Valvoline Inc. (VVV) Earnings Call Transcript & Summary

Good afternoon. Welcome to this 3:00 slot with Valvoline. Thank you for being here. I'm pleased to have with us Lori Flees, CEO; and Mary Meixelsperger, CFO, who's announced an intent to retire if and when we find a replacement. I'm going to introduce, read a quick disclosure and then ask a question and then sit down and have a discussion for the next 37 minutes. For important disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. I was reminiscing with Mary, and the first time we met probably 7-ish years ago.

Longer than that.

8 years?

Longer than that. Like 8.5.

8.5. In Lexington when this is still part of a bigger corporation, and we had to follow base oils a little more religiously on what journey this company has gone through. And the core was always a great Quick Lube oil change business that we would have to spend long periods of time explaining why they're oil changes per day were so much higher than the rest of the industry. And this is the story that is left with Lori now leading the charge. So the story has evolved quite a bit over the past few years, and now it's positioned as a pure-play with a refined capital structure and new management. Can you talk about how you've adapted to these significant changes and how you're positioned for future growth?

Sure. Thanks, Simeon, thanks for having us. Yes, Valvoline has gone -- undergone significant change in the last couple of years as we've transitioned to a pure-play high-growth retail services provider. If you think about in 2023, we sold half of the business from a top line perspective, the Global Products division. We sold that and started focusing and investing specifically on retail. And then in 2024, we completed the full separation. We had transition services agreements, and we were -- we implemented a new ERP system in 2024 to really complete the separation of the 2 businesses in any way, shape and form. And throughout that process, we continue to deliver compounding growth. So we just delivered our 18th year of same-store sales growth. We had -- just in fiscal '24 alone, we grew the top line 12%. We grew our EBITDA of 17%. We now stand at over 2,000 stores as the market leader on transactions and revenue but yet our stores still only cover 35% approximate of the population. And I would say that our capacity in markets is not rightsized to the population that it serves. So there's still significant upside. We've also brought together an incredible leadership team that both includes veterans in Valvoline who've been in our retail business for more than 30 years but it also includes new talent from the likes of Amazon, Wingstop, McDonald's, Nordstrom, Zappos, et cetera. And that's because the opportunity in the business model that we have is tremendous. It's a great business, and it has a lot of growth upside. So it's a fun place to be. You combine that with a growing base of well-capitalized franchise partners. It's a pretty exciting play. So...

Another big milestone, Lori, was passing the $3 billion mark in system-wide sales this past year. So that was really exciting as well. When I started the month before you and I met, Simeon, we were less than $1 billion of system-wide sales. So it's been a really exciting journey.

Great. And we'll get back to why you do so many oil changes per site per day. A year ago, we caught you with less experience at the helm. You were new. I think I asked you to compare and contrast. But I guess, what surprised you? What didn't you fully appreciate that you do now?

