Is the U.S. Stock Market Currently in a Bubble? (Part 2)

Expanding on my previous post, let’s look at a few other measures that can give us an idea of the current state of market valuations.

The Ratio of Market Capitalization to GDP

In a Forbes interview, Warren Buffet described this ratio as “probably the best single measure of where valuations stand at any given moment.”  It’s simply the total market capitalization of the stock market divided by GDP.  The following chart shows how this measure has varied over the years and where it currently stands.  Below that is a chart of the S&P 500.


Market Cap / GDP Ratio, Source:


S&P 500, Source:

As we can see, this ratio is the highest its been since around the year 2000.  It suggests that market prices are rich relative to GDP at the current moment.  Of course that doesn’t mean that stock prices are ready to crash, just that investors should be cautious.

John Hussman, a stock market analyst and fund manager ( says that annual returns are driven by the following:

1.  Growth in nominal GDP

2.  The reversion in the ratio of market capitalization to GDP toward its historical norm

3.  The annual dividend yield

For a 10 year horizon, the formula can be written out as:

The historical norm of the market cap to GDP ratio has been about 0.63.  In early 2000, it hit its highest level of 1.54.  At that point, the dividend yield for the S&P 500 was 1.1%.  If we assume a generous nominal GDP growth of 6.3%, Hussman says that an estimate of the subsequent 10 year annual return could have been calculated as follows:    (1.063)(0.63/1.54)^(1/10) – 1.0 + .011 = -1.7% annually.  This means pretty much negative to flat returns for a decade.  Sure enough, the actual total return of the S&P from 2000-2010 was still negative even after bouncing back from the March 2009 lows.

Hussman then provides a valuation study for 2014.  The current market cap to GDP ratio is 1.25, about double its historical norm of 0.63.  If we assume nominal GDP gets back to a healthy growth rate of 6.3% and with an S&P dividend yield of 2%, we can estimate the following 10 year return to be:

(1.063)(0.63/1.25)^(1/10) – 1.0 + .02 = 1.3% annually

In other words, according to this, we can expect pretty anemic returns for the next decade at these levels.  Off course, if the market sells off drastically, investors getting in at better levels can expect to achieve greater returns.

The chart below from John Hussman’s website is instructive.  It shows projected 10-year return based on the formula above against the actual 10-year return that occurred.  As we can see, the two lines correlate pretty well with each other, so the formula does a pretty good job of predicting what the return will be based on current market cap / GDP and dividend yield.  Based on current stock market valuations, the chart and formula is predicting low single digit returns over the next 10 years.

Projected and Actual Returns for the S&P 500, Source:

Projected and Actual Returns for the S&P 500, Source:

Corporate Profits to GDP

Another area where we see evidence that the U.S. market may be overvalued is company profits.  The corporate profits to GDP ratio is at all time highs.  Profit margins are cyclical and mean-reverting, so they’re not likely to remain at these levels forever, unless something fundamentally has changed and companies can expect permanently high profit margins.


Corporate Profits to GDP Ratio, Source:  St. Louis Fed

Corporate Profits to GDP Ratio, Source: St. Louis Fed

The Current Market Is Still Not As Frothy as in 2000

Although valuations may be rich, we still aren’t seeing the same maniacal prices for tech stocks especially as exhibited in 2000.  From a recent BBC article, Kathleen Smith of IPO investment advisory firm Renaissance Capital says there have been 53 listings of IPOs so far in 2014 which is half what we had for the same time period during 2000.  Also, the price performance of newly-listed shares isn’t as extreme as in 2000.  In 1999, more than 100 companies saw their share price double on the first day.  In 2000 there were 80.  So far this year, there have only been 4.  (

It also seems like large-cap stocks are still reasonably priced.  Based on data from the Bespoke Investment group from a New York Times article:

In 2000, the 10 biggest stocks in the S&P 500 had an average P/E ratio of 62.6. Today, that number is only 16.1.

Today, only one stock among the largest 10 stocks has a P/E above 30: Google. (

I did a Google Trends search to see how often the term “Stock Bubble” was searched for and came up with the following chart:

"Stock Bubble" Search Interest, Source:  Google Trends

“Stock Bubble” Search Interest, Source: Google Trends

After the peak in interest in middle 2007, the years 2008 and 2009 were some of the most turbulent market periods in history.  For 2010, 2011, and 2012, we don’t see much interest in the term, until late 2013, where searches for “Stock Bubble” increased again.  Not to say that this is predictive of a market crash in any way, it was just something I found interesting to note.


