Undervalued Dividend Growth Stock of the Week: Marathon Petroleum (MPC)

Investing during times of uncertainty seems scary.

The COVID-19 outbreak has seemingly kicked up uncertainty a few notches.

But I have a secret to share with you.

Life is always uncertain. 

You’re just not constantly aware of it.

Until, that is, some kind of major event happens.

Warren Buffett noted this very recently, discussing how September 10, 2001 was very uncertain.

However, nobody knew it until the September 11 attack happened the next day.

How to fight uncertainty? 

With a little bit of certainty, of course.

And few things in life are more certain than growing dividends from blue-chip companies.

I’m talking about blue-chip companies like those you’ll find on the Dividend Champions, Contenders, and Challengers list.

It’s fairly certain that world-class enterprises will continue to sell the products and/or services the world demands and requires.

As more people pay higher prices for more of these products and/or services, profits and dividends rise.

That means more wealth and passive dividend income for shareholders.

This is why dividend growth investing is so powerful.

I used this strategy to go from below broke at 27 years old to financially independent and retired at 33, as I lay out in my Early Retirement Blueprint.

I built the FIRE Fund using dividend growth investing.

That’s my real-money early retirement stock portfolio.

It generates the five-figure passive dividend income I live off of in my 30s.

Now, dividends aren’t guaranteed. I’m not saying that.

But as long as society continues to demand things like energy, medicine, and access to the Internet, I feel pretty good about the long-term prospects of companies that provide all of that.

Jason Fieber's Dividend Growth PortfolioOf course, it’s more than just picking the right company.

The price you pay at the time of investment can have a major impact on the long-term results.

More specifically, it’s all about the value you get for the price.

It’s price that you pay. But it’s value that you get.

An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk. 

This is relative to what the same stock might otherwise provide if it were fairly valued or overvalued.

Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.

That higher yield correlates to greater long-term total return potential.

This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.

Prospective investment income is boosted by the higher yield.

But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.

And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.

These dynamics should reduce risk.

Undervaluation introduces a margin of safety.

This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value.

It’s protection against the possible downside.

Buying high-quality dividend growth stocks when they’re undervalued can give you just the kind of long-term certainty you need in an uncertain world.

And I have great news for you.

The process of estimating intrinsic value isn’t really that difficult.

Fellow contributor Dave Van Knapp greatly demystifies it with Lesson 11: Valuation, part of a series of “lessons” on dividend growth investing, which provides an easy-to-follow valuation process that can be applied to just about any dividend growth stock out there.

With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…

Marathon Petroleum Corp. (MPC)

Marathon Petroleum Corp. (MPC) is a US independent petroleum product refiner, marketer, and transporter.

With a corporate history dating back to the late 1800s and now employing more than 60,000 people, Marathon Petroleum is the largest petroleum refinery operator in the United States. They have refining capacity in excess of 3 million barrels per day.

The company owns and operates 16 refineries in the in the Gulf Coast, Mid-Continent and West Coast regions of the US.

They’re the general partner and majority limited partner unitholder in two midstream companies, MPLX LP (MPLX) and Andeavor Logistics LP (ANDX). This gives them a strong midstream footprint in the Marcellus, Permian, and Bakken fields.

They also lay claim to the nation’s second-largest company-owned and -operated convenience store chain, primarily under the Speedway brand.

They report operations across three segments: Midstream, 48% of FY 2019 operating income before unallocated items and impairments; Refining & Marketing, 31%; and Retail, 21%.

Today’s theme is uncertainty.

Well, Marathon Petroleum’s business has been walloped by two big elements of uncertainty made known.

First, there’s the aforementioned COVID-19, which is causing a demand shock across the global economy. Less consumption across the world means less demand for energy.

Second, there’s the oil price war that just started this past week after Russia and Saudi Arabia couldn’t come to terms on production.

This double-whammy has knocked the stock down by almost 50% since the start of the year. That’s a ~50% market cap elimination in less than three months. It’s astounding.

But the uncertainty existed before it came to light. It’s only now that we actually see it.

Long-term investors have to acknowledge there’s always uncertainty, and it’s important to capitalize when uncertainty manifests itself and causes emotional reactions by the market.

The good news for dividend growth investors is that their dividends aren’t subject to the emotional whims of the market.

The dividends are dictated by companies themselves.

And Marathon Petroleum has built up a very nice track record of delivering growing dividends to their shareholders.

Dividend Growth, Growth Rate, Payout Ratio and Yield

They’ve increased their dividend for 10 consecutive years, with the most recent increase coming just last month.

That’s as long as the dividend growth track record could possibly be – Marathon Petroleum was spun off from Marathon Oil Corporation (MRO) in 2011.

The five-year dividend growth rate is 18.2%.

That’s an amazing growth rate when you consider the stock is yielding 9.86% right now.

It’s almost unheard of to land a yield over 9% along with a growth rate well into the double digits.

This yield, by the way, is over 700 basis points higher than the stock’s own five-year average yield.

Then there’s the fact that it’s more than three times higher than the broader market.

And with a payout ratio of 58.4%, the dividend looks very secure.

Free cash flow is very strong, further indicating no problems with covering the dividend.

However, these numbers are looking backward. It’s difficult to determine exactly how much and for how long the reduced demand and price war will impact companies like Marathon Petroleum.

But this company has been down this road. They’ve seen this movie before. It’s not a new energy company. They have a legacy dating back more than a century.

In the end, the world demands a lot of energy – and that demand is rising. This puts a company like Marathon Petroleum in a good position over the long term, even if the near term is, well, uncertain.

Revenue and Earnings Growth

The stock’s spectacular YTD drop is something to behold, but long-term investors must keep value as their north star.

In order to ascertain an estimate of the stock’s intrinsic value, I’ll build out a growth trajectory.

