Marathon Petroleum: Still Has Gas In The Tank After 100% Returns (NYSE:MPC)

Thesis

In my original coverage of Marathon Petroleum (NYSE:MPC), I highlighted the company’s diverse revenue streams, strong cash balances, and undervaluation given the sum of its individual parts. Following my original buy recommendation, the company is up over 100%. Now, after more than doubling in share price, the obvious reaction is to wonder if it’s time to cash out, or to see if more can be squeezed out of MPC?

In this article, I will show how strong crack spreads, coupled with rising distributions from MPLX will support long term appreciation of the company’s stock. This appreciation will mainly occur as a result of forced appreciation through a strong share buyback plan.

MPC is capable of allocating nearly all of its free cash flow to investor returns through its strategic investment in MPLX. Distributions from MPLX cover the entire dividend and roughly half of the company’s CAPEX spending. This allows MPC to continue to buy back shares, regardless of the cyclicality of the refining business.

The Macro Environment For Refining Remains Strong

Over the last two years, MPC has been able to reduce its share count from 638 million to 409 million shares, or a 36% reduction. This reduction came at a total cost of $24 billion and has only been possible through strong profitability in its refining segment and consistent cash distributions from its equity stake in MPLX. Given the macro environment for refined fuels globally, this trend is well supported to continue for at least the medium term.

In today’s market, US inventories for gasoline and distillate remain below five-year averages. Despite several additions in global capacity, the early spring inventory levels in the US are roughly at the same level as observed in the spring of 2023. Low inventory levels will continue to support crack spreads, particularly as the Northern Hemisphere enters peak driving season.

Globally, capacity is expected to grow slightly but only marginally. Phillips 66’s VP of IR, Jeff Dietert, made the following comments regarding global capacity additions over the next several years at the Bank of America Refining Conference.

The industry is not announcing new capacity additions and years a meaningful way as it has historically. And when we look at net capacity additions, we’ve got about 1.5 million barrels a day this year.

But as we look at ’25, ’26, ’27, ’28, there’s 1 million barrels a day or less per annum of new capacity planned. And so a very light program. It’s about a 5-plus year lead time for construction of a new facility. And so we’ve got pretty good visibility on capacity adds. And as you think about demand for this year, the IEA is at 1.3 million barrels a day. They’ve now increased their expectations four months in a row.

These statements indicate a general balance in the status quo as the industry moves forward in the coming years. Capacity additions are expected to be met through incremental increase in demand, thus not creating any large disruptions.

But What If The Good Times End?

As with any cyclical business, it is rational to assume that one day, the good times won’t be so rosy. To understand the implications of such an event, I like to use an annual 20% EBITDA reduction for my two year look ahead.

In this bear case, MPC had $8.7 billion in EBITDA by year end 2025. Even in this case, MPC would still have $9 billion to spend in share repurchases after funding the dividend, or about 12% of the current market cap. This assumes a 20% increase in CAPEX spending as well as a 10% increase in the dividend.

Future Refinery Bear Case

Click to enlarge

In a slightly less bearish scenario, I have instead modeled an EBITDA contraction of 10% annually. In this model, MPC can spend up to nearly $12 billion in share repurchases, or 15% of the current market cap.

Future Refinery Base Case

Click to enlarge

While both of these scenarios are serious steps down from the last two years, I believe it gives a realistic performance floor for MPC’s refining segment.

What I have not accounted for in this model, is the contribution from the company’s midstream segment. The business structure is a little different here. MPC’s midstream business is operated by MPLX LP (MPLX).

MPC owns 65% of MPLX, a master limited partnership that owns and operates a pipeline network for refined products and natural gas processing and transportation. Through this ownership, MPC was able to realize $2.06 billion in distributions in 2023. This is expected to increase to $2.2 billion in 2024, thanks to a distribution increase by MPLX.

The important take away here is that this is straight cash from a very stable business entity. Unlike the refining business, midstream companies have a stable earnings profile, generally supported by take or pay contracts. The earnings generated from these assets are correlated to shear volume moving through the system and not directly tied to the commodity price.

MPC’s management paints this payment as a method of covering the expense of the dividend and approximately half of the companies CAPEX spending. I like to take that view one step further. By having $2.2 billion in external cash flow, nearly all of the refining segments FCF can be returned to shareholders. As result, MPC was able to return 92% of operating cash flow in 2023.

Valuation

The valuation metric is another point that gets skewed by the equity stake in MPLX. The market value of the 647 million units of MPLX is worth approximately $27.3 billion. If the operating performance of the refining segment is separated from MPC, it paints a very different picture of the company’s valuation metrics. To do so, I have removed the market cap, debt, and cash impacts of the MPLX units. Doing so gives an EV to EBITDA ratio of 3.78x.

When compared to pure play refiners such as Valero or DF Sinclair, MPC’s refinery business clearly trades at a moderate discount.

Using the same calculation method for the bear case two year forecast, the current share price would yield a EV to EBITDA ratio of 4.88, which is more generally in line with peers. This model assumes $9 billion in share repurchases occur over the two year period.

This is quantitative evidence that MPC’s refining segment remains undervalued, even after a tremendous run. Further growth in the MPLX distribution provides even more margin to share price decline should a disruption occur in the refining sector.

With the current market set up to continue to generate large amounts of cash, I expect MPC’s share repurchase rate to exceed both the bear and base case models. Assuming MPC continues to trade at the same valuation, the base case share repurchase program implies a 12% increase in share value. The modest dividend of 2% will push the total return into the mid teens for 2024.

Upside performance is available through increased distributions from MPLX in 2024/2025 as well as the strengthening crack spreads as the country enters peak driving season.

While a significant portion of the money has been made with MPC, I do not think it is quite done yet. MPC simply prints cash and the refining business is required to reinvest only minimal levels of its operating cash flow to meet its CAPEX needs. I believe that MPC will be a steady performer for the long term and the current price of $219/share represents a modest entry point. Downside protection is provided by growing MPLX distributions and a strong share buyback program.

Risks

The refining business is renowned for its cyclicality. As such, the earnings potential of MPC can fluctuate in ways that are largely outside of its control. This is in part related to the season variations in fuel consumption, while also tied to the variations in crude oil production and pricing.

These factors will cause volatility in earnings. An example can been seen from Q3 to Q4 of 2023 as peak fuel demand faded into the winter months. Investors should be aware of this volatility prior to investing.

Summary

The current inventory of distillates and gasoline support strong near term profitability for the refining sector. MPC will continue to generate strong cash flows in this environment. I anticipate the company will continue to be able to return large amounts of cash to shareholders through share repurchases. This in turn will force capital appreciation of the share price through organic EPS growth. Therefore, it does not appear that MPC has reached its ceiling yet.

To understand the downside risk, I have modeled both a 10% and 20% annual EBITDA decline on a two year outlook. In both scenarios that refining segment remains cash flow positive while funding CAPEX, the dividend, and between $9 and $12 billion in share repurchases between now and the end of 2025.

Overall, the macro supports the current rate of profitability. Downside impacts are mitigated by a severely undervalued refining business as well as a fixed influx of cash from MPLX ($2.2 billion). Even after a tremendous run, the math supports more upside than downside for MPC. I would not expect the same monstrous returns but MPC should still perform solidly. I rate MPC as a buy at the current share price of $219/share.