Well, there's a lot that doesn't surprise me but excites me about the business. So you think about, we have 5% market share, but still a lot of white space to add. So there's still tremendous opportunity for growth. And our return on new units, whether it's ours or a franchise partner's is still impressive. Considering a ground lease, it's in the mid-teens IRR. So really amazing return on invested capital in our space. We also have a lot of upside just running the core business better. When you look at -- we quartile our business, when we look at the ability to grow transactions, the ability to grow non-oil-change revenue service penetration. And then just broad margin expansion. There's still a lot of opportunity. Now what has surprised me in this last year is we were quite open over a year ago that we were open and really wanted to encourage new franchise development. We wanted to accelerate the pace of franchise unit growth. And I would say the interest in franchise partners wanting to invest in our business has been stronger than I expected, honestly. And I think some of that comes because of the resiliency of the business, but also we create the recipe for a very tight standard of deviation on operating results and our franchisees can create great returns. If you think about -- we said we wanted to double the number of units our existing franchise partners. We're developing on an annual basis. We're well on track to that. When you look at the commitments that our existing franchise partners have made. And we also said we wanted to bring new partners into the system. We said we'd do that in 1 of 3 ways. We would take white space areas that we didn't have stores and we would invite franchise partners to do that. We've done that. We have 3 new partners in brand new spaces that they're building, actively building a pipeline for. We also said that we had some retiring franchisees. We have franchisees. We've had in business, on average, 25 years, but some that have been 30-plus years, and they're at a stage where they don't want to invest more capital. They're looking at taking capital off the table. By saying we wanted to bring new partners in, we have -- we had 1 partner that just transitioned with a private equity backing, and they've now tripled just within a few months, tripled the pipeline of new stores for their markets and committed to significant growth beyond that. And then we also said we would refranchise markets where when you look at the capacity we have to build and really run stores and grow our store base, we said we wanted to get it in and around 100 stores. And that we were open to refranchising where we had a well-capitalized partner who would live up to the standards that we have for our brand, and they would want to develop those markets faster than we otherwise would. We -- within this very short period of time, we did 3 different transactions, which in each of those cases, when you combine them up, we will triple the number of stores in those markets within a very short period of time. That kind of acceleration, we thought, would take more time. As soon as we made it known that we were open and wanted new partners, the level of interest was surprising. It's great because it's a great -- it's a testament to the business model and the return, but that is the one thing that I found quite surprising this last year.

When we visited at headquarters, and I think it's been twice since you've been running the company. One of the things that I think we noticed that investors is a much more institutionalized process around openings and the structure of franchise versus non, but also pipeline and development. And it's felt like then there must have been some opportunity to enhance that. Is that a fair observation?

It is a fair observation. We brought in our Head of Real Estate and Construction for Wingstop. He was at McDonald's. He was really used to working with franchisees. He went to Wingstop, continue that, but also just the pace of keeping up and understanding how to build a pipeline, both for company-operated stores but also for franchisees. It's something that he has significantly enhanced in our business.

Yes. 6% to 9% comp growth. I don't know if that's a monkey on Valvoline's back, but it will be a little less in the next year, 5 to 7. It's not too shabby. I don't know if we were spoiled for all those years. The model just kept producing that number or we will get back to that and how to think about the moderation, why, when do we get back? Should we get back?

Well, I'll first reiterate what Lori said earlier, 18 consecutive years of same-store sales growth in this business. And we believe that we still have a significant runway to continue to grow same-store sales. The guidance we provided for fiscal '25, the major change in the 5% to 7% guidance versus the 6% to 9% we had spoken about earlier is around net price. And so over the last 4 years, starting in '21, we saw significant pricing pass-through of inflationary costs in the business that substantially helped comp store sales growth, but didn't necessarily help from an earnings accretion perspective because it was really offsetting that cost increase, right? So think about the moderation in same-store sales really being around, we think that there's less demand or less requirement for us to pass through net pricing. We still think we have that ability in terms of if it's required, if we start seeing higher inflationary costs come back again. We certainly think that we have the ability to pass those costs through and benefit from a higher comp as a result of that. But we're thinking, without there being the impetus to do that, now is not the time, with a little bit more price-sensitive consumer out there now is not the time to be pushing harder around pricing.

So if I can just paraphrase it, it's not really an oil change velocity throughput. It's more about how price is woven itself throughout the P&L over the last few years and how it's going to appear in the next 12 months.

That's absolutely correct. We continue to see growth in transactions. And we're also seeing and have always benefited from premiumization, benefiting their comp as well as increased penetration of our non-oil change revenue services.

Yes. And there are a couple of competitors that are growing. This is not reflecting cannibalization, any kind of saturation or competitive encroachment?

