The Cents Behind Spinoffs

Companies are separating their retail and midstream divisions, with no end in sight

A dramatic shift is underway in the convenience and petroleum retailing industry that will forever alter the landscape. Spinoffs and master limited partnerships (MLPs) have dominated the headlines recently, and industry insiders expect this trend to continue indefinitely.

Several companies have spun off their retail divisions — parent to their convenience store and gas station assets — while even more have spun off their midstream pipeline assets into initial public offerings. Some corporations in the industry have gone so far as to do both.

Take San Antonio-based Valero Energy Corp., which spun off its entire retail division into a company called CST Brands Inc. on May 1. Last month, the company announced it will spin off a midstream division Valero Energy Partners LP into a MLP, while the parent company will primarily focus on exploration and production.

In addition, Murphy Oil Corp. spun off its retail division as Murphy USA Inc. on Aug. 30. The new El Dorado, Ark.-based company expects to operate 1,235 convenience stores by the end of this year. “Separating these two businesses will allow each to unlock its own potential for growth,” said Claiborne Deming, Murphy Oil Corp.’s chairman of the board. “We have built two strong, but distinct businesses. Murphy will be a pure-play exploration and production company with strong returns and attractive investment opportunities, while Murphy USA will be a leading retailer with over 1,100 retail gasoline outlets.”

So, why are companies taking this approach? From the retail c-store perspective, spinoffs have unlocked value for companies, said Bonnie Herzog, senior analyst at Wells Fargo Securities LLC. They also can provide tax benefits and more flexibility.

Kim Bowers, CEO of the new CST Brands, operator of 1,040 Corner Store locations in the United States, believes her company will be better than ever before.

“As part of a much larger refining company, retail in a good year was 10 percent of Valero’s overall income pie. So, we had a fairly slower growth model recently,” she explained. “Prior [to being spun off], we were more focused on [selling] Valero’s fuel, which is how it should be as a subsidiary. But going forward, we are all about doing the best for our shareholders, providing the best opportunities for employees and providing the best experience for our customers.”

Herzog predicts that retail spinoffs will continue over the next several years. The search for growth, she said, is the main reason why such spinoffs will become commonplace.

“I wouldn’t be surprised…if we see this trend continue,” she added. “The drivers of this industry are consolidations and acquisitions. It’s still a very fragmented industry, but organic growth through store builds and acquisitions of smaller independents or smaller chains will be an ongoing trend over the next five or 10 years.”

MLP FEVER

While retail spinoff activity has been busy over the past two years, MLP spinoffs have clearly hit a fever pitch. Nearly every large c-store-related company with a midstream oil and gas pipeline has spun off that division or stated publicly that it’s considered doing so.

To qualify for MLP status, a partnership must generate at least 90 percent of its income from what the Internal Revenue Service deems “qualifying” sources. Those sources include activities related to the production, processing or transportation of oil, natural gas and coal.

Among the companies that have created MLPs currently trading on the New York Stock Exchange are Speedway LLC parent company Marathon Petroleum Corp.; MAPCO Express parent Delek US Holdings Inc.; Alon USA Energy Inc.; Stripes parent Susser Holdings Corp.; Phillips 66; and Tesoro Corp. Western Refining Inc. also filed an S-1 registration statement with the U.S. Securities and Exchange Commission to spin off its midstream business into an MLP.

A handful of existing MLPs own significant convenience store and gas station assets, including Energy Transfer Partners LP, which purchased Sunoco Inc. last year; Global Partners LP; Lehigh Gas Partners LP; and SuperAmerica parent Northern Tier Energy LP.

More than 100 MLPs exist today and that number is growing rapidly. Companies have been spinning off MLPs for several reasons. One major advantage is that MLPs avoid corporate taxation because they pay out most of their cash flow to shareholders. Unlocking potential growth in other segments of a company’s business is another benefit.

Herzog specifically highlighted Susser Holdings as a company having great success since spinning off Susser Petroleum Partners LP last year. Wells Fargo initiated Susser Holdings with an “outperform” rating, meaning Herzog is bullish about the stock.

“We believe [Susser Holdings] is not being given the credit it deserves in the market,” Herzog wrote in an equity research report. “…This structure and the cash flow it will ultimately generate for [Susser Holdings] is generally misunderstood and undervalued by the market.”

An unrelenting appetite on the part of the investor community also makes companies want to formulate MLPs. MLPs have outperformed the benchmark Standard & Poor’s 500 index for 11 years running, by an average of 20 percentage points per year through 2012, according to Barron’s. MLPs also distribute an average of 6 percent a year to unit holders in the form of cash payouts, which clobbers the interest rates banks can offer their customers.

Currently, the only real negative for unit holders is the tax headache MLPs can cause. Unit holders receive an annual K-1 form — as opposed to a traditional 1099 issued for regular dividends — something that has, in turn, baffled some accountants.

WILL THE OTHER SHOE DROP?

The old adage, “What goes up must come down,” is certainly pertinent for the stock market, making experts wonder when MLPs will finally return to normal levels.

Rising interest rates could cause the other shoe to drop. Since MLPs pay out so much of their cash flow to unit holders, they must borrow money to help finance their growth. If interest rates begin to rise, which the Federal Reserve has hinted will start taking place soon, borrowing costs will go up, something some experts believe will thoroughly damage MLPs.

MLPs have already survived both rising and falling interest rate environments, however. In addition, once interest rates rise, they should do so slowly and gradually, according to Herzog. Hence, MLPs may be able to withstand a rising interest rate environment successfully.

“Of what I understand of interest rates from economists and strategists, they are not going to double in the next year. It will be more of a steady climb,” Herzog concluded. “Therefore, I think the structure of [MLPs] still can be pretty successful.”