|Shares Out. (in M):||37||P/E||0||0|
|Market Cap (in $M):||2,700||P/FCF||0||0|
|Net Debt (in $M):||0||EBIT||0||0|
|Borrow Cost:||Available 0-15% cost|
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Murphy USA Inc (NYSE:MUSA) is a gas station and convenience store operator with over 1,400 locations in 26 states across the Southern and Midwestern United States. MUSA, whose stores are primarily located on or adjacent to Wal-Mart locations, focuses on driving higher fuel volumes than its peers by providing the lowest cost gasoline in a geographic area. I believe there are several structural issues facing the industry, including falling gasoline demand and declining cigarette consumption (a key driver of profitability for MUSA). Moreover, most of MUSA’s competitors are benefitting from growing store counts and a heavier reliance on higher margin food and merchandise sales, both of which are areas in which MUSA is structurally hindered. Additionally, I believe MUSA is likely overearning from a favorable government policy – its generation and sale of Renewable Identification Numbers (RINs), and that investors have capitalized this income stream in the stock price. RINs have been trading at abnormally high prices due to government policy changes over the past several years that have created a shortage of RINs. I believe the new EPA will bring changes to this policy over the next 12-18 months, and MUSA’s earnings contribution from RINs will return to lower, historically normalized levels or disappear entirely. With lower normalized earnings power and the Company facing several structural headwinds in its core business, I believe MUSA is worth $45 per share, or over ~40% lower than current prices.
For background, Murphy USA spun out of Murphy Oil in 2013. At the time, MUSA was an interesting value play – a small cap, underfollowed spinout in a limited growth market still trying to find its footing amongst the investor and research community. Since the spin, the Company was able to sell non-core assets, return capital to shareholders, and grow its store count through its relationship with Walmart. As significantly, as an independent Company, MUSA was able to focus on lowering its cost structure through optimizing it labor model, executing a new lower cost distribution agreement for its C-store products and capitalize on quick and high return capital products. However, this low hanging fruit is now in the backdoor and the Company is lapping the margin benefit from these initiatives. Additionally, the Company profited from the appreciation of RIN prices from the spin, which have increased from just $3 million of earnings contribution in 2011 to over $180 million in 2016. Moreover, management has changed its tone on RINs from the spin having previously described the benefited of RIN sales as a one off benefit to cash flow to their current messaging that RIN prices are fully reflected in their rack price of fuel (and hence in their wholesale business) and therefore earnings and cash flow are indifferent to changes in RIN prices.
I believe MUSA (along with other gas station operators) is facing a structural decline in gasoline volume. This decline was evident a couple years ago, and at the time was reflected in the multiple investors would pay for gas stations. However, falling oil prices spurred additional demand for gasoline and the market re-rated gas stations as low growth SSS operators. However, in recent quarters as oil prices have remained range bound, MUSA’s SSS volumes have declined. Over the last four quarters, MUSA’s same store fuel have declined an average of (2.5%) YoY. The Company has guided towards SSS fuel volumes returning to flat. A sustained rebound in fuel volumes from current levels is unlikely. As a result of CAFE mandated fuel efficiency standards, the US vehicle fleet is getting increasingly fuel efficient. Over the last 10 years, fuel efficiency for new models increased 28%. From 2015-2025, fuel efficiency gains will increase by 40%. The EIA projects that fuel consumption will decline 1.7% annually between 2017 and 2030 and this will accelerate as EVs become a larger percentage of the overall fleet. Further, over the last 5 years, the gas station industry has added 1-2% annually to the station fleet, increasing capacity in the face of declining secular demand. MUSA, which is exposed to brick and mortar Walmart traffic trends and lacks a competitive C-store offering to drive traffic, is unlikely to outpace declining industry volumes. As a result, MUSA SSS fuel volumes are likely to disappoint management’s guidance of flat and experience low single declines.