So what I'd say is we have built a really robust real estate analytics model. So every time we look at buying or building a new store either for us or our franchise partners, we have the knowledge of all customers that go into any stores around it. And if that store is going to be more convenient. We know there's transfers. We expect transfers in our model. What typically happens is over time, we backfill the car park that leaves 1 store to go to a new store while we're filling the new store. And what's incredible about this business is that the returns are still very robust. We're delivering mid-teen returns on invested capital, and that hasn't changed. Even though we've had increases in construction costs, the performance of our boxes just continues to elevate as we drive more throughput and better margin in the business.

The other thing I would say, though, Simeon, is from a competitive landscape perspective, it's a highly fragmented market and continues to be a highly fragmented market. So I -- where we see the opportunity is the continuation, we're in the business of acquiring independent operators that make sense as proven by our real estate analytics. And we think that there's continued opportunity for us to grow through new store development, both company and franchise stores. I would tell you that we really haven't seen the competitive encroachment that you mentioned. While we are seeing certain competitors grow, we believe because of this highly fragmented space and combined with the consumer's desire for more convenience. We're really seeing our model, grow market share and have a continued long runway for that market share growth.

Back to the highly productive store base, the number of oil changes per day. The perception, Lori, that you came into the business, why we were so productive? Is it the same of why we still are so productive today?

Absolutely. I think, one, it is an incredibly consistently great experience. So the retention of customers is really high. And then you have a very sophisticated marketing engine that both reminds the customers when they need to come back, so they stay up to date on their maintenance, but it also is very good at acquiring new customers. We look at where we get our new customers from, 75% of them come from outside the Quick Lube market. We are drawing customers from across the market, consistent with where the market oil changes are done. So it is an incredibly strong business. And even our mature stores who've been running for decade or more, 2 decades, they're still growing in transactions. Now albeit at a smaller clip than our stores that are still maturing, but all of them -- all of our store segments, if you look at it by year, are growing in transactions.

And how important is real estate and at the actual location?

Real estate is critical. We are a retail business. And so proximity to housing and other retail throughput are what drive great real estate sites. So when we -- our real estate analytics capability has been built based on the 2,000 stores that we have opened, and it takes into account the car park demographics, the household demographics, traffic patterns, competitive locations, competitor locations, et cetera. But we've gotten to a point now where we can predict how successful a site will be before we have to either buy or build something.

Yes. The election and things that could be impacted in your business, your labor force, if we're fracking oil again, what that consequently means for EV and then other things that we can talk about. But what is your board -- what are your management conversations of what could happen?

Yes. I think there are a number of things when we look at it. Tariffs is the one that's being talked about a lot right now in retail. When you look at our cost of goods sold, less than 1/3 of our cost of goods sold is coming from products that we use in the service. Most of those have ingredients or are wholly sourced outside of the U.S. So depending on how much the tariffs are, we've seen a lot of variation in the conversation. I think some of what's going on now is they're testing the waters to understand the impact to businesses, consumer and the response rate, the response from other countries. So tariffs will likely increase our COGS base on the product side. But our supply chain is not unique. All of the competitors in our space will experience the same cost increases. And history has shown that when costs do rise, they pass towards the customer. Labor rates and interest rates. I don't really know how all of that will play out. We typically see some seasonality of our labor rates right around the summer. We kind of have a transition of labor. We have some of our workforce that goes into construction and landscaping for the summer, but then we get an influx of students who need jobs for the summer and they come back every summer or they go from part-time to full time. So we expect some labor changes. But exactly how that will play out, I think we still -- it's very unsure. I think the 1 thing that we're confident in is that the incentives for EV purchases for consumers, the investment in the EV infrastructure, is likely not going to be as strong under the new administration. And that just means the time frame for EV adoption rate is likely going to slow even further. It definitely has already slown in the last year or 2 since I joined the company, but I think some of that will extend. Now that's beyond the 5-year window we typically plan for. But even in certain markets in California, where the adoption rate was growing more steadily, we see some of that slowing down.

Can we tackle EVs broadly? It was something I was going to maybe look at, at the end. You answered most of the points. The adoption curve, what Valvoline is and was doing to position itself and then the overall level of either preparedness or lack thereof to what EV -- 20% EV population future could look like.

