil prices rise operating earnings will jump, and Kerr-McGee's ROCE should increase significantly (although the debt it's assuming from Oryx will dampen the effect). However, even during a strong period in 1997, Kerr's ROCE was "only" 2.7%. Based on this, but more importantly on the posts that you shared on the message board, we're going to pass on Kerr-McGee, pass on it's merger partner Oryx, and pass on its hefty dividend. A 5.8% dividend yield doesn't do you much good if the stock depreciates, as Kerr has done over the past ten years.

So, another one bites the dust. The only survivors on our list so far: Exxon/Mobil and BP Amoco. Can our next contender be stronger? Turn out the lights, turn on the microphone, start the spotlights swinging over the crowd, and listen to the roar of the announcer...

Annnnnnnnd now, in this corner, wearing yellow and green, weighing in at a cool $1 billion in market value, the US leader in motor oil, contestant number six...

Pennzoil-Quaker State (NYSE: PZL)

Description: Another Houston-based giant, Pennzoil-Quaker State was formed in 1998 when the two well-known oil leaders merged to form the leading seller of motor oil in the whole dang country. Pennzoil has been the leading oil brand in the U.S. for years counting, but with the addition of Quaker State, the new company controls 35% of the country's market for motor oil. It focuses on this and other retail-related products.

That's right: no exploration and production.

The new company was spun-off from Pennzoil's oil exploration and production operations. (Bye bye giant, heavy assets.) Alongside selling oil in wholesale and retail chains, the company also sells many other products for automobiles, including fuel additives, Gumout, car wax, flat tire inflators, engine and fuel treatments, Rain-X, air fresheners and more. Beyond this, Pennzoil-Quaker State owns Jiffy Lube International, with 1,500 locations. (Half of them are franchised.) Also, from the Quaker side of the family, the new company runs over 600 Q Lube oil-change centers in the US.

Pennzoil-Quaker State is our pure play in retail motor oil and other auto products that you buy off a shelf, rather than from a pump. In today's oil environment, that plays in the company's favor. It isn't experiencing plummeting sales and profits as are oil explorers and producers. And what else does the company have going for it? If you're an Indy car racing fan, you probably have fond memories of Rick Mears and his yellow Pennzoil Indy car, or of Teo Fabi and his green Quaker State Porsche. Cool, man. Let's buy this company.

Financials: Okay. We can't be that free-wheeling in our decision. We'll look closely at the company before buying it on sentiment alone, of course. So, moving on: we now consider valuation and profitability on the surface level.

Valuation: Since its 1998 creation, the stock of Pennzoil-Quaker State has far from boiled. Instead, it cooled and sank. At a price of $13, the company (with $3.2 billion in annual sales) is granted a market capitalization of $1.01 billion. As of its last 10-K from September, Pennzoil-Quaker State had $376 million in long-term debt and $6.6 million in cash, putting its enterprise value at about $1.371 billion. Its book value is $6.08 per share, putting the stock at 2.3 times book.

Pennzoil-Quaker State is estimated (by some) to earn $1.02 per share this year, putting it at just over 13 times earnings. Over the next five years, it's estimated that the firm can grow earnings 10.3% annually (the low estimate is 7%), while the S&P 500 overall is estimated (guessed) to grow earnings about 7.2% annually.

Profitability: Big Yellow and Green (our new nickname for the company) achieved net profit margins (which is net income divided by revenue) of 0.5% in the nine months ended 9/30/98. On sales of $1.4 billion, the company earned $7 million. Before an income tax provision, it earned just over 1% net profit margins. More meaningful in the long term, the company's gross margin (found by sales minus cost of goods sold divided by sales) was 35% -- quite respectable.

Obviously, the low net margin at Pennzoil-Quaker State isn't the greatest, but it's a volume business and the newly merged company should uncover more efficiencies. For comparison, although the businesses are different, recall that Exxon's net profit margin was 5.5% in 1998, and Mobil's was 3.2%.

Return on capital employed is a slightly different beast with this company, too, but the results are about the same as we've seen with most of our oil companies. For the first nine months of last year, Pennzoil-Quaker State had operating income of $15.6 million, total debt of $1.2 billion (most of it short term), and shareholders equity of $290 million. So its ROCE is 1%. Using only long-term debt and not current liabilities in the figures, ROCE jumps to 2.4%

Preview. Tomorrow we'll continue our look at Pennzoil-Quaker State by considering leverage and cash flow. We'll try to reach a conclusion, too: does it make Round Two or Bite the Dust? If you have thoughts on the issue, now is the ideal time to please share them!

Today. We added our late January Mellon Bank (NYSE: MEL) purchase statistics to our numbers today, as shown on our transaction page. Also, Campbell Soup (NYSE: CPB) reported earnings that were 27% below last year's results. We'll take a gander at that before the week ends. Also by the end of the week, we'll announce where we'll send our $100 (plus $40 more, due to our lost check from November) for the month's investment.

See you on the Drip Companies message board. Fool on!

[To discuss these columns, please visit the Drip Companies message board on the Web.]

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