Description

Murphy USA is a small-cap gas station operator that was spun out from $11.5 billion market cap E&P Murphy Oil.  The current price of $41 is below conservatively estimated replacement value of $42 and well below intrinsic value of $68 based on peer multiples.  Murphy has a unique partnership with Wal-Mart that will allow it to grow stores 5% organically over the next three years and which drives volumes significantly higher than industry peers.  Meanwhile, Murphy’s focus on opening slightly larger stores going forward will allow it to capture a greater amount of higher-margin merchandise sales without significantly increasing costs.

Murphy USA (MUSA) is a convenience store/gas station operator in the Southern and Midwestern U.S.  As of June 30, 2013, Murphy had 1,179 locations in 23 states.  Murphy USA was spun out of Murphy Oil (MUR) and began trading on August 29, 2013. 

Murphy focuses on driving high volumes of gas purchases at low prices.  This is driven by its unique relationship with Wal-Mart: nearly all Murphy locations sit on or directly adjacent to a Wal-Mart parking lot.  The traffic driven by this Wal-Mart affiliation combined with generally the lowest-priced gasoline results in fuel volumes that are 2.5 times the industry average.

Murphy’s convenience stores are generally in two formats: a 280 sq. ft. kiosk (77% of locations) and a 1,200 sq. ft. store (4% of locations).  The small size combined with the high traffic translates to merchandise sales per square foot that are greater than 8.5 times the industry average.  Given their physical proximity to Wal-Mart, Murphy pursues a strategy of offering SKUs that complement Wal-Mart’s as opposed to directly competing.  In-store sales consist primarily of relatively lower-margin cigarettes.  In the kiosk model, tobacco products account for 90% of merchandise sales, while in the larger store format, they account for 73% of merchandise sales.  Because of the relatively higher level of tobacco sales, non-fuel merchandise margins are in the 13-15% range versus 30-40% for peers.

The newly spun-out company is being led by new CEO Andrew Clyde, who spent 20 years with Booz & Company in the Global Energy Practice.  Clyde was elected partner in 2000 and held leadership positions as North American Energy Practice Leader and Dallas office Managing Partner.  During his time at Booz, Clyde focused primarily on downstream petroleum and retail clients.

The U.S. c-store count increased by ~1% in 2012, driven by a ~9% increase in the number of stores operated by companies running 500+ stores.  It is a highly fragmented industry, with 60% of all c-stores run by single-store operators.  Large chain operators represent only ~15% of total c-stores in the U.S.  Tobacco represents ~41% of in-store sales industry-wide.

The spin-off process is a fundamentally inefficient method of distributing stock to the wrong people.  At the current price of $41, Murphy has a market value of $1.9 billion.  The company was spun out to the shareholders of the much larger – $11.5 billion market value – Murphy Oil, in a ratio of one share of MUSA for every four shares of MUR.  There are several attractive spin-off characteristics at work here.  First, institutions do not want this stock.  MUSA is simply too small relative to the size of MUR for most of MUR’s original shareholders to own.  Moreover, MUSA is clearly in a different business than most institutional investors had been seeking to invest in when they bought shares of Murphy Oil.  Further, MUR is a member of the S&P 500 and ETFs and index funds tied to that index are now forced to sell their new shares in MUSA.  This has almost definitely led to indiscriminate selling of MUSA shares without regard for the underlying business fundamentals or valuation, temporarily depressing the price of MUSA shares.

Second, insiders want this stock.  We have already seen insider buying in the open market.  Since the spin-off about a month ago, three company officers have purchased shares in the open market at prices slightly lower than current.  CEO Andrew Clyde has invested $150,000 and Directors Thomas Gattle and Jack Taylor have invested $77,000 and $185,000, respectively.  Further, the company has adopted ownership guidelines whereby the CEO will own stock worth five times his annual salary and the CFO three times her annual salary.  Management is well aligned with shareholders to reap the benefit from their strategy.  In addition, prior to being named CEO, Andrew Clyde had been leading the development of the business strategy for the Murphy USA spin.  Clearly he has intimate knowledge of the situation and sees great opportunity in executing his business plan. 

Aside from these positive spin-off dynamics, Murphy has an excellent business plan to grow organically, leverage costs, and dispose of non-core assets.  Murphy differentiates itself from competitors in the following ways:

• Small format box leads to higher sales per square foot.
• Locations adjacent to Wal-Mart leads to 2x industry-average fuel volumes.
• Low operating costs ($30,000 per store month v. $40,000 for peers).

Murphy recently entered into an agreement with Wal-Mart to build an additional 200 stores on Wal-Mart locations over the next three years.  This equates to greater than 5% annual growth from new store openings alone.  Wal-Mart experimented with doing their own fuel sales but ultimately did not find it attractive, which led to the Murphy relationship.  Wal-Mart views Murphy as a competent operator, a driver of retail traffic for the stores, and a way to keep pace with gas programs offered by Costco, Safeway, Kroger, etc. 

