Marathon's Spin-Off Holds Potential Upside

Earlier this year,  Marathon Oil (MRO) announced plans to spin off its downstream operations on June 30, 2011, into a new company called Marathon Petroleum Company, or MPC. Shares have subsequently rallied to almost $53 on the news, and in part due to higher oil prices and strong refining margins. However, we still see further upside considering shares continue to be valued as an integrated firm rather than as the independent companies that will exist after the spin-off.

Based on the company's proposed spin-off, which gives current Marathon shareholders one share of MPC for every two shares they hold, we think Marathon could be worth $65 per share if the exploration & production and downstream segments are valued in line with comparable companies after the spin-off. We value MPC at $40 per share or about 4.2 times our 2011 EBITDA estimate of $4 billion and 4.5 times our 2012 EBITDA estimate of $3.6 billion. To derive our valuation of MPC we applied a range of multiples based on current market valuations of comparably positioned independent refiners. We value Marathon Oil after the spin-off at $45 per share or about 5.2 times our 2011 EBITDA estimate of $7 billion and 4.6 times our 2012 EBITDA forecast of $7.9 billion. Our valuation assumes MRO will trade at a discount to similarly sized E&P firms because of its relatively weaker growth outlook, exposure to risky international assets, and significant oil sands reserves.

Background
Marathon has long traded at a lower multiple than many of its larger peers, in part due to its greater reliance on refining. As a result, the company explored plans in 2008 to separate itself into two different companies. However, the stock market collapse and deteriorating economic environment later in the year scuttled those plans.

With refining margins and refiner valuations staging a recovery, Marathon resurrected its plans to separate into two separate companies by spinning off the downstream assets into a new company. However, in contrast to the previous years, we actually see the downstream segments as having the more attractive assets.

While MRO is unlikely to rate at the top of our independent E&P coverage list, its independent listing should result in a higher valuation than it currently receives within the integrated Marathon. Also, with its mix of conventional, offshore, international, and oil sands assets, it has few peers.

Marathon Petroleum Company (MPC)
Once spun off, MPC will consist of three segments: refining, pipeline transportation, and retail or Speedway. MPC's refining assets include six refineries with a throughput capacity of 1,142,000 barrels per day. However, MPC's total capacity is not spread evenly amongst its refineries, with the Garyville, La., refinery at 464 mb/d comprising 40% of total company capacity. Garyville also received the bulk of Marathon's recent downstream investment through its major expansion. The $3.9 billion investment increased total capacity by 208 mb/d as well as increasing diesel yield, making it the third-largest refinery in the U.S. Garyville also represents most of MPC's Gulf Coast exposure. While the Mid-Continent refiners are currently enjoying stronger margins than their Gulf Coast counterparts, Garyville has the capability to capitalize on strong export demand from Europe and South America.

However, we see the real positive for MPC in its exposure to the Mid-Continent. While we generally have a negative long-term view of refining given various industry headwinds, Mid-Continent refineries enjoy several competitive advantages that could lead to sustained higher margins relative to other regions. First, PADD II is a net importer of refined product. Given that PADD III or Gulf Coast refiners provide the marginal barrel, PAD II refiners enjoy a premium margin. Second, Mid-Continent refiners are currently enjoying a crude advantage thanks to the discount of West Texas Intermediate crude to comparable quality waterborne crudes such as Brent and LLS. The combination of Gulf Coast margins and high-quality discount crude results in strong margins for Mid-Continent refiners. With large-scale logistics solutions years away, we expect the crude advantage could persist for several more years. Even then, increased production from new unconventional plays like Bakken, Niobrara, and Woodford/Cana could overwhelm new takeaway capacity from Cushing, prolonging the discount. Finally, Mid-Continent refiners also have greater access to discount, heavy Canadian crudes. As a result, these refiners not only capture additional margin on the feedstock discount, but also a transportation cost advantage relative to Gulf Coast refiners. We see MPC as well-positioned to capture all these trends. With 602 mb/d, 53% of its total capacity, MPC will have the most PADD II capacity of any company.

 

Marathon Oil (MRO)
After the spin-off, Marathon will be a pure E&P company. While we anticipate the firm will fetch a higher valuation as a stand-alone company, we do not believe MRO is nearly as attractive as some of the other E&P firms under our coverage. However, given its mix of assets, we also do not see a directly comparable E&P. MRO's upstream asset base, with offshore production in the North Sea and the Gulf of Mexico, oil sands volumes from Canada, and LNG in Equatorial Guinea, is more similar to large international integrated firms than comparably sized E&P companies.

