Marathon Petroleum: Only For a Spin(off)

Marathon Petroleum (MPC)
Stock Price: $55.12
Market Cap: $28B
EV: $54B
While MPC by itself is not attractive (see risks cited), the increasing prospect of the Speedway spin-off has intrigued me to pursue this as an idea.

Business Review
Refining & Marketing-
Consists of 16 refineries, it’s the nation’s largest refining business, and responsible for the production of higher value products. The largest refineries are Galveston Bay, Dickinson Renewable Diesel, and LARIC. The segment is focusing on increasing capacity in order to upgrade residual fuel oil and export capacity. One of the biggest undergoing projects, besides LARIC, is to bring infrastructure in-house. This is being done through the Whistler system, which will provide low-cost natural gas to Galveston Bay refinery, and will lower overall cost by not using third-party infrastructure.

Includes Speedway, which is responsible for company owned and operated convenience stores. The direct dealer business is under ARCO  (primarily concentrated in California, 930 locations) which provides long-term fuel supply contracts. Speedway is the second largest chain of company-owned and operated retail gasoline and convenience stores. Speedway’s highest concentration of locations are in California (492), Ohio (491), Indiana and New York (309 each), Michigan (306), North Carolina (276), and Florida (239). As of 2019, Speedway completed its conversion of recently acquired locations, and remodeled by offering food service.

The segment is responsible for long-haul pipelines and growing NGL production. It is conducted primarily through ownership interests in MPLX and ANDX. With MPLX, and ANDX consolidated into the segment, the segment is supported by large-scale diversified midstream companies anchored by stable, long-dated cash flows. 60% of MPLX’s cash flows come from logistics and storage services.

Marathon Petroleum trades at a TMT P/E of 10x, P/FCF of 11x, and P/OCF of 5x.
Marathon Petroleum is mischaracterized as a merchant refiner, despite the growth in its midstream and retail operations surpassing refining. Stable earnings growth has increased from 12% in 2011 to 69% to 2017, which are largely not backed by refining. R&M decreased from 88% to 31%, while Speedway increased from 7% to 23%, and MLP from 0% to 32%. Furthermore, Marathon Petroleum expenses its turnaround costs, while peers capitalize. This obscures valuation just because they’re more conservative.

That being said, valuing MPC based on a consolidated multiple is misleading due to the large number of minority interests the company has. The valuation below does not take into account the value of the JV stake in PFJ Southeast, nor does it account for the various midstream equity method investments.

Marathon Petroleum will be valued both with Speedway, and without. The valuation method used will be sum-of-the-parts (SOTP). The underlying assumptions made per segment were estimates of normalized EBIT, with DA add-backs, and subtracting maintenance cap ex. 5-year growth rates (ranging from 1-4%) were estimated for each segment, and the EBIT multiples applied ranged from 4-6, depending on those growth rates (and the discount rates pictured in the table below).

The Speedway Spin-off:
The case for standalone Speedway is that it would be able to improve its higher margins and merchandise mix. Already it’s already begun to offer fresh food and made-to-order by converting its retail locations. The assumption for the parent is that standalone midstream will be able to further increase its terminal utilization. Marathon Petroleum doesn’t need to maintain ownership of pipelines to benefit from supply contracts. MPC can always contract with Speedway post-spin to place volunteers through an arms-length wholesale supply agreement, like Valero/CST. Marathon doesn’t need to own pipelines to access cheap crude. Advantaged contracts through commercial agreements are a viable alternative. They should focus on divesting and reinvesting proceeds of ownership, especially those from JV stakes and equity method investments.

Financial Review
The atypical line items that I found included related party transactions between parent and subsidiaries. They primarily consist of purchasing ethanol from equity affiliates, and sales of refined products to PFJ Southeast. The other line items included seller financing in 2017 and 2016 related to a purchase and sale agreement for Galveston Bay refinery, and a possible suspicious supply agreement (for which there was a lawsuit in 2015).

Working capital turnover, inventory turnover, receivables turnover, and payables turnover have all been decreasing consistently over time. Cash per share and the cash ratio has been decreasing over time, since 2011. Receivables as a portion of current assets, total assets, and sales have also been decreasing over time. Inventory to cash, and inventory to sales have been steadily increasing over time. Finished goods are either declining or stable, while the earlier inventory stages are increasing. There have been sharp increases in inventory to sales due to raw materials, not finished goods. Debt to equity is around 0.8. Net debt to EBITDA is around 3x. The company does not have recourse debt, MPLX and ANDX have no recourse to MPC’s general credit through guarantees. The amount of fixed debt is $25 million versus $1 million in variable debt. The only guarantees MPC makes it towards the indebtedness of LOOP LLC and LOCAP LLC.

EPS has increased four-fold since 2011. Free cash flow matches earnings.

Interest coverage is 6x, OCF/interest paid is 7x, and FCF/interest paid is 3x. These metrics are all roughly in line with the company’s current bond rating of BBB.

Proxy Review:

I would cite internal conflicts of interest as the biggest red flag.

The CEO’s pay to median employee pay ratio is 714x, which I consider extremely egregious compared to peers HollyFrontier (82x), Phillipps 66 (98x), and Valero (122x). Furthermore, the CEO is also the Chairman of the Board. Management overall owns less than 1% of stock, and any that they have was mostly given to them.

The CEO’s bonus is roughly 6x his base salary.

10/12 directors are independent in the Board. They have chosen to elect a Lead Director to offset any power the Chairman might have. Shareholders with 25% ownership have a right to call for special meeting, and the company has eliminated any supermajority provisions.

Activism Needed: Elliott Management has a 2.5% stake in MPC, and has been rallying for independence in the Chairman position. They have also advocated for better strategic moves for the company, such as the MPLX drop downs (which were completed in 2019), and the spin-off of Speedway (expected to occur later this year).

Related Party Transactions:
There has been a large increase from 2016-2018 in sales to related parties. The aggregate amount itself is pretty sizeable. MPC has commercial agreements between ANDX and MPLX on an annual fee basis. MPLX provides terminal and storage services in exchange for MPC refining providing quarterly throughput volumes on crude oil/refined products.

To conclude, I am not a fan of seeing these types of transactions in companies, nor am I a fan of poor governance. Both are these are large factors which would deter me from initiating a position had it not been for the Speedway spin-off (and the discount MPC is trading it). Nonetheless, I am conflicted, and could change my mind in the future should other negative developments occur.

Speedway spin-off: MPC will keep its direct dealer businesses which supply only fuel, no merchandise sales. The company-owned and operated convenience stores will be spun-off. Clearly, Speedway shows great potential for tremendous earnings power. The number of stores have tripled since 2011 to 4,000, all the while same-store merchandise growth and fuel margins have risen. EBITDA has grown four-fold during the same duration of time. Speedway has industry leading profitability, and exceptional FCF conversion. And, it trades at a discount to peers.

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