The last few years were an ideal situation for fuel margins. Low fuel prices resulted in fuel demand growth. SSS fuel gallons increased across the industry and operators in a healthier ‘growth’ environment were able to edge out better fuel margins than they had in prior years leading to a belief that operators developed a new discipline in this fragmented and price sensitive industry. However, as SSS fuel volumes declined, competition for customers increased and fuel margins compressed even in quarters with a favorable crude price backdrop, falling to $11.6 cpg in 2016 and $10.1 cpg in Q1’17 (I’d also note Q2 fuel margins and EPS will be stronger as a result of steep fuel prices declines during the quarter which benefit retail fuel margins due a pricing lag). Outside of 2011 and 2014 when oil prices experienced sharp declines, MUSA averaged fuel margins of $11.6 cpg over the last couple of years. I assume $11.5 cpg of retail fuel margin on a go forward basis. It is likely that margin continues to get squeezed as operators compete for fewer customer trips to the gas pump. Additionally, MUSA’s fuel centric model is likely not well positioned for price compression. Unlike peers who generate the majority of their profit from C-store merchandise sales, MUSA generates the majority of their profit from fuel. The Company’s agreement with Wal-Mart prevents MUSA from selling many items and as a result the Company’s C-stores profits are reliant on tobacco sales. Should the environment get more competitive and operators such as Casey’s, Speedway, Wawa compete by discounting fuel to drive traffic to their higher margin and more important merchandise sales, MUSA would take a direct hit given their inability to absorb price compression with a vibrant C-store business.
Further, most gasoline retailers, including MUSA, have attracted investor interest (and somewhat masked the structural decline in gasoline demand) by adding more locations. This became important to investors in the space as new station openings that could contribute a few points of growth helped fueled growth above other consumer names. Post spin, MUSA fit well into this narrative - the Company had a natural growth trajectory and demand base. However, in early 2016, Walmart decided to end its growth relationship with MUSA beyond the current commitment of stores. Instead, Walmart will build its own gas stations in its parking lots. This forced MUSA to find another avenue for growth. In response, MUSA is building Murphy Express locations “close to Walmart”, a significantly different strategy than being located on Walmart property that benefits from Walmart traffic. The Company is also building larger, 1,200 square foot store formats with less dependence on gas volume, increasing the risk of whether they can compete in the highly competitive C-store business vs. their legacy model of one person in a 400 foot or smaller kiosk. In addition, there is no guarantee that Walmart won’t add their own fuel stations on parking lots where MUSA has built a Murphy Express. While Walmart hasn’t made formal announcements, industry analysts believe Walmart has already built 70-100 gas stations in front of supercenters. Further, MUSA management is promising higher returns for Murphy Express locations than their historical investments. This is a marked divergence in strategy. I believe their returns will disappoint and the number of Murphy Express locations will prove to be smaller than anticipated.
As mentioned above, the convenience store operations of competitors help to insulate them from the volatility of fuel and the cyclical and structural issues facing the industry. The stores are much higher margin than gasoline retailing, and many competitors are increasing their share of prepared food services. However, given the smaller footprints of MUSA’s stores, the Company remains much more reliant on fuel sales than its competitors. Even worse, 75% of its convenience store sales are from tobacco, which is in structural decline. This represents a much higher dependence on tobacco than its competitors, and government data shows cigarette sales are declining 2-3% annually. While this helps to explain the negative same store merchandise sales trends over the past year, it is troubling that sales even outside of cigarettes are down.
Lastly, MUSA has significant exposure to RINs, which investors have capitalized as a recurring income stream but have significant policy risk over the next 1-2 years. In 2016, sales of RINs constituted 45% of the Company’s EBITDA. MUSA creates RINs through its wholesale operations by blending ethanol with gasoline to comply with the Environmental Protection Agency’s (EPA) Renewable Fuel Standards (RFS) mandate. As per the RFS, refiners generate an obligation to purchase RINs when they create or import non-renewable fuel, which puts blenders, such as MUSA, in an enviable position of being able to generate additional profit from its ethanol blending operations. Since most vehicle manufacturers will not warranty a car if its gasoline composition is over 10% ethanol, there exists a “blend wall”, which is the maximum quantity of ethanol that can be sold each year given legal or practical constraints on how much can be blended into each gallon of motor fuel. Over the past several years, the EPA has consistently increased the amount of ethanol that must be blended into gasoline, ultimately exceeding the 10% “blend wall”. Bumping up against the “blend wall” has caused RIN pricing to significantly increase from 20 cents in 2013 to over $1 in 2016.
