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Pennzoil-Quaker, Pt. 2
The final thought (?) on the finalist

by Jeff Fischer (TMFJeff)

ALEXANDRIA, VA (March 24, 1999) -- We must decide the fate of finalist Pennzoil-Quaker State (NYSE: PZL) today. Following yesterday's column, today is our fourth look at the company.

Much like Campbell Soup (NYSE: CPB), Pennzoil has new management who wants to create a company worthy of a premium valuation. That won't be easy, but the new man in the saddle at Pennzoil thinks he can do it.

CEO James Postl arrived at the company last Fall after serving as president of Nabisco, where he increased Oreo cookie sales 42% in two years and boosted annual profits 50%. Selling oil isn't much different -- it's a low growth commodity that moves largely on brand name, and we already know that Pennzoil and Quaker State are the two leading motor oil brands in the country. They account for over 35% of retail market oil sales and 60% of the oil used in quick-change centers.

Mr. Postl aims to grow annual sales 2% to 3% by increasing advertising and through economies of scale -- meaning, in this case, capitalizing on the company's size and relationships with retailers and quick-change centers for premium shelf-space and promotions. Much like Campbell Soup and its aggressive goal to grow condensed soup sales over 5% annually, aggressive marketing alone isn't enough to push earnings growth into double digits. Cost cutting is also necessary. Having merged, Pennzoil-Quaker State wants to cut costs by up to $125 million per year by eliminating duplicate offices, plants, and distribution centers.

Decreased costs increase earnings per share, but it doesn't improve sales growth. For growth beyond 2% to 3%, Pennzoil-Quaker State will focus on growing its automobile care business (waxes, tire car, rain guard, etc) because these sectors are growing 15% to 20% annually -- monstrous gains compared to anemic 1% gains in motor oil. Just recently, Pennzoil-Quaker State acquired Blue Coral car washing products, Slick 50 motor oil additives, and Axius automotive products. The company plans to increase automotive product sales to $1 billion in the next five years. (Pennzoil-Quaker State currently has over $3 billion in total sales, much of it motor oil.) However, sales in this division declined last quarter on slow demand, despite increased advertising.

Much of what we have here reminds me of Campbell Soup. Pennzoil-Quaker State is trying to increase sales and earnings in a slow-growth commodity product through increased advertising (which has had mixed results at Campbell), by focusing on related but different products (like Campbell with crackers and cookies -- the problem is these divisions still account for a small percentage of overall sales), and by acquisition, which isn't organic growth and often adds debt to the books. (Both of these companies have substantial debt -- not that smart acquisition through debt is a bad thing.)

Much like Campbell, this stock's performance is largely contingent on management's ability to power past meager industry characteristics and grow via sheer ambition, marketing muscle, and smarts. Coca-Cola does it in a slow-growing domestic beverage market. Campbell did it one quarter before hitting slow sales in the warm winter, and Pennzoil-Quaker can probably do it sometimes, too. But over the long run, can it consistently grow sales and earnings at a double-digit, market-topping pace?

That'll be very difficult for a few reasons. One is that oil prices are not in the company's control, and it already sells oil at a premium price compared with generic motor oils. Another is that cars, the source of most retail sales for motor oil, are becoming more and more efficient. Pennzoil-Quaker State and its Jiffy Lube branches recommend that you change your oil every three months or 3,000 miles, but new cars often state that you need to change your oil only every 15,000 miles. So, will consumers change oil four times before they reach 15,000 miles, or not at all? Increasingly, as new cars replace old, probably not at all until 15,000 miles.

Campbell Soup has market-leading profitability margins. Pennzoil-Quaker State's margins are low enough to mirror those of a capital-intensive behemoth like General Motors, with profit margins skimming below 2%. Of course, margins aren't everything. Consistently high inventory turnover can easily compensate for low profit margins. Home Depot (NYSE: HDT) and Wal-Mart (NYSE: WMT) are prime examples. Divide the cost of goods sold over a time period (typically one quarter or a year) by the inventory left at the end of the period to see how many times a company "turned" its inventory in that period. Pennzoil-Quaker State turned its inventory four times in 1998. You wouldn't expect a company in this industry to have incredibly high inventory turns, but this compares with double-digit inventory turns at other leading retail sellers.

Pennzoil-Quaker State had 1998 gross margins of 31.4% (sales minus cost of goods sold = gross earnings, which gives you gross margin) and operating margins of 4.8%. Administrative costs are high at the company, keeping operating margins down, but perhaps a portion of them will be cut with the merger. Net margins were 1.6% -- the company has steady interest expenses on its billion-dollar debt level.

Today a Fool posted on our Drip Companies message board:

"I purchased [Pennzoil-Quaker State] several
months ago based upon several articles I'd read
about the company in Barron's and other
publications. Also [it] had been a recommended
purchase by several analysts on CNBC. Purchased
@$31 pre-split and now languishing around a
combined $22.00.This company rebuffed a
[take-over] offer a couple years ago in the
$80.00 plus range. What are prospects for this issue?"

The question is a good one.

The current snapshot of the company shows a profitable operation with manaegable debt and decent equity, a high dividend yield, and great brand name products but in a slow growing, less than ideal niche. Overall, however, the merged company proves too new to realistically analyze. We invested in Campbell Soup partially due to new initiatives (which I still think will pan out, because I believe in management's ability to make something work), and we're suffering losses because some of Campbell's first initiatives aren't living up to the promise. With Pennzoil-Quaker State, initiatives and prospects are even less certain given the industry, and the business model isn't nearly as favorable profit-wise.

Decision: We must take a wait-and-see approach on the company. Let's see what a few quarters look like for the combined entity. Let's see what management comes up with next. Mainly, let's give this new merger some time to mature and see what kind of company we've got. (This year is transitional for the newly formed company. Revenues should grow only 2% and operating margins should be around 5% again.) Pennzoil-Quaker State goes on our Watch List. (Our Watch List is new as of today. I'll throw Coca-Cola, PepsiCo, and Pfizer on it, too. More on this later.)

A month ago we mentioned that we'd consider Pennzenergy (NYSE: PZE), the company spun-off from Pennzoil. The yield on the stock is only 2.3%, however, not 8% as was thought, so we're not interested.
Pennzoil-Quaker State made our Watch List, but the only companies remaining on our Finalist List are BP Amoco and Exxon/Mobil. We'll begin to look at these two tomorrow.

For discussion (we further discussed Pennzoil-Quaker State on the boards today), please visit the Drip Companies message board.

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