Marathon Petroleum - More Than 350% Upside Potential With Very Limited Downside Risk
Summary
- Even after a significant increase from recent lows, the firm still offers one of the best risk/reward tradeoffs.
- MPC has one of the finest assets base in the U.S. petroleum space and is currently significantly undervalued.
- The two main catalysts are the end of the pandemic and the pressure from one of the largest activist funds in the world.
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What do you get when you have a pandemic that adversely impacts the demand for oil, a downstream player with a strong balance sheet, a misunderstood quality asset base, and one of the largest activist shareholder groups in the world? The answer is a buying opportunity with 2-4X upside potential with very limited downside risk.
Overview of assets
Marathon Petroleum Corporation (NYSE:MPC) is an integrated downstream oil company. Simply put, the firm owns and operates retail (gas stations and convenience stores), midstream, and refining operations. The largest contributor to income from operations was the midstream business, then the refineries, and lastly the retail & marketing segment.
(Source: Company's 2019 annual report)
Refineries
MPC owns and operates a coast-to-coast refinery operation with 16 refineries that spreads-out across the US. The economics behind the refining business is such that MPC benefits from a low oil price environment as long as there is a high demand for crude oil products (e.g., gasoline). In other words, in a perfect world for a downstream business, such as MPC, crude prices are low and the demand for refined products is high.
(Source: Company's 2019 annual report)
(Source: Company's September 2019 Investors presentation)
Marketing & Retail
MPC's retail operation includes 3,898 company-owned and convenience stores across the US (under the brand name "Speedway"). Additionally, the firm has long-term supply contracts for 1,068 direct dealers primarily in southern California (largely under the "ARCO brand"). MPC also supplies gasoline to independent entrepreneurs which maintain branded outlets, marketed under Marathon, Shell, Mobil, and other brands.
Moreover, Speedway owns a 29 percent interest in PFJ Southeast LLC ("PFJ Southeast"), which is a joint venture between Speedway and Pilot Flying J with 125 travel center locations primarily in the Southeast United States as of December 31, 2019.
(Source: Company's 2019 annual report)
(Source: Company's September 2019 Investors presentation)
Midstream Operation
MPC has control of the general partner and owns a 63% majority stake in MPLX (MPLX). MPLX is a midstream publicly traded partnership which owns and operates a network of crude oil, natural gas, and refined product pipelines and has joint ownership interests in other crude oil and refined products pipelines. Additionally, the firm owns light product terminals, storage assets, and maintains a fleet of owned and leased towboats and barges. MPLX's assets also include natural gas gathering systems and natural gas processing and NGL fractionation complexes.
(Source: Company's 2019 annual report)
(Source: MPLX Q4, 2019 Investors presentation)
Credit analysis
I am a strong believer that in-depth credit analysis or assessing "balance sheet risk" is always a prerequisite to equity analysis.
With regards to MPC, a scrutinized credit assessment reveals that the firm has a strong balance sheet, sufficient interest coverage, long maturities on debt, large available credit facilities, and a list of ready-to-sell quality assets that it can turn to in case of extreme distress.
Most of the debt that appears on MPC's consolidated statement is the result of its ownership of MPLX. The equity method of accounting asserts that MPC (the parent firm) should consolidate the financials of a subsidiary MPLX in which it has "significant control". This is an essential detail: MPC does own the general partner and a majority stake of MPLX. However, its debt and liabilities are non-recourse to MPC.
Put differently, out of nearly $30 billion of debt that appears on MPC's consolidated balance sheet, almost $20 billion of it is non-recourse to MPC. This means under severe distress, that is unlikely but possible, the firm can shed-off $20 billion worth of debt by dumping MPLX's equity. The true debt to equity ratio of MPC excluding MPLX is much lower than it seems - in fact, it is one of the lowest in the industry.
(Source: Company's Q3, 2019 Investors presentation)
In addition to relatively low leverage, MPC has a satisfactory interest coverage (4.68 last year including MPLX) combined with long debt schedule (need to pay only $2.6 billion in maturities over the next 4 years) and ample accessible liquidity ($8.2 billion in cash and available credit lines as of the end of 2019). Moreover, the firm has recently further strengthened its liquidity by $3.5 billion by adding two new notes and an additional credit facility.