Beyond the 200 contracted locations that Murphy will open over the next three years, there are several hundred more Wal-Mart locations that do not currently offer gas.  As Wal-Mart continues to build out its gas presence, it is reasonable to assume that they will look to partner with the most cost-advantaged provider in a given region.  It is unlikely that this will be Murphy in all cases, but at the very least it is reasonable to assume that Murphy will be the operator of choice in its core and adjacent markets (yellow dots on the map below).  Meanwhile, given the success of the Murphy relationship so far, there is a chance that Wal-Mart chooses Murphy to provide fuel at all supercenter locations (purple dots).

Aside from the generally high traffic driven by being in close proximity to Wal-Mart, Murphy also participates in a Wal-Mart discount program that further helps to drive traffic.  Wal-Mart debit and credit customers save 3 cents and 5 cents per gallon, respectively, at Murphy locations.  During the first half of 2013, 25% of payments came from either a Wal-Mart branded shopping or debit card, 35% of sales came from non-WMT debit cards, 15% of sales were non-WMT credit transactions, and the remaining 25% of sales were cash.  As an offset for the reduction in price to consumers per gallon, Wal-Mart helps on the interchange fees, such that Murphy’s economics are basically a wash between Wal-Mart discount sales and normal sales (except the Wal-Mart discount helps drive higher volume).  Wal-Mart can afford to comp Murphy the interchange fee because Wal-Mart controls the payment processing value chain.

Meanwhile, there are 150 Murphy Express locations that are not currently part of the Wal-Mart fuel program.  Murphy is in the process of converting these locations to the Murphy USA banner and linking them to the Wal-Mart program.  This should help drive additional traffic to these stations.

In addition to growing the Wal-Mart relationship, all of Murphy’s new locations will feature the 1,200 sq. ft. format.  This slightly larger box should increase both sales per store and gross profit per store due to increased volume of higher margin beverage and non-tobacco products.  These 1,200 sq. ft. stores currently make up only ~3% of the store base (38 as of December 31, 2012), but will grow to over 17% once the current Wal-Mart agreement is completed.  The new format emphasizes fountain beverages, coffee, and other high margin merchandise, resulting in 15.5% non-fuel margins versus 12.8% in the smaller-format store.  Overall, the larger-format stores sell 30% more non-fuel merchandise, with tobacco falling to ~73% of the mix from ~90%.  These new larger-format stores should push total company merchandise margins from 13.5% to over 14% in the next few years, without adding materially to expenses.

On the cost side, there are likely some costs that can be streamlined out of the business, given the lack of attention previously paid by Murphy Oil management.  New management has already identified opportunities where non-essential back-office functions such as payroll and benefits can be outsourced.  Murphy runs stores with only one or two employees at a time, uses one distributor (McLane) for 80% of non-gas SKUs, and the smaller stores require less maintenance. 

Murphy owns 90% of its retail locations, which leads to lower operating costs through the elimination of rental expense.  Meanwhile, it takes only $2.0-2.3 million to open a Murphy location compared to the industry average of $3.2 million.  Due to the small size of the store, Murphy also spends about half as much as peers on wages and maintenance expenses.  This all leads to a relatively low 6.6 cents per gallon cash breakeven level for Murphy. 

Meanwhile, Murphy is able to source fuel at lower prices than competitors for a variety of reasons.  The spin-off of Murphy included several mid-stream assets, most important of which are seven proprietary terminals.  8.8% of 2012 fuel volume was sourced via proprietary terminals.  Due to its high volume of gas sales, Murphy also enjoys preferred shipper status on the Colonial pipeline system.  Moreover, Murphy is not restricted to selling branded fuel.  Instead, the company employs a “best buy system,” where it dispatches third-party tanker trucks to the most advantaged terminal to load products daily for each Murphy site.  In 2012, 45% of fuel was contracted outside of Murphy’s wholesale business, 35% was proprietary supply, 11% was exchange, and 9% was rack.

This participation in the broader fuel supply chain provides Murphy opportunities to enhance margins and volume.  For example, Murphy sources fuel directly at the terminal and then splash-blends it with ethanol, generating RINs in the process that Murphy can then sell to others.  In 2012, Murphy generated less than $10 million from the sale of RINS.  Due to ongoing supply/demand issues in the RIN market during 2013, Murphy could generate as much as $90 million from the sale of RINs this year.  This revenue essentially flows 100% through to the bottom line.

In addition to its product distribution terminals and pipeline positions, Murphy also owns two ethanol refineries that it is actively looking to sell.  The two refineries are located in Hankinson, ND and Hereford, TX.  The Hankinson refinery was acquired in 2009 for $92 million.  It is currently rated for 132 million gallons of ethanol per year.  The Hereford refinery was acquired in 2010 for $40 million.  It is currently rated for 105 million gallons of ethanol per year.  During 2012, Murphy wrote these plants down by $60 million and currently carries them on the books at $83.2 million.