Overall, I think that investors need to be cognizant of the fact that the market is valued more richly than in the past few years, especially certain sectors such as internet and biotech.  At least part of this recent bull market has been the result of easy money policies by the Fed.  Interest rates are bound to increase at some point and that will put pressure on corporate profits and stock prices.  This doesn’t mean you should dump your stocks however, especially if you have a long-term time horizon and a diversified portfolio.  If you do, then a 30% or more market correction should not scare you and will actually be an opportunity to get in at better levels.  If however, you are close to retirement, then considering moving a part of your portfolio into cash or safer assets may be a prudent strategy.


Weight Watchers (WTW): A Bargain Price in a Pricey Market Presents a Multi-Bagger Opportunity

Weight Watchers International (WTW)



  • Weight Watchers’ (WTW) current price provides an opportunity for investors to buy a brand-name, high-margin, cash-flow-rich business at a bargain price.
  • Concerns over WTW debt are overblown as company interest coverage ratio more than provides enough cash to cover interest and principal payments.
  • Management has lowered expectations and set the bar very low for this years’ earnings, therefore the market could be overly discounting the chances of a turnaround.

There have been some great articles written recently regarding Weight Watchers (WTW) stock and the favorable risk-reward profile it presents investors.  I won’t delve into all the particulars of the company and its business details so as not to repeat what others have already mentioned.  I would however, like to add my two cents briefly in a quantitative way with some number crunching to come up with an estimate of intrinsic value based on free cash flow, something that Weight Watchers has consistently been able to generate.

Weight Watchers (WTW) is the most well-known weight management services and products company in the world.  With shares down 75% from their all-time highs, investors can acquire a business with brand-name recognition along with a methodology that’s been proven to work systematically for people over the company’s 50+ year history.  Management has pretty much lowered all expectations by reducing 2014 EPS guidance by 63% from 2013 EPS.  The share price currently reflects this.  Therefore, any kind of earnings surprise or good news can give the stock a big bounce.  In other words:  “Heads:  I win a lot, Tails:  I don’t lose that much.”

Using a free cash flow model, I’ll attempt to show that even under pessimistic scenarios, patient investors have a good amount of potential upside with the current share price around $20.

Investment Positives

  • Ability to acquire a consistently cash-generative, low capital intensity business for about 4 times median free cash flow over the past 7 years. (Where free cash flow is defined as cash from operations minus capital expenditures.)  This is about a 20% free cash flow yield based on median free cash flow over the past 7 years.
  • Ability to acquire the business for 2.5 times median EBIT over past 7 years and 4.5 times expected 2014 EBIT.
  • Management considers debt reduction a priority.
  • Management expects revenues to decline at a higher rate in fiscal 2014 than that experienced in fiscal 2013.  To offset, they expect to reduce costs and support plans for future growth.
  • $150 million gross annual savings goal by end of 2014.
  •  Management expects revenue growth in 2016 and $2 billion in revenue by 2018.
  • 50% stake of large investor Artal Group can give investors confidence that there are large stakeholders that won’t stand idly by without initiating a turnaround.
  • Interest coverage ratio (EBIT/ Interest Expense) of 4.4 for 2013 and expected value of 2.0 for 2014 shows that company has sufficient cash flow to cover their interest expense.
  • WTW plans to expand into healthcare and partnerships with health plans to provide dieting and weight management solutions.  Recent offering of Weight Watchers for Diabetes has landed Orlando Health, a large not-for-profit health care network, as its first client.  Weight Watchers has been trying out its new diabetes offering in several areas around the country.
  • Spokeswoman and celebrity Jessica Simpson providing her testimony and how well Weight Watchers worked for her can lead to increasing brand popularity.

Investment Risks

  • Revenue decline may continue to accelerate faster than cost savings can be achieved.
  • Debt-service on long-term debt of $2.36 billion can become overwhelming if revenues continue to decline, resulting in less cash available to invest into the business.
  • Continuing declines in “paid-weeks” metric and meetings recruitment may be difficult to turn around.
  • Propagation and increasing popularity of free mobile weight loss apps can continue to lead to revenue declines.
  • Uncertain outcome from recent class action lawsuit filed on behalf of investors who purchased Weight Watchers common stock between February 14, 2012 and October 30, 2013 alleges that Weight Watchers misrepresented material facts and/or failed to disclose adverse facts.