Yes. I think, one, I do think the adoption rates will extend out. The reality is the vehicles will still be a major purchase for in household and people will want to maintain their vehicles. I think they're going to want to know and have a more independent view of the battery health. But there's a lot more maintenance around the wheel well in terms of tire rotations because of the heavy battery of the vehicle. There's also more -- a little bit easier parts replacement more than what we do today, alignments, break cleanings, other things. We're learning a lot about how the technology is going to change the maintenance needs. So while there may be less fluid, there's still going to be maintenance. If you look at what current OEM providers are charging for that maintenance and you look at it on an annual basis, it's higher than the average ticket that we charge for our customers. We're always looking to be higher value than a dealer, an OEM dealer. But even with that, we see that There will still be healthy revenue to be earned and the customer is still going to want convenience. They're not going to want to give up their vehicle for a day or have to schedule it out in time. They're going to want something quick and easy from a trusted provider. So we see that as the technology evolves, we don't -- we're not concerned about it. We have to invest to understand what the maintenance will be and how we use our assets. But even in some of the pilots we've done and focus groups with customers, they don't want to give up on quick and easy. They do want it from a trusted provider, but Valvoline is a very trusted brand, and we have adopted our model as the car park has evolved, and we'll continue to do that.

Market share and competitive landscape. I think it's important in the sector that it's either less followed and there's just less data. So it's always helpful to get a state of the union. What's the largest competitor up to, we generally have a sense. And then where or -- not who, but where are the competitive encroachment, like which parts of the country is it happening? And are there many or just a handful?

It's an incredibly fragmented space. So 75% of the market is actually being served by dealers and/or general automotive repair and tire installation. And even within those spaces, they are very fragmented. When you look within our Quick Lube space, which is about 25% of the do-it-for-me oil change business, it's really -- there are 3 players that are of size, Jiffy Lube has always had over 2,000 stores. They're mostly franchise. There -- some franchisees are growing and some are shutting, but they tend to stay roughly at the same level. They've expanded their business beyond just oil change. They're now multipoint care. And so their proposition has changed significantly as they look to increase ticket as their traffic has come down. We have over 2,000 units. We do 50-plus cars a day in our stores on average that ranges like the range that goes much higher than that. And our ticket continues to grow as we add non-oil-change revenue services at a higher percentage of the customers we see than we have in the past. And then I think the next largest player is Driven, and they have about 1,000. I think between us and Take 5, we're growing stores at a pretty good clip. But as Mary said, there's such a fragmented market and the drive for convenience is high, that there is a lot of opportunity for growth in this category.

Have you ever shared a share gain or share target that Valvoline can occupy?

We haven't. We've talked -- we've only started measuring within the last few years what we estimated our share to be, which is about 5%. So you think about $3 billion in sales as a system, at 5%, you can quickly see that there's lots of opportunity. We've also talked about the fact that we aspire to double our network. So if you think about double our network at mature, that could be 10% at 3,500 stores. That would only get us to less than 60% or 70% of the population covered. Again, there's a lot of opportunities.

And Lori, we have talked a little bit about some of our markets we have market share that's 3 or 4 times what we see on average. And so we know that we can penetrate and significantly infill in markets where we operate today at a much higher level and see significant market share gains in those existing markets as well. So in some of those best-performing markets, we're seeing high teens market share relative to the overall DIFM activity that's occurring in those markets.

So we can double the 10% over time?

Well, the whole point is if we can get to the position we have in some of the stores that are 15-plus market share, like some are well above 15, that's a tripling. And really, it's about making sure that you have the right store locations mapped based on where the car park is and what's convenient for customers.

And the path towards this consolidation and market share, at one point, it was done a little bit through M&A. Are there still those opportunities?