I believe the new Administration is likely to change the RIN policy over the next 1-2 years and possibly much sooner. Senior advisor Carl Icahn (who has a financial stake in this given his ownership of independent refiners) has publicly written several pieces about RINs, calling it a “rigged” market that has been “the mother of all short squeezes”. He believes the burden to refiners is too onerous and that the current RIN policy unnecessarily burdens refiners in order to benefit large integrated oil companies and large gasoline retail convenience store chains. He cheered Trump’s EPA appointee, Scott Pruitt, and Icahn and other independent refiners have lobbied to shift the point of obligation from the refiners to the blenders, where the burden to “retire” the RIN would rest with blenders like MUSA who could more easily do so given they control the amount of ethanol ultimately blended into the gasoline. After Pruitt was nominated, RIN pricing in the open market fell to nearly 30 cents, indicating the market’s cautious view on the issue. However, when Pruitt and the EPA released their proposed RFS blending mandate for 2018 in early July, the EPA made minimal change to the ethanol blending mandate from 2017 levels and RIN prices sustained in the low $0.70s. This should not come as much of a surprise as the pushback against Icahn’s involvement made a near term change in the point of obligations associated with 2018 RFS blending mandate release politically untenable as it would have been viewed as a win and favor for Icahn. However, I think the market focused on the RFS headline and missed the bigger point in that the EPA signaled a potential major revamp of the RFS that would upend the future statutory volumes that are in place through 2022. Specifically, the EPA made clear they intend to following through on a requirement under the Clean Air Act known as the “reset rule.” The requirement is triggered if the EPA grants waivers from statutory requirements of at least 50% in one year or 20% in two consecutive years for any of the four RVO categories. Once the requirement is triggered, the EPA is required to throw out the numbers Congress laid out in the 2007 rule and finalize new volumetric standards. The EPA has already hit the 50% target for cellulosic and for total advanced biofuels and for total renewable fuels (advanced and conventional), the proposed 2018 number would trigger the 20% reduction threshold and is likely to in 2019 as well (the EPA under Obama decided to take no action despite of the requirements of the “reset rule”). So while the proposed 2018 RVOs largely maintain the status quo, we think Pruitt signaled that he is planning to do a major overhaul of the RFS that would likely plummet RIN prices. His willingness to do this also is a bargaining chip that makes it easier for him to change the point of obligation that could be done without lowering the ethanol volumetric mandate and getting pushback from the corn belt lobby.
Management will argue that RINs are fully reflected in the wholesale, or PS&W margin (despite that just 2 years they would tell investors it was a one off benefit to cash flow). While RINS are likely partially reflected in rack prices, it’s highly unlikely that its fully reflected. Before RIN prices spiked, MUSA made between $0.01 and $0.015 per gallon in their PS&W business. Since 2013, MUSA’s PS&W business has averaged $0.031 per gallon as the Company has benefited from high RIN sales. Needless to say, MUSA has publicly commented about its active lobbying effort in Washington to prevent a change in the point of obligation with the CEO making multiple trips to DC. If there is no excess profit in their PS&W margin as they represent to their investors (hence their would be no profit hit from a change in the point of obligation), it is quite odd that the Company would be spending so much time and effort to combat a change.
In conclusion, despite the structural declines facing the industry, I believe MUSA’s normalized and recurring earnings reflect a very expensive stock. Using a retail fuel margin of $0.115/gallon and a PS&W profit of $0.015/gallon (the high end of the pre-RIN range), I think the earnings power of the Company is ~$2.75/share. With excess cash flow generation from RINs in the short term, I think the fair value for MUSA is $45/share.
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