Ultramar Diamond
Is this shamrock lucky?

by Jeff Fischer (TMFJeff@aol.com)

ALEXANDRIA, VA (Feb. 24, 1999) -- Part two of our look at Phillips Petroleum (NYSE: P) is today's consideration of Ultramar Diamond Shamrock (NYSE: UDS). The two companies have planned to create Diamond 66, a joint venture that will merge Ultramar's North American downstream operations (namely, refining and marketing) with those of Phillips Petroleum. This will nearly double Ultramar's number of gas stations. Overall, the partial joint venture means: consider both companies side-by-side first.

Yesterday was the overview of Phillips. The company's profitability is strong enough that it wasn't flogged off the stage. Today we consider Ultramar. As usual, we first scratch the surface to see if there's anything of value under the mud. If we like what we see initially, we'll shine our investigative flashlight much brighter in round two.

Description: Ultramar Diamond Shamrock was formed by the 1996 merger of Ultramar and Diamond Shamrock. With $11.1 billion in 1998 sales (up 2%), the company is the second-largest independent oil refining and marketing firm in the United States, behind only Tosco (NYSE: TOS). Ultramar focuses on the southwestern U.S., the northeastern U.S., and eastern Canada. The company owns seven refineries and has the capacity to produce 650,000 barrels of oil daily. In 1997, our guy Ultramar stepped forward and bought Total Petroleum North America from TOTAL for $1.3 billion.

$1.3 billion. Thatsa lotsa meatballs!

Ultramar runs 6,300 gas stations and operates petrochemical, home heating oil, natural gas liquids, and convenience store businesses. Most of the company's U.S. and Canadian convenience stores operate under the Diamond Shamrock, Total, Ultramar, and Beacon names. As for Phillips: last year Ultramar agreed to form a joint venture with the company for $800 million. Ultramar will own 55% of the combined downstream operations of the two companies. Following the merger, Ultramar gas stations will operate in 40 states (up from 23) and six Canadian provinces.

Financials: As always, the key elements that we focus on are: 1) How does the market value the company? 2) How profitable are its chosen operations? 3) How does the company finance operations? 4) And what does management do with the money that it earns?

Valuation: With 87.6 million shares outstanding and a share price hovering around $18, the company has a market capitalization of $1.6 billion. Ultramar recently had $105 million in cash and over $2.5 billion in long-term debt. (It's not exactly a Cash-King or Rule Making company; we've found that not many oil companies are!) When the debt and cash is considered in the company's valuation (adding the debt and subtracting the meager cash to find the enterprise value), Ultramar is priced above $4 billion, putting it in mid-cap land.

Ultramar's book value is an encouraging $17.23 per share, which might -- for now anyway -- put a floor beneath the falling stock; the stock hasn't yet declined below book value. In fact, it now trades just above book value, at "1.08 times book, baby." (Say that like you really mean it this time.)

Profitability: Ultramar provides an excellent summary of 1998 in its year-end report, detailing each business operation to the dollar. Last year, retail operations held the ship afloat as refining took a swan dive along with oil prices. Retail operations are our primary point of interest, because they'll impact Phillip's operations soon. (By the way, which company would we buy, Ultramar or Phillips, if they should both pass our tests? Well, that's something that we'll need to decide later, which is why we're considering both companies as a whole first, before considering them -- if at all -- with the new merged operations.)

Anyway, for profitability we look at a company's return on capital employed (ROCE), which you should understand by now. We found Phillips' ROCE to be 14% in 1997 and 4.6% last year. Those are decent results compared to most of our candidates. In Ultramar's case, if 1997 margins had prevailed in 1998, which is the company's base for measuring improvement, ROCE would have been 9.6% last year.

9.6% is near the high-end of our companies, but keep in mind that margins in 1997 were record-high for most oil companies. By contrast, in 1998 our Ultramar Diamond Shamrock wasn't so lucky; it lost money due to lower oil prices and extraordinary charges. In fact, all of its profitability ratios were negative except for gross margin (of course) and operating margin (which is profit after expenses and product costs, but before taxes and charges). The operating margin was 3.1%. In 1997, the operating margin was 3.5% and the net profit margin equaled 1.4% -- well below Phillip's 5%. Overall, Shamrock's (as it were) recent 9% ROCE is worthy of at least a one-handed clap.

Leverage: Yowsa! This company is a debt-king.

Ultramar has over $2.5 billion in long-term debt and a pittance in cash by comparison. Overall, its long-term debt-to-equity ratio is 1.24, with $2.5 billion in cold, icy debt striking up against $2 billion in shareholders equity. (Picture the Titanic striking an iceberg, except not that hard -- Ultramar is far from sinking by any measure.)

Use of Cash Flow: There is positive cash flow and it will be used to service the debt and pay the handsome 5.9% dividend yield. Period. (Pretty much.)

So, is that yield enough to make us approach the company's Dividend Reinvestment Plan with our tongue-lolling? Well, unlike our other high-dividend yielding candidates, over this decade Ultramar's stock did beat the S&P 500 until the end of 1997. Since then, it has fallen significantly behind, but that's largely (if not completely) due to industry conditions.

However, you can't forgive a company's performance due to its industry. That can belie the point of investing, because even great, excellent, tremendous, mind-blowing companies operating in mediocre or very questionable industries (over the long term) are to be avoided. (Is the oil industry mediocre? We're still learning.)

Snapshot: Click here for Ultramar's business snapshot, financials, SEC data, stock quote, earnings estimates, message board, and much more. The Fool conveniently offers all of this for every public company in one place (along with portfolio tracking tools, too). We hope that you enjoy all of this free data as regularly as need be. (You can also visit the company's website at www.diasham.com.)

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Conclusion. Da da da dum! Da da da dum!

Beethoven's Fifth We leave the final vote up to you, so please chime in. Tonight, the next few days, and over the weekend, post the thoughts (however basic) that you have on Phillips and Ultramar. Do we keep one or the other? Should we keep both and look closer at each in round two? Or do we dump them both and move on? Your belief is important. In fact, the collective belief of the community is what we, as a portfolio, will act upon. So, hopefully we'll see you on the Drip Companies message board.

Tomorrow Brian will begin to consider the next company on our list: Sunoco (NYSE: SUN).

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