However, like other high-flying E&P firms, MRO is counting on U.S. domestic liquids-rich resources for its future growth. It has recently acquired acreage in the Bakken Shale, Anadarko Woodford Shale, Niobrara, and Eagle Ford Shale. Just last week, Marathon bolstered its Eagle Ford position further with a $3.5 billion acquisition of 285,000 net acres. The acquisition brought Marathon's total domestic unconventional acreage to over 1 million net acres and boosted its potential production growth rate over the next five years 5%-7% from 3%-5% previously. Albeit from a small base, MRO expects to grow production from its unconventional plays at a 25% compound annual growth rate over the next five years. The acquisition and higher growth targets help Marathon close the gap somewhat with comparable E&Ps.

Valuation
We typically use a discounted cash flow model for valuation purposes. However, to best estimate what MRO and MPC could trade for after the spin-off, we use a relative multiple valuation approach.

MPC
For MPC, we attempt to identify refiners with a relatively similar asset base and apply a similar multiple. However, few independent refiners have a similar mix of Gulf Coast and Mid-Continent refining capacity. So in order to extrapolate an appropriate multiple for MPC, we use a range of possible multiples that is set by current multiples of the most closely related companies.

Based on asset location, we view  Valero (VLO),  Holly ,  Frontier , and  Western  as the closest comparable companies. However, not one of them is a perfect comparable. Valero is much larger than MPC, with 2.6 mmb/d of refining capacity and assets on the West Coast. Holly and Frontier are much smaller than MPC and have assets exclusively in the Mid-Continent. Western is also much smaller and located in the Southwest, but it does enjoy similar margins to Mid-Continent refiners due to crude access. Despite the differences, we think that given MPC's Gulf Coast and Mid-Continent exposure, both Valero and the three smaller refiners can provide an adequate proxy.

Currently, the smaller Mid-Continent refiners are receiving a higher multiple from the market for the factors we discussed above. Given MPC's exposure to those same factors, we expect it to trade in line with those firms but potentially at a slight discount given the Gulf Coast assets. Balance sheet items are based on management guidance, while share count is based on the 1 for 2 spin-off. Our EBITDA estimates of $3.9 billion in 2011 and $3.6 billion in 2012 assume a strong margin environment persists throughout 2011, weakening somewhat in 2012. Continuation of today's refining margins into next year would offer upside to our forecast and valuations.

We value MPC at approximately $37-$40 per share based on a multiple of 3.9-4.15 times our 2011 estimated EBITDA. We use 2011 EBITDA for valuation purposes given the long-term uncertainty of refining margins and their volatility's affect on refiners' stock prices.

MRO
As we mentioned above, finding a direct comparable to MRO is a bit difficult. However, we have identified five E&P firms that have similar enough characteristics--size, production and reserve location and mix, and growth--to adequately derive a potential post-spin-off multiple. Below we lay out the varying firms' characteristics.

Though none of these firms are a perfect comparable, we think we can infer from their valuations and asset profiles a reasonable multiple for MRO by looking at  Anadarko ,  Apache (APA),  Devon (DVN),  EOG (EOG), and  Occidental (OXY). MRO's five-year forecast is low compared to most of these other firms. On reserves and production, MRO has an advantage with liquids comprising 73% of reserves. However, some of those reserves are attributable to oil sands, which require substantially more investment to extract than conventional production. Marathon also has substantially more international reserves than the other firms, but--as Libya illustrates--that comes with risks. Also, its U.K. North Sea assets were recently subject to tax revisions by the government. Meanwhile, it recently lowered reserve estimates for its key Gulf of Mexico project, Droshky.

Overall we believe MRO has a lower-quality asset base than the other firms. However, we think it should receive credit for its oil-dominant production portfolio, 66% of total production. To err on the side of caution, we are inclined to believe MRO will trade at a discount to these other companies. Anadarko is likely the exception, since it currently trades at a discount reflecting uncertainty related to the Macondo incident.

We value MRO at approximately $45 based on a multiple of 4.5-5 times our 2012 EBITDA estimate of $7.9 billion. We think this valuation makes sense when you look at MRO on an EV per barrel of proven reserves basis. Using this metric, our valuation implies MRO will trade at $21 per proven barrel of proven reserves. We believe this metric adequately reflects MRO's asset mix.