Drip Portfolio Report

<THE DRIP PORTFOLIO>
Finalist Pennzoil-Quaker
The "Procter & Gamble" of the oil biz

by Jeff Fischer (TMFJeff)

ALEXANDRIA, VA (March 23, 1999) -- Compared to Sunday's Academy Awards, today's study of an oil company finalist will be among the most exciting five minutes of your life.

Our finalist: Pennzoil-Quaker State (NYSE: PZL).

We first looked at Pennzoil-Quaker State in two parts: part one and part two. The company is considerably different from our two other finalists. Giants such as Exxon and Amoco BP make money by drilling for oil, refining it, and finally marketing it. Pennzoil-Quaker State is mainly a marketer of consumer oil products, which in many ways makes it closer to Gillette than it is to Exxon. In fact, Hoover's calls Pennzoil-Quaker State the "Procter & Gamble" of the auto world.

Is the company a brand leader like Procter & Gamble?

Yup. Pennzoil and Quaker State motor oil are the top two in the country (Pennzoil is #1), and together they hold over 35% of the U.S. market. Pennzoil-Quaker State also owns the largest chain of quick oil change stores with 1,500 locations -- it's everybody's favorite, Jiffy Lube.

In 1998, Pennzoil alone achieved sales of $1.8 billion, an 8% decline from 1997. The decline was due partially to lower oil prices and restructuring. The company merged with Quaker State and the merger was accounted for as a purchase on December 30, 1998. On a pro forma basis (or a continuing basis), the newly combined company had revenue of $3.0 billion. All of the following figures, however, are as the company reported them -- that is, they're Pennzoil numbers only. Despite this, we'll share Quaker's numbers, too. (Beginning in the current quarter, only the combined figures will be reported -- that'll be nice.)

Somewhat like Campbell Soup, Pennzoil-Quaker State divides its business into three main segments.

Lubricants and Consumer Products. Representing a majority of revenues for Pennzoil, this division had sales of $1.2 billion in 1998. Adjusted for charges, operating income totaled $104.6 million, up 16% compared to 1997. Net profit margins in this division were over 11%. Income rose because motor oil and other lubricating product's sales volume increased 4.8% and 9%, respectively. Also helping were lower raw material costs, lower expenses (always good), and a full year's worth of income from the acquisition of Snap Automotive Products.

Pennzoil motor oil remained America's number one oil for the 13th consecutive year, with 21.8% market share compared to 21.5% in 1997. Other consumer products sold in this division are:

Autoshade
Black Magic tire and wheel care
Blue Coral car waxes and washes
Classic Car Wax
Fix-a-Flat (a recall in 1998 cost PZL money)
Gumout
Rain-X glass treatments
Slick 50 engine treatments
Snap maintenance chemicals
Westley's tire and wheel care
...and more

In oil and related products, Quaker State alone had 1998 sales of $1.02 billion (down from $1.07 billion), giving the combined companies annual oil and consumer product sales of over $2.2 billion.

Base Oil. The second-largest division, base oil and specialty products, achieved 1998 operating income of $6.5 million on sales of $745.3 million, for profit margins below 1%. Revenue declined 19% from 1997 primarily due to lower market prices for refined oil products and an exclusion of some sales following restructuring (an ongoing theme). In this division, Pennzoil-Quaker State's Excel Paralubes division and Penreco division both have sales agreements with Conoco. This oil isn't sold in fancy bottles on shelves but primarily to other service retailers. Quaker State doesn't report numbers for this division.

Fast Lube Operations. The majority of Pennzoil's fast lube business is Jiffy Lube. Jiffy Lube reported an operating loss of $33.7 million on 1998 revenue of $335.9 million. Adjusted for special charges, income was $10.7 million, down from $24.5 million in 1997. The decline in performance was primarily due to a drop in same-store sales and increased expenses (never good). Management states that these problems are being addressed and same-store sales are on the rise again. Quaker State reported $171 million in sales (up from $146 million) from fast lube operations, namely its 600 Q Lube locations.

Combined. For the year, Pennzoil and Quaker State were able to combine these three business lines to earn, on a pro forma basis and disregarding one-time merger costs, $48.4 million, or $0.62 per share, on $3.03 billion in sales. The $12 stock trades at 19.3 times those results and pays a 6.0% dividend yield.

Although management warns that this is a transition year and revenue should rise only about 2% and pre-tax, pre-interest margins will be just over 5.5% again, the lone analyst covering the stock expects $0.74 per share in earnings, followed by $1.10 in the year 2000. The stock trades at 16 times and 10.9 times those estimates, respectively. A long-term growth rate of about 10% might be aggressive, but it is likely if oil prices rise steadily and if management of the merged company can execute cost-cutting and sales volume growth.

Today's Conclusion. What this company lacks is a long history of dividend increases and share buybacks, strong profit margins, cash rather than long-term debt, and -- as far as we can tell -- sustainable market-beating sales and earnings growth. The company misses on many of our investment criteria, yet the strong brand name, respected management with new initiatives, potentially reasonable valuation, and high dividend yield make it somewhat of a conundrum for us. It does have half of the attributes we seek, and it has them strongly. Tomorrow we'll consider management's strategy and more numbers in attempt to reach a conclusion.

To discuss PZL and share your vote on it, please visit the Drip Companies message board.

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