All of the above provide significant protection to the equity investor. It is important to mention that MPLX is a profitable enterprise with valuable assets. Thus, the likelihood of MPC to dump it is extremely low. What I am trying to convey is that MPC has much wiggling room even under extreme market conditions.
(Source: Company's 2019 annual report)
(Source: Company's 2019 annual report)
Valuation:
MPC offers a huge margin of safety with one of the best risk/reward tradeoffs in today's market. I would highly recommend the reader focus on the enterprise value (EV) of MPC with and without its partly owned subsidiary MPLX. This is because accounting rules, specifically the equity method of accounting, distorts the picture and underrate MPC's true value.
First a few numbers:
(Source: Seeking Alpha )
An EV of a publicly-traded company is a theoretical price that a private investor will pay for the whole firm, it includes all the value of all the equity (market cap + any other claim to the company such as minority interest or preferred equity) + the sum of the total debt - cash and cash equivalents.
MPC, the parent organization, has 100% of the refinery and gas retail businesses and 63% of the equity of MPLX. As mentioned before, the debt and liabilities of MPLX are non-recurse to MPC and they thus should be viewed more as an equity holding and not as a subsidiary.
The current EV of MPC without the liabilities of MPLX is around $35.8 billion ($21 billion in market cap + 3.3 billion in minority interest (without MPLX + 11.5 billion in debt (includes the new senior notes)).
In other words, a private owner who wants to buy MPC will pay $35.8 billion and for that price, he will get all the refinery business with all the retail operation and as a cherry on top he will also enjoy a majority stake in MPLX (63% + the general partner).
This valuation is absurd given that the Speedway alone (the gas retail) negotiated sale price was between $18 and $22 billion just 2 months ago. What the market is saying is that the largest coast-to-coast refining operation in the US together with all MPLX's equity without Speedway is worth somewhere around $13.8-17.8 billion.
Just to stress out how off the market is in valuing MPC, I will point out that the current market value of 63% of MPLX which MPC owns is now trading around $12.6 billion. This means that an investor who puts money today in MPC will get all the Refining Business for $1.2 to 5.2 billion dollars.
I just want to remind the readers that MPLX went down 40% in the past year and that the income from operations of the refining business alone was more than $2.3 billion dollars. Following this line of reasoning makes MPC's refining business the cheapest in the world.
Sum of parts valuation and the Elliott Management factor
Elliott Management, one of the largest activist funds in the world, is a vocal minority shareholder that has even opened a website devoted to the restructuring of MPC. This arguably should put pressure on the management to align their interests with the shareholders and increase dramatically the probability of a spinoff and allows us to conduct a sum-of-part valuation.
Elliott's push for the separation of the company segments into individual firms seems to work. Thus far, the management of MPC agreed to try and sell their retail division (SpeedWay) and the deal was on the brink of closing just before the COVID-19 issue.
As previously mentioned, SpeedWay is estimated to be worth around $18-22 billion (EV value). A fair assumption will be that once the COVID-19 situation relaxes MPC's management will renegotiate the sale of SpeedWay using a similar price tag. Elliott Management estimated the price of Speedway to be around $18 billion.
(Sources: Elliott's presentation, "Remaking MPC")
With regards to the value of the midstream business MPLX, the equity which MPC owns in today's depressed environment is worth around $12.3 billion. It is important to stress out that this value is a suppressed one: around 40% decrease in the past year. it is a fair assumption that under regular market conditions, MPC's equity MPLX will be worth more.
How much more? Well, the managers of the firms did consider the sale of their equity stake for around $15 billion (valuing the whole equity value at around $24 billion). This valuation of MPLX's equity gets reinforced from Elliott Management:
(Sources: Elliott's presentation, "Remaking MPC")
Finally, we get to another crown jewel - the refiners. Their value is harder to approximate because every refinery is different. the intrinsic value of a refinery is greatly impacted by different factors such as location, competitive forces, environmental regulation in the respected state, the complexity of the refinery, and many other factors.
