Stock Strategist

Marathon Moves Beyond Refining

Allen Good, CFA

 Marathon Petroleum (MPC) held its first analyst day since merging with Andeavor, during which it updated strategic plans and financial targets for the next five years. The key takeaways include an increase in its merger synergy target to $1.4 billion annually, from $1.0 billion initially, and a 50% free cash flow payout rate in 2019. Nothing in the presentation warranted a change to our fair value estimate or narrow economic moat rating. However, the event served as a reminder of Marathon’s high-quality asset base, earnings growth potential, and cash-generating capability. After steep share price declines during the past two months over concerns about IMO 2020 implementation, weakening gasoline margins, and narrowing crude spreads, the refining sector has become more attractive. Of these companies, Marathon is trading at the widest discount to our fair value estimate and is our top choice.

About half the synergies are in the refining segment; the rest are spread over retail, midstream, and corporate, with full realization targeted for year-end 2021. In addition to the synergies, strategic investments that increase upgrading capacity, yield flexibility, and conversion capacity should lead to $1.1 billion in refining earnings growth by year-end 2022. In 2019, management is targeting at least a 50% payout of free cash flow including at least 10% dividend growth and repurchases of $2.5 billion. Management anticipates its current $5.6 billion repurchase authorization being complete by year-end 2020. The large repurchase plan brings Marathon’s total cash return yield in line with peer Valero (VLO), which sports a higher dividend yield.

While its existing refining asset base is well positioned to capitalize on the ever-changing domestic crude market, Marathon Petroleum is investing to expand its midstream and retail businesses in an effort to diversify its earnings stream away from the more volatile refining business. In addition to organic growth, Marathon has used acquisitions to achieve its goal and add value, nearly doubling its Speedway retail segment with the purchase of Hess’ retail business and leveraging its master limited partnership, MPLX (MPLX), to acquire another MLP, MarkWest Energy Partners. It has also implemented an accelerated drop-down schedule and converted its general partner incentive distribution rights to limited partner units. Most recently, it acquired independent integrated refiner Andeavor.

Marathon aims to eventually reduce refining’s midcycle EBITDA contribution over time. Currently, the refining segment still largely determines Marathon’s profitability. While earnings have suffered due to poor market conditions over the past year, our longer-term outlook for U.S. refining remains positive, and Marathon’s competitive position is strong. The acquisition of Texas City transforms Marathon into primarily a Gulf Coast refiner (62% of capacity in the region) while reducing its midcontinent exposure that drove earnings over the past few years. However, the deal added complex capacity on the cheap and holds ample improvement opportunity for a competent operator like Marathon. Also, greater amounts of discount crude will become available on the Gulf Coast with the startup of new pipeline capacity. Meanwhile, the company’s sole exposure to the midcontinent and Gulf Coast results in greater profitability and leaves it better positioned to capitalize on differentials compared with more geographically diversified peers.

Though capital will increasingly be directed toward midstream and retail projects, Marathon is still investing to improve its competitive position and profitability. It is increasing light crude runs from regional domestic plays while also working to increase product exports. Currently able to export about 250 thousand barrels a day, Marathon is investing to increase that capacity to 500 mb/d by 2019.

Prospect of Excess Midcycle Returns Results in Narrow Moat
Marathon Petroleum’s high-complexity facilities in the midcontinent and Gulf Coast leave it well positioned to capitalize on a variety of discount crude streams, endowing it with a feedstock cost advantage. As a result of this advantage, we see higher midcycle margins and returns compared with historical averages. Given the sustainability of the feedstock advantage and the company’s ability to deliver excess midcycle returns, we think Marathon earns a narrow economic moat rating.

Marathon’s overall complexity stands at 11.6, on par with peers, after the completion of its Detroit heavy upgrade project in late 2012, which increased throughput of discount heavy Canadian crude by 80 mb/d and the Galveston Bay acquisition. High-complexity refineries like Galveston Bay possess flexibility to run domestic or imported, light or heavy crudes, based on which offers the greatest discount. The addition of new pipeline capacity to the Gulf Coast should give Marathon greater access to discount domestic crude. Meanwhile, its Ohio and Kentucky refineries stand to benefit from the growing production of the Utica formation and the addition of condensate splitters. Thanks to the locations of these two refineries, both could see an incremental advantage over our anticipated midcontinent discount due to transportation savings.

We also think the Speedway retail segment enhances Marathon’s moat as its part of an integrated business and offers cost benefits. Marathon recently noted in its analysis of whether to keep or spin off its Speedway retail segment that it realizes upward of $390 million per year of synergies through integration with refining. Importantly, a retail segment provides opportunities to blend biofuel and create RINs, defraying a cost incurred by the refining operation. In an environment of high RIN prices, an integrated refining retail business would be at a cost advantage.

Marathon also holds a 64% interest in MPLX, which independently holds a narrow moat rating.

Energy Prices a Primary Risk
Success in refining is primarily a function of the difference in the amount the refiner pays for oil and the amount at which it sells the refined product. As such, the short- and long-term risks depend on movements in the prices of crude oil and gasoline or diesel. Most notable is any compression in the currently wide domestic crude discounts that benefit Marathon. Supply interruptions or increased demand that drive up oil prices as well as demand destruction or economic slowdowns that depress refined product prices are the primary risks. Any extended turnaround or shutdown because of an accident or weather could also damage financial performance. With greater reliance on the export market, construction of overseas refiners could pose a threat. In the long term, electric vehicle adoption, autonomous vehicles, and ride-sharing present challenges to demand for Marathon’s primary products.

Given our outlook for continued strong cash flow generation, we are unconcerned about the greater leverage Marathon has after its strategic actions involving MPLX. Marathon’s strong cash flow and relatively low capital spending have allowed it to return cash to shareholders through dividends and share repurchases. Also, Marathon has steadily increased its quarterly dividend since going public, and we expect it will continue to raise its payout as refining conditions warrant. We do not expect any outsize dividend increases or special dividends, as Marathon plans to set the dividend at levels that are sustainable through downcycles. Marathon also authorized another $5 billion share-repurchase program, which will be funded with existing cash from the drop-downs executed earlier this year. Given our forecasts for cash flow relative to capital spending and dividend requirements, we expect the company to authorize additional repurchases in the coming years.

Allen Good, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.