Industry-Implied Free Cash Flow Valuation

WTW free cash flow for the fiscal year ended Dec 31, 2013:

Operating Cash Flow ($mm):  $323.52

Minus Capex ($mm):  $61.93

Equals Free Cash Flow ($mm):  $261.59

Divided By Average FCF Yield of Personal Services Industry:  5%

Equals Industry FCF Yield-Implied Fair Value ($mm):  $5231.80/56.4 million shares out = $92.76 per share

If we require a more stringent free cash flow yield than the industry of say 7.5%, we get a fair value of:

$261.59 / 7.5% = $3487.87/56.4 million shares out = $61.84 per share

Discounted Free Cash Flow to Equity Valuation


2014 numbers are taken from management guidance given in the fourth quarter earnings conference call.  The following years’ numbers are using assumptions I believe are reasonable and conservative.  Free cash flow to equity is defined as:

FCFE = Net Income + Depreciation/Amortization/Non-Cash-Charges – Fixed Capital Investment – Working Capital Investment + Net Borrowing

Since the value of a stock is theoretically the present value of all future cash flows available to shareholders, this is the amount that is available after all capital expenditures, interest, and principal payments are paid.  What’s leftover is money that could be paid as dividends to shareholders.

Intrinsic Value per Share based on Free Cash Flow to Equity Valuation given below:  $57.29

As can be seen, the valuation depends heavily on the company’s ability to repay debt and eventually reverse their revenue decline.

You can download the spreadsheet from the link below and play around with some of the assumptions to see how it affects intrinsic value.

WTW Valuation Excel Spreadsheet

Free Cash Flow to Equity Valuation of WTW

Free Cash Flow to Equity Valuation of WTW


The current price of Weight Watchers (WTW) stock ignores the value of the company’s brand power and cash flow generating abilities.  Management’s commitment to drastically reduce costs and pay off debt is another positive.  For patient investors that have at least a year or two horizon, WTW’s current price presents a bargain opportunity to invest in a high-margin, low capital intensity business that has proven it’s not a fad over 50 years of history.   In today’s current market of lofty stock valuations, WTW is one company where the risk-reward is skewed to the upside.

Disclosure: I am long WTW. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Harvest Natural Resources (HNR): Upcoming Catalysts Provide an Opportunity for a 50% Return

Harvest Natural Resources (HNR)

Investment Thesis

Investment opportunities are sometimes found in the tucked-away, nether regions of the stock market where few analysts will take notice.  But as they say, the fishing is best where the fewest people go.  Harvest Natural Resources (HNR) is one of those stocks that present a unique opportunity.  The problem is that it’s a company that hasn’t made money in five years that’s trading below tangible book value, and who’s very ability to operate as a going concern is questionable.  So why even bother?  The reason to consider this stock is that HNR is in the midst of a sale of its share of a partnership in Venezuela and also looking to sell its assets in Gabon to interested parties.  HNR has received cash for half of the Venezuela deal.  If these transactions close successfully, the company’s net asset value alone will be over $7.00 per share, 45% higher than its recent closing price of $4.80.  The question that remains will then be:  Will management take shareholder-friendly action and return the cash to shareholders?

HNR Company Overview

HNR is an oil and natural gas exploration / development company with assets / interests in the following regions:

  • Venezuela:  Through affiliates, HNR owns a 32% interest in Petrodelta.  The majority owner is PDVSA, the Venezuelan state-owned oil and natural gas company, which exercises most of the control over Petrodelta’s operations.  PDVSA however, has been derelict in its duties, providing insufficient monetary support in capital expenditures and falling behind in payments to contractors providing services to Petrodelta.   HNR is still waiting on a $9.8 million dividend that was declared in November 2010, and is uncertain on when or whether this or any future dividends will be paid. This is due to Petrodelta’s liquidity constraints from PDVSA’s lack of monetary support.
HNR's Venezuela Properties, Source:  HNR 2012 Annual Report

HNR’s Venezuela Properties, Source: HNR 2012 Annual Report

Although Petrodelta has consistently earned a profit from 2007 to 2013, dividends of profits since 2010 have not been declared, and there’s uncertainty over whether any future dividends will be paid.  The key point:  It’s probably a bad idea for HNR to keep doing business in Venezuela!  Recently, HNR entered into an agreement to sell its interest in Venezuela for an after-tax amount of $330 million.  The first payment has been received and the next payment is expected several months from now.