There are many moving parts when trying to determine the trajectory of Murphy’s EBITDA going forward, including fuel margin, fuel volumes, merchandise margin, and square footage growth, among others.  However, by making some reasonable assumptions, I believe we can come up with a fairly good idea of what EBITDA could look like in 2015.  Fuel margin per gallon in 2012 was 12.9 cents, which also happens to be the five year average fuel margin.  Through the first six months of 2013, fuel margin is down ~2% year over year.  I will assume that fuel margin stays at its five-year average of 12.9 cents going forward.  I will also assume that fuel volumes remain flat at 277,000 gallons per store month, in line with trends through the first six months of the year.  As noted earlier, this could prove conservative as Murphy brings the 150 Murphy Express locations into the Wal-Mart discount program.  Therefore, fuel sales will grow in line with store growth.  On the merchandise side, I assume that sales per store month will grow 2% per year, due to the expansion of the larger-format concept and general inflationary trends.  Combined with store growth north of 6% annually yields merchandise sales growth in the 7-8.5% range annually.  I assume that fuel gross margin remains relatively in line with the three year average at 3.5% and that merchandise margins grow slightly to 14% due to the higher-margin larger-format stores.  Finally, I assume that RIN sales are in line with historical results of less than $10 million per year.

Based on these assumptions, I believe that Murphy can grow EBITDA to $425 million in 2015 from $300 million in 2012, or 12% annually.  This only requires total sales growth of 6-6.5% annually and EBITDA margin expansion from 1.6% in 2012 to 1.9% in 2015.  Put another way, Murphy only has to open the 200 stores it has agreed to open at Wal-Mart sites and do similar business to the rest of its store base, while capturing slightly more margin due to the higher-return larger stores.

Murphy’s peers currently trade at 5.7x EBITDA at the low end (Pantry) and 10.6x at the high end (Susser).  Pantry has its own problems and therefore its valuation is not representative of the group at large.  Meanwhile, Susser’s success with its MLP structure accounts for its superior valuation.  Given where CST, Couche-Tard, and Casey’s trade, I think that 9x EBITDA is a reasonable valuation for this type of company.  9x 2015E EBITDA of $425 million equates to a per share value of $68 for MUSA, or 65% above the current price of $41.

Obviously, there are many assumptions that go into the prior analysis, so let us take a look at downside protection by estimating replacement value.  Per management, it costs $2-2.3 million to build a Murphy USA site, including the land.  At $2.1 million per site and 1,179 sites, Murphy’s retail gasoline assets are worth ~$2.4 billion.  We will use the net book value of the ethanol refineries at $83 million and the other midstream assets at $35 million, though I am quite certain the seven terminals are worth more than this and that they will likely be able to get at least $100 million for the ethanol facilities.  Add $30 million of net working capital and subtract $607 million of net debt and the total replacement value of Murphy’s assets is ~$2 billion, or $42 per share.

It is important to note that Wal-Mart has a first right of refusal on any assets that Murphy wants to sell, which basically removes the ability to pursue an MLP or REIT structure.  However, owning the real estate allows MUSA to provide the lowest price gasoline and offers downside protection for investors.

1. Fuel margins are volatile and unpredictable.  Fuel margins are vulnerable to volatility in WTI crude prices.  While all of the companies in the c-store industry are exposed to this volatility, Murphy is particularly vulnerable because fuel represents such a large percentage of the company’s sales.
2. Wal-Mart could discontinue its relationship with Murphy.  If Wal-Mart were to end its relationship with Murphy, it would greatly impact the company’s ability to build new stores and would likely have a negative impact on fuel volumes.  I believe this is unlikely given that Wal-Mart is looking to partner with the low-cost provider of fuel.  In the core markets of the Southeast and Midwest, this is clearly Murphy.  Meanwhile, given the extent of the Wal-Mart relationship so far, Murphy has at least a fighting chance of winning the Wal-Mart business on a nationwide level.
3. Growth could squeeze future cash flow and negatively affect the capital structure.  Management has talked about funding growth through free cash flow, which should be doable.  Further, a sale of the ethanol assets will also go toward funding organic growth.  At 65 new locations per year, the company will need $143 million per year for growth.  Murphy generated cash from operations of $237 million, $188 million, and $355 million in 2012, 2011, and 2010, respectively.

1. Higher fuel margins or decreased fuel margin volatility.
2. RIN values could remain elevated.
3. Re-branding of Murphy Express locations and addition of these sites to the Wal-Mart fuel program.
4. Sale of the ethanol assets.
5. Margin expansion from opening larger format stores.
6. Street coverage.
7. Abatement of selling pressure from MUR holders.

Disclosure: The author, his family, and funds the author manages and/or is associated with may or may not have a position in any of the securities mentioned in this write-up. Any of the aforementioned may trade in and out and around any of the securities mentioned without notifying you. The analysis presented is the author’s own and is believed to be accurate. Do your own diligence. This write-up constitutes analysis and/or market commentary and is not an investment recommendation and as such, should not be used in isolation to make an investment decision. The author undertakes no obligation to update this report based on any future events or information. Estimates are subject to numerous assumptions, risks and uncertainties which change over time.

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