Description

Thesis

MUSA had been written up before by jbur on July 14, 2017 but I wanted to provide some fresh perspectives and provide an update on why I have more conviction on MUSA as a short at these levels. Since the jbur write-up, Hurricane Harvey propped up MUSA retail margins for 3Q17 which masked the secular pressures that MUSA faces, but 4Q17 and 1Q18 results have given me increased confidence that the headwinds continue to worsen in 2018 barring another catastrophic Gulf Coast hurricane season. Despite MUSA missing 1Q18, RINs having fallen back into the 30’s, WTI rallying into the $70s and no sign of SSS declines slowing, MUSA is only down 7% YTD. I believe the opportunity is where it is because there was a combination of broad-based buying in the retail sector and short-covering in May and June.

MUSA’s 2017 and 1Q18 results have shown continued pressure on retail gasoline volumes on a SSS basis and meanwhile, MUSA has grown total debt from $490m in 2015 to $880m in 1Q18 to fund an increased level of capex and buybacks. Since the beginning of 2016, MUSA has spent $560m in capex, not grown EBITDA and SSS declines are not showing any signs of slowing. I think the secular pressures MUSA has been facing over the last few years will continue in 2018 and even though consensus has drifted below the low end of management’s EBITDA guidance, I think there is a strong possibility that there is further downside to consensus. If EBITDA falls low enough, MUSA will have to slow or stop their buyback program as a result of financial covenants, which has propped the stock up through 2017. On top of downside to guidance, I think MUSA could potentially re-rate as the market realizes how challenging the MUSA retail gasoline model is and there will be long-term pressure to SSS growth and or margins.

Business Description

MUSA is a gas station and convenience store operator with over 1,400 locations in the U.S. and MUSA’s strategy has been to focus on being the lowest price retailer of gasoline. Historically, to maximize the margin in this business model, MUSA has kept costs lower by minimizing their kiosk footprint, which primarily sells cigarettes, sodas and snacks. In recent years, MUSA management pivoted away from that strategy and has tried to expand their kiosks into larger formats that sell a bigger mix of convenience store items, more like a 7-11 format and the reasoning for the move is to attract more customers and drive more merchandise sales and retail volumes.

That strategy had many challenges form the onset, including an increase to capex to unsustainable levels vs historical ($135m in 2014 going to $260m+ in 2016 and 2017), while being faced with increasing competitive pressures from other retail stations. Lastly, there has been a secular change in the behavior of consumer preferences towards more destination mini-malls that include a variety of food and retail options. As a sign of confidence in the strategy, management also accelerated their buyback program, which was almost entirely debt funded in 2017.

Thesis Point #1: Further Downside Risk to 2018 Consensus EBITDA

MUSA provided 2018 guidance in February where they provided ranges on key items such as volumes and gasoline margins, merchandise margins and opex. The guidance essentially states 4.1-4.3bn gallons with a range of 14 - 16.5cpg on retail gasoline contribution margins (aka gross profit). MUSA expects merchandise contribution of $390-$400m and retail station opex per store to be flat or up 2% from 2017 and G&A of $135-$140m. Using those simple parameters on guidance, we can provide a quick illustration of how unrealistic EBITDA guidance is:

$600m of gasoline contribution margin (low end of margin but high end of volumes. MUSA guides to $575m - $700m of contribution margin)

+ $400m of merchandise margins (high-end of guidance)

- $135m of G&A (low end of guidance)

- $525m of opex, which is generous since per store opex is flat to up and store count is growing)

= $330m of EBITDA which is below the low end of MUSA’s $390-$440m EBITDA guidance. (2017 EBITDA works out the same math for reference).

Using this illustration, MUSA needs retail margins to be at least 15cpg for all of 2018 to hit the low end of the guidance and MUSA’s 2017 guidance was 12.5-15.0cpg. MUSA was able to hit above the high end of guidance for 2017 because Hurricane Harvey provided windfall margins for gasoline distributors in extremely tight gasoline markets. I do not expect there to be another major hurricane in 2018 to bail MUSA out in 2018.

Furthermore, MUSA’s retail margins or volumes are likely to see pressure in 2017 as they try to remain the lowest cost retailer of gasoline, which puts a ceiling on their upside returns and increases the downside risk to margins or volumes sold, or both. From the 4Q17 call:

“As we compete for customer with a larger number of low price operators, our volumes are going to continue to be under pressure”

“While some notable competitors like Walmart have dramatically reduced their brick-and-mortar investment in both neighborhood markets and Supercenters, other public and private convenience store operators continue to open new stores in the areas we operate.”

At the time of the initial guidance, sell-side gave management the benefit of the doubt and 2018 consensus EBITDA hovered at $410m until 1Q18 results made FY guidance much less likely. Since then, 2018 consensus has been revised to $375m currently but I think that we might be closer to the illustrative EBITDA guidance for the following reasons:

1. RINs contributed ~4cpg of margin in 2017 and averaged 72c for MUSA. RINs are close to averaging 30c in 2Q18 and currently trade at 25c.