  • Indonesia:  Operational activities in this region are onshore in West Sulawesi and are still in the exploration stage.

HNR's Indonesia Properties, Source:  HNR 2012 Annual Report

HNR’s Indonesia Properties, Source: HNR 2012 Annual Report
  • Gabon:  Off-shore deep-water drilling exploration is the focus here.  The first high-quality 3D seismic images are expected during the second quarter of 2014.  In September of 2013, HNR entered into negotiations with Vitol S.A. to sell HNR’s 66.67% interest in Gabon for $137 million in cash.  Net proceeds were expected to be $121.8 million after transaction costs and taxes; however HNR and Vitol S.A. were unable to reach a deal.
HNR's Gabon Properties, Source:  HNR's 2012 Annual Report

HNR’s Gabon Properties, Source: HNR’s 2012 Annual Report

  • Colombia:  HNR signed farm-out agreements with another company.  (Farm-outs are when a company assigns its oil or natural gas interest to another party for an up-front payment in addition to a percentage of the revenues)  HNR has received notices of default from its partners for failing to comply with certain terms of the farm-out agreement, and has fully impaired the costs associated with that transaction, to the tune of $2.3 million.

 Recent Insider Transactions

Date Insider





Nov 27, 2013 SPEIRS ROBERT Officer



Purchase at $3.15 per share.


Nov 27, 2013 EDMISTON JAMES A Officer



Purchase at $3.15 per share.


Nov 27, 2013 HAYNES STEPHEN C Officer



Purchase at $3.15 per share.


Nov 27, 2013 MURRAY PATRICK M Director



Purchase at $3.15 per share.


Nov 27, 2013 STINSON JOHN MICHAEL Director



Purchase at $3.15 per share.


Nov 27, 2013 CHESEBRO STEPHEN D Director



Purchase at $3.15 per share.


Source:  Yahoo Finance

As we can see, the insiders have been buying since November.

Selected Balance Sheet Data (for the quarter ended September 30, 2013) (thousands)

Total Current Assets:  $7,581

Other Assets:  $6,258

Long-Term Receivable – Equity Affiliate:  $14,947

Total Current Liabilities:  $17,262

Long-Term Debt:  $76,793

Embedded Derivative-Debt:  $3,487

Warrant Derivative Liability:  $4,757

Other Long-Term Liabilities:  $640

Total Equity:  $528,345

Stock Data

Price per Share:  $4.80

Tangible Book Value:  Total Equity – Other Assets – Long-Term Receivable = $528.345-$6.258-$14.947 = $507.14 (To be conservative, we subtract the other assets and the long-term receivable and assume they will never be recovered)

Tangible Book Value per Share = $507.14 / 45 million shares out = $11.27

Price / Tangible Book Value = $4.80 / $11.27 = 0.43

Recent Key Events / Catalysts

  • In a press release, HNR announced on Dec 16, 2013 that it entered into an agreement with Pluspetrol to sell all the company’s interests in Venezuela in two transactions totaling $400 million in cash.  The net proceeds after taxes are expected to be $122 million and $208 million.  The transaction for the first amount has already been closed.  The closing of the second transaction is still subject to approval from the government of Venezuela, and if granted should happen around mid-year.
  • Proceeds from the transaction will be used to pay down HNR’s long-term debt and the rest used for working capital.
  • In a press release dated November 19, 2013, HNR announced that it was unable to reach an agreement with Vitol S.A. for the sale of the company’s interests in offshore Gabon.
  • In a press release dated January 15, 2014, HNR announced that it completed redemption of all $79,750,000 of its outstanding 11% senior notes due 2014 plus accrued interest.


How can you value a company that doesn’t make any money?  Well, a sum-of-the-parts asset valuation is one way.

If the Venezuela transaction closes as expected, HNR will have net cash of (Balance sheet data as of 9-30-13):

$122m + $208m + Current Assets – Current Liabilities – Long-Term Debt – Embedded Derivative Debt – Warrant Derivative Liability – Other Long-Term Liabilities = $122 + $208 + $7.581 – $17.262 – $76.793 – $3.487 – $4.757 – $0.640 = $234.64m

Monthly expenses: $2m* 6 months till Venezuela deal close=$12m

Net cash per share by June 2014~ (234.64m-$12m) / 45m shares outstanding = $4.95

Their net cash will exceed their stock price by $4.95/$4.8 – 1 = 3%

If we add the valuation of their oil and gas properties according to their carrying value on the most recent balance sheet, we get the following:  $106.366m, or $106.366m / 45m shares outstanding = $2.36 per share

Then a sum-of-the-parts valuation gives us a fair value of ($4.95+$2.36) = $7.31 per share, which is about 50% higher than the current stock price of $4.80.