Absolutely. There's still 4,000 at least independent operators. What's interesting with our real estate analytics model is we can look at any site that may be doing broader set of services, and we can model it like a new site that already has permitting and just use it for oil change. Where in the past, our business development team would only go out and talk to Quick Lube independent operators as potential options for us to acquire their business. Now we actually have the real estate analytics that if there is an automotive service provider, they may do 10 or 15 oil changes a day, but they do a smattering of other things. We can turn that business over based on the permitting that already exists, and we can ramp it to 50 or 60 cars a day. Very attractive economics.

The new unit economics, speaking of that, how have they evolved over the last few years? There's an opening?

Well, as Lori said, we're seeing mid-teens in terms of return on invested capital. We've continued to grow the pipeline and grow our talent that is helping us to extend that pipeline as well and also working very much with our franchisees and helping them to grow the pipeline franchise stores. So we typically see about a 4-year ramp to maturity for stores, where we continue to work from a marketing perspective on marketing techniques that we can use to potentially accelerate that ramp. And we -- I believe we still have significant opportunities there. We basically start out with a ground-up store in the 67% to 70% of maturity in terms of where we think the store can get to. And then over time, we're able to grow the store from there. And then we're able to see that overall mid-teens returns. And we've been very, very accurate because of the real estate analytic model that Lori's talked about in taking -- derisking the capital investment essentially because we are able to have a very high level of confidence in terms of how that store is going to perform. And been able to prove that, that's probably been one of the most rewarding things about having been here. We basically -- when I joined the company almost 9 years ago, we were not investing in company-owned stores or building new stores and I think our first company-owned new stores came out of the ground in 2018, early -- our fiscal '18, maybe late '17. And it's been really rewarding to see how accurate we've been in predicting how those stores are going to perform. So it's not just a great return, but it's very much a derisked return in terms of the analytics we use.

As the store productivity has increased, you mentioned 50 oil changes per day, has that new space or that 60% to 70%, have you had to take it down or these stores are still hitting that level, not 50 right away, but 60% of that in year 1 or if you've taken that, has 70 come down to 60 over time?

I think our ramp has actually improved. That's been some of the work we've done on the marketing side, which is how do you spend the right marketing to get the right bump in the first year. Now the team is looking at the second year. So we did a lot of work to increase the ramp in the first year. And now we're looking at doing the same thing for the second year. So instead of a 3- to 5-year horizon for -- closer to 5 for brand new builds that are not in markets with other stores, bringing that maturity curve in closer to the 3- to 4-year period. The interesting thing is the margin dollars driven by our mature stores continues to grow just like transactions grow. Then when you talked about how does that maturity curve look, one, we're stepping up faster to get to maturity. So the first year is definitely improved since the time that I joined through the work that we've done, but also the mature stores are continuing to expand their 4-wall EBITDA. So we continue to see improving returns at maturity.

When you started and it wasn't long after separation, the market was gone whole on value creation. So we've had this conversation about refranchising. And I think like the market's appetite for it was probably maybe greater than not yours, but you had to study this. And now we're seeing a mix. So have you draw a line in the sand of where you want to get to the business over time? Or the business is flexible and you're able to flex with it and make the right decision? Which of the two?

I think it's better for us to be flexible. So if I had to say what do we prefer us investing capital to build a company store or franchisee investing the capital, from a return standpoint, a franchisee spending their capital is a much better option for us. But our stores still deliver incredible returns. The profit dollar piece is much greater when we have a company store, but the return on invested capital is significantly better on the franchise side. Now for us, the economics, and we've gotten a lot of feedback as we've announced these refranchising deals, the economics is not straightforward. We have to sell our stores for higher than the market will bear, but nobody wants to buy them at our multiple. But they are willing to invest because the way they make money is to grow their system over time. So we look at if they commit to a development agreement that has carats and sticks that we can pull money off the table if they don't deliver. But then we take the timing of their new store build, and we discount it to present value, we are getting more than our value for the stores that we're selling over a period of time. So look dilutive in the short term but very accretive in the long term. And it's the only way you can get folks to buy well-performing stores at a premium and they still get the return that they need over the whole period that they would anticipate having. So it's a difficult equation. You've got to find the geographies that have some stores as a base, but a lot of growth opportunity, and that's how you can make it work. So they're not a ton. And I think from -- based on where we are, we don't need to do a lot more in order to hit the numbers of new units on the franchise side that we've outlined.