2. Gasoline prices generally track WTI and WTI is currently in the $70s. Higher gasoline pricing generally hurts demand.

Thesis Point #2: Lower EBITDA will Prohibit MUSA from doing further Buybacks

MUSA has a restricted payments basket covenant of 2.5x total/debt to EBITDA, after which they will no longer be allowed to buyback shares. MUSA’s total debt has grown from $490m in 2015 to $880m at 1Q18. The debt has risen because of $260m and $274m of capex in 2016/2017 and $500m in total buybacks in 2016 and 2017. It is worth pointing out that the elevated capex levels has led to little to no EBITDA growth in 2017 and 2018.

With the existing restricted payments basket covenant of 2.5x, MUSA will be unable to buyback shares if their EBITDA falls below $360m, which is entirely possible given the math I walked through earlier. If EBITDA falls below the range, management has barely any excess FCF for 2018.

Thesis point #3: Declining MUSA SSS Retail Volumes Despite Flat to Growing Industry Volumes Shows MUSA is Facing Idiosyncratic Headwinds to their Business Model

The EIA estimates that total US gasoline consumption grew 1.5% in 2016 and was flat in 2017. However, during those time periods MUSA SSS gasoline volumes declined 3% in 2016 and 5% in 2017. Between 3Q17 and 1Q18, MUSA SSS were down 10%, 6% and 5% respectively, showing no abatement to the pace of SSS declines. Management’s 2018 retail volumes per store guidance of flat to down 4% despite the EIA expecting flat to very modest growth in 2018 shows the predicament that MUSA is facing with their business model.

Anecdotal Evidence from Management about Upcoming Challenges

Management has hinted to the potential upcoming headwinds through their actions and comments on conference calls.

1) Management has alluded to increasing competition in their most recent 4Q17 call which is a dramatic change in tone from his previous earnings calls and the most recent investor day

2) Management is slowing their new store growth in 2018 from prior guidance in response to increasing competition and to slow down capex spend going forward. I think this is further admission that the elevated capex levels on new stores or raze-and-rebuilds is not resulting in growth to SSS retail volumes.

Thesis Point #4: Valuation (and Estimates) and Potential for Multiple De-rating

I think MUSA likely continues to face secular headwinds on retail volume growth and/or fuel margins and I think 2018 EBITDA comes closer to $350m (consensus is at $375m vs management guidance of $390 - $440m). I also think the set-up for 2Q is also quite challenging, where QTD scrapes of wholesale margins is likely to put MUSA in the 15cpg range or lower as gasoline prices keep pace with a rapidly rising WTI index and RINs pricing averaged half of 1Q18’s average.

Based on my 2018 EBITDA estimate of $350m, MUSA is trading at 9.2x 2018 EBITDA (consensus 8.6x). While their closest comp is CASY, who trades at 10.0x EV / 2018 EBITDA, CASY is not a good comp because they are not in the low-cost gasoline model, even though they are also facing declining SSS issues as well. Without a relevant comp in retail gasoline, I defer to the next closest retail proxy - groceries. Within groceries, KR and SVU are seen as the secular losers to WMT, COST and SFM - KR and SVU trade at 6.3x/5.6x 2018 EV/EBITDA vs WMT (8.8x), COST (15.4x) and SFM (10.0x). I think MUSA is the SVU/KR equivalent of groceries and the lack of growth in their 2018 guidance shows it. MUSA also has the lowest EBITDA margin of the gasoline retail group, as do KR and SVU in the groceries group. Assuming a 6.0x multiple on MUSA’s 2018 EBITDA of $350m, I get to a price target of $40/sh (45% downside).

Risks and Mitigants

MUSA has a higher than average short interest of 10 days, which is the largest technical headwind and risk to the short. That said, MUSA has recovered 20% from the lows of their bad 1Q18 results announcement and a move back to the low $60s isn’t an aggressive assumption.

I think the risk of activism like that seen in CASY is a low probability, particularly because MUSA’s business model of being the lowest cost seller in an extremely competitive market does not make it very attractive to activism. Furthermore, there are limited options that management has to undo the leverage that has grown over the years.

M&A as a risk is also unlikely in my mind. In 2017, there was a real risk that WMT could acquire MUSA given the long-standing partnership the two companies had. Since then, WMT and the rest of the industry is shifting away from brick and mortar and more towards e-commerce. MUSA ultimately is not an attractive business model that faces secular challenges in a highly competitive industry.

Downside correction to oil is a reasonable risk to the MUSA short. When oil prices fall quickly, retail margins are slow to follow and there will be a period where MUSA benefits from excess profits. However, I think we are likely in an elevated (albeit range bound) oil pricing scenario where Saudi Arabia wants to maximize price for their Aramco IPO and Venezuela and Iran struggle with idiosyncratic headwinds to increasing production.

Catalyst

I think sell-side estimates for 2Q18 and FY18 will continue to come down ahead of the 2Q18 result. 

Management will likely need to lower 2018 guidance although sell-side is already partly there with consensus below guidance.

Management may have to stop the buybacks, which has been propping up the stock. 

Sustained weakness or decline in RINs pricing.

Continued decline in SSS results in MUSA's quarters until consensus gets to a normalized EBITDA range, which I believe will be 15cpg or below.