One way to estimate the value of the refinery unit is to examine the cash flows of the assets while conducting a peer analysis showing what similar assets are selling for. Elliott Management did just that and estimated that MPC's refining business worth around $30 billion under regular market conditions.
(Sources: Elliott's presentation, "Remaking MPC")
Upside potential
So how much is the equity of MPC worth? Well, this depends on your assumptions. In the past 3 months, the firm lost more than 50% of its value which was already arguably undervalued. If you assume a full separation, the one Elliott Management is aiming to achieve, the value of the firm is somewhere between $89-115 a share (around 3-4X from today's prices). If you assume a partial separation from the sale of the Speedway, the value is probably north of $60 a share which is around 2X of today's prices.
The point is that even under the worst-case scenario, the investor in MPC is well protected from permanent loss of capital in the medium to long run. This is to say that I don't know where the market is headed, and I didn't yet met someone who does. However, I do know that MPC offers an asymmetric bet, where the downside is limited (as seen from the credit analysis) and the upside is more than satisfactory.
(Sources: Elliott's presentation, "Remaking MPC")
(Sources: Elliott's presentation, "Remaking MPC")
(Sources: Elliott's presentation, "Remaking MPC")
Final thoughts
Headwinds
It is not all perfect for MPC. There are some headwinds that an investor should consider. MPC now has a new CEO, Michael J. Hennigan, the former MPLX head of operations. Some concerns may arise as for his commitment to maximizing shareholder value. rumors say that the former CEO has left his seat due to pressures from Elliott, although he denies it. Since Hennigan entered his position, he had objected to the spinoff efforts of the midstream business. However, the same announcement also mentioned that there are no changes in the plans to sell Speedway.
This probably goes without saying but a prolonged COVID-19 situation can be a major issue. This being said, I do maintain the opinion that for a medium-long term investors, the duration of the COVID-19 should not be the main determinant as for whether or not they should invest in MPC. The firm has enough liquidity to pull through this storm and eventually people will go back to consume refined crude products (drive, take flights and one day may even take cruises).
Although the liquidity of MPC is strong, some investors may want to wait for the soon to be published quarterly report to examine its cash burn rate. In any case, MPC did announce that it will raise its quarterly dividend.
Tailwinds
One short-term tailwind for the company is its huge storing capacity that allows it to store cheap oil and sell it for a higher price when the COVID-19 situation relaxes. Through MPC's position as the general partner and its majority stake in MLPX, the firm has access to oil storage access which other players do not. This means that the firm is likely to enjoy a significant tailwind by buying cheap oil today, storing it, and then selling it for a larger-than-average profit as COVID-19 situation eases.
(From the article "Oil Refiners Face Grim Times Despite Collapse in Crude Costs")
(MPLX Q4 2019 Company's presentation)
Conclusion
Contrary to the conventional view, the energy sector did create a few bargains and MPC is arguably one. The mixture of low valuation and strong balance sheet together with the Elliott factor and the expected spinoff creates a rare buying opportunity with plenty of upside and not much downside.
Therefore, I recommend investors initiate a position in MPC and add this integrated downstream oil company to their portfolio.
This article was written by
Analyst’s Disclosure: I am/we are long MPC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
I’m invested in MPC since it went down to the low twenties. I do advocate my readers to come up with their own opinion as to how much MPC is worth: I provided you with my thoughts.
If you enjoyed this article or you share my enthusiasm for finding mispriced assets follow me on Seeking Alpha or and please feel free to share your opinion in the comments.
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Comments (75)
I did mention that they are going to slightly increase their quarterly dividend. The ex-date is 19/05.
Best,
You raise a good point, and in hindsight maybe I should have stressed out more that MPC and MPLX have a strategic alliance.MPC holds the general partner in MPLX. This resulted in a strategic alliance with MPLX and in 2019 more than 93% of MPLX's revenue in the logistics and storage segments came from MPC.This fact does leave my thesis intact as MPC virtually have access to almost all of MPLX's storage and logistics assetsif you want to see the details, I refer you to the 2019 MPLX's annual report, page 148.