You can give them equity and then show how franchisee multiples happen over time. Can you talk about the franchise base? Concentration health, you put an example about someone leaning in and you've tripled a future road map. So what is the grand plan for the franchise?

Yes. So we had -- when we talked last time, we had 39 systems, we now have over 40 because we've brought 4 new partners, and we've transitioned the partner. So we have 5 new players in and 4 systems -- 4 new systems. When you look at -- it's very consolidated. So in the top 5 make up over 70% of the total units in the U.S., I'm speaking just for the U.S. When we look at the number of franchisees who are developing, it will be about 7 or 8 who are developing 90% of the units as we start to ramp. So our top 5 will make up a big portion of that but we have a couple of new partners that will, 2 to 3, that will end up becoming big developers within our pipeline. The average duration of our relationships with these partners is 25 years, not including the new ones, that's going to bring our number down probably by a few years. And these are well-capitalized players. These 5 to 7 have a lot of capital to put in play to build their business and they're getting incredible returns. So in a market where a lot of people are saying has an interest rates really put some pressure on new unit development, I think the combination of the returns plus the real estate analytics, taking some of the risk out of the equation, we're seeing them lean in and develop more and that's what we're excited about.

In the last 4 minutes, I'm going to jam 2 questions into 1 because we didn't really talk financials other than top line. Margin and capital allocation. It wouldn't be complete without capital allocation. So on the margin, the '25 was positioned as a reset year. A couple of years ago at separation, we talked about margins expanding higher 20s EBITDA margin. So talk about the relationship between reset year and then when we get back from reset. And then Graham scheme of capital allocation, I think you have good problems generally in this regard.

Yes. So margins really have expanded nicely. A couple of years ago, we provided guidance that we expected 26% to 29% EBITDA margins in the year we just finished at September 30 ended up with 27.2% margins. And so we've seen it was a 100 basis point improvement in our fiscal '24. So we certainly have seen expanded margins. We do expect '25 to be more of a reset year. Really resulting from a couple of things. One is the refranchising that we just talked about, that took about $100 million of revenue out of the system and related earnings offset by -- we have earnings from the franchise system. So on a net-net, it took out about $24 million of earnings. And then we've made some significant investments in both technology and talent. And the technology investments, we had previously run on some legacy ERP systems, both for the financial and supply chain systems as well as for our human resource information systems. And replacing those systems to be very much retail, pure-play retail focused. We started with the ERP system last year. And we're continuing this year with the HRIS system implementation. Those systems are replacing fully amortized legacy systems that we shared the cost with our Global Products business that we sold. And so we see a step-up for those technology investments, and we've also been investing more in talent, in relationship to the key areas of the business that we know we need to invest in, in order to be able to continue to grow in scale. So think about '25 as some modest deleverage on the SG&A line, followed by a more normalized SG&A growth rate that we'll continue to see a leverage against as we scale the business moving forward. On capital allocation. We've always first looked to growth where we can get meaningful returns, and we've talked a lot about that today in terms of the growth of our new stores. The second we look to, maintaining a solid balance sheet and we've just are below the high end of the leverage ratio that we've talked about. And then third, we look at returning excess cash flow to shareholders. And I expect, as we look forward, that we'll continue to follow that approach and see returns of excess cash flow to shareholders via share repurchases in fiscal '25.

Perfect. Any 10-second questions? Fine. I think with that, we appreciate you being here. Thank you very much, all the best and good luck in fiscal '25 and calendar '25.

Thank you.

Thanks, Simeon.