A company’s value is largely based on how much growth it can produce, so this trajectory will greatly help us with the valuation.

I’ll first rely on what Marathon Petroleum has done in terms of top-line and bottom-line growth since operating as an independent company.

Then I’ll compare that to a near-term professional projection of the firm’s profit growth.

Blending the proven past with a future forecast like this should give us a very good idea as to where Marathon Petroleum is going over the long haul, near-term turbulence notwithstanding.

Marathon Petroleum grew its revenue from $78.709 billion in FY 2011 to $123.949 billion in FY 2019.

That’s a compound annual growth rate of 5.84%.

This is very good for a large and mature business like this.

Meantime, earnings per share expanded from $3.33 to $3.97 over this period, which is a CAGR of 2.22%.

That bottom-line growth is anemic, but I think it’s also deceptive.

Because of the nature of the business, GAAP EPS can fluctuate wildly from year to year.

In addition, there was the ~$23 billion acquisition of Andeavor in late 2018, elevating Marathon Petroleum into a premier midstream and downstream energy player.

However, we can look past GAAP numbers and lumpiness to see that free cash flow approximately doubled between FY 2011 and FY 2019. Operations are incredibly healthy as of the end of FY 2019.

Looking forward, CFRA is predicting that Marathon Petroleum will compound its EPS at an annual rate of 14% over the next three years.

This is aggressive.

But it’s a number that was put forth before the monumental shift in oil prices.

Near-term volatility will affect energy companies far and wide, but I think the long-term thesis here is still intact. Energy demand is rising over time. And traditional energy sources still account for the majority of supply. This dynamic doesn’t show signs of changing in a material way over the foreseeable future.

Marathon Petroleum doesn’t need to compound at 14% in order to be a fantastic investment.

Not with the way the stock’s price has completely cratered.

With a yield of almost 10%, low-single-digit bottom-line growth is all you need to generate like dividend growth and provide for a very satisfactory investment in terms of aggregate income and total return.

I think Marathon Petroleum can do much better than this over the long run, even if the short term offers less.

Financial Position

Moving over to the balance sheet, they’re in a good financial position.

But the balance sheet could stand to be markedly improved.

The long-term debt/equity ratio is 0.83, while the interest coverage ratio is under 5.

The company has taken on a lot of debt in recent years, primarily to finance the Andeavor deal.

Making matters worse, the timing of that deal looks bad in retrospect.

On the other hand, the deal is generating much higher synergies than originally predicted. With their full-year earnings release, they stated that the company had realized $1.1 billion in synergies in 2019, well ahead of the targeted $600 million of annual gross run-rate synergies.

Operating with a lot of debt is modus operandi in this space, but I’d like to see Marathon Petroleum clean up the balance sheet in the coming years.

Profitability is competitive for the industry, but I think margin could be expanded.

Over the last five years, the firm has averaged annual net margin of 3.08% and annual return on equity of 15.26%.

Overall, Marathon Petroleum looks like an appealing long-term investment in the energy space.

With massive scale and complex infrastructure already built in key locations, the company has durable competitive advantages.

However, there are risks to consider.

Regulation, litigation, and competition are omnipresent risks for every industry.

There is significant exposure to volatile commodity pricing here. As a price taker, Marathon Petroleum is exposed to pricing swings.

The company heavily relies on the MLP model, which has some question marks regarding capital structure and growth models.

Also, there is some black swan risk here in terms of unexpected problems with infrastructure (such as explosions).

Even with those risks, I still think this stock could make a lot of sense for a long-term investor looking for exposure to a quality refiner.

That’s especially the case with the current valuation – the stock has fallen ~50% YTD.

The stock now looks extremely cheap…

Stock Price Valuation

The P/E ratio is at 5.92.

And that’s on depressed GAAP EPS.

Compared to the five-year average P/E ratio of 13.7, there’s obviously a major disconnect.

Furthermore, the P/CF ratio of 2.2 is less than half of its three-year average of 5.9.

And the yield, as noted earlier, is substantially higher than its recent historical average.

So the stock does look cheap. But how cheap might it be? What would a reasonable estimate of intrinsic value look like? 

I valued shares using a dividend discount model analysis.

I factored in an 8% discount rate (due to the high yield) and a long-term dividend growth rate of 5%.

This is a very conservative DGR.

But I’m erring on the side of caution.

While the COVID-19’s shock to demand will pass soon enough, the oil price war has an indeterminate time frame. And it offers far more severe consequences for energy companies.

I think Marathon Petroleum could easily surpass this expectation over the long run; however, it does make sense to be ultra careful in this fluid environment.

The DDM analysis gives me a fair value of $81.20.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

Even with a thoughtful reduction in growth expectations, the stock still appears to be incredibly undervalued.

But we’ll now compare that valuation with where two professional stock analysis firms have come out at.

This adds balance, depth, and perspective to our conclusion.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates MPC as a 5-star stock, with a fair value estimate of $89.00.

CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

CFRA rates MPC as a 3-star “HOLD”, with a 12-month target price of $58.00.

I came out slightly less than Morningstar, but we all agree that the stock looks extraordinarily cheap. Averaging the three numbers out gives us a final valuation of $76.07, which would indicate the stock is possibly 223% undervalued.

Bottom line: Marathon Petroleum Corp. (MPC) is a high-quality energy company that is integrated across its midstream and downstream business lines. With a market-shattering yield of ~10%, double-digit long-term dividend growth, a reasonable payout ratio, and the potential that shares are 223% undervalued, this could be a once-in-a-generation type of investment opportunity for dividend growth investors.

-Jason Fieber

Note from DTA: How safe is MPC’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 50. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, MPC’s dividend appears Borderline Safe with a low risk of being cut. Learn more about Dividend Safety Scores here.

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