  • Although we have potential sum-of-the-parts valuation of $7.31 per share, in order for that value to be realized by shareholders, HNR needs to return that money back to shareholders.  If they continue with their exploration and development activities and continue to lose money, shareholder value will be destroyed.
  • The Venezuela transaction may not be approved by the Venezuelan government, thereby further hindering HNR to unlock the value of its assets and return capital to shareholders.
  • The value of HNR’s oil and gas properties as listed on their balance sheet may be overstated or they may not be able to find a buyer, particularly for their assets / interests in Gabon.  (The recent deal with Vitol S.A. fell apart.)


Overall, I think HNR is a unique investment opportunity with the above catalysts / recent developments.  The fact that it’s trading below tangible book value minimizes downside risk.  Although there are no sure things in life, the management seems confident that the Venezuela transaction will close, and it seems that they’re committed in unlocking the value of their assets for shareholders.  With HNR’s debt extinguished and with a strong, liquid balance sheet, I think this is a low-risk value investment with the embedded option for a large payoff should their remaining oil and gas properties prove valuable.

Aeropostale (ARO): A Beaten-Up Retail Stock That May Hold Opportunity for Contrarian Investors


Investment Thesis:

Aeropostale (ARO) has been among the worst-performing retail stocks of the year, down about 35% the last 52 weeks as of this writing.  This may provide an opportunity for contrarian, patient investors to acquire a stock that is relatively cheaper than its peers and among the leaders in market share among young adults aged 14-17.

I will show that shares have gotten to a point where the risk-reward trade-off is skewed to the upside, and if the company can turn things around or the teen retail environment  picks up, or if Aeropostale can adapt to the changing market environment by expanding their target audience, ARO shares will recover quite nicely.  ARO’s debt-free balance sheet and large cash balance also give us a margin of safety.

As investors, we ask ourselves: “Is this decline due to a permanent impairment in the company’s prospects for profitability, or is it a temporary one which can be reversed when the retail market picks back up again or the company adapts to changing tastes?”  I will argue for the latter argument in this article.


If you’ve been reading the news headlines, you’ll see plenty of articles talking about how fashion retailers expect weak holiday sales this year, especially the three major teen retailers, Abercrombie & Fitch, Aeropostale, and American Eagle.  There’s been a lot of bearish talk about the three “Big A’s” as they are called as you can see from the news article snapshot below.



Declining sales have forced analysts to all but write-off any kind of investment in teen retailers at this point.  Teens have “new tastes”, “the three A’s are no longer in vogue” and “teens are spending more on electronics than clothing” are just some of the things you’ll read.  While to a certain extent this might be true, I believe analysts are underestimating these retailers’ ability to quickly adapt to changing tastes and the fact that the retail industry goes through cyclical highs and lows.  I also believe that a good deal of the pessimism is already built into the stock price of ARO.  This creates a situation where any sort of good news can result in a quick turn-around of the stock price.  Now let’s look at ARO as compared to some of its peers.

Aeropostale vs. Peer Comparable Companies


  • Right away, we can see that ARO has been the worst performer over the past 52 weeks with a negative 34.73% return.
  • Aeropostale’s EV / LTM Revenue of 0.24 is cheapest among its peers, 67% less than American Eagle’s, which is next best.
  • Also notable, is ARO’s Price to Median Free Cash Flow multiple (P/FCF) of 7.44, where free cash flow is taken as the median of the past 7 years.  This is also the best value among its peers.
  • Finally, the price investors pay per dollar of sales is only $0.28 for Aeropostale, much less than any of its competitors.  (This is measured as Market Cap. / LTM Sales.)  So, with the stock price at $8.25, we are only paying 28 cents and are getting a dollar of revenue.

In terms of value, ARO seems to be a steal at this price, at least when measured against its peers.

Now let’s attempt to value the common stock of Aeropostale based on three models.

Aeropostale Intrinsic Value Estimates

Valuation Based on Tangible Book Value

  • Industry Price to Book Ratio:  2.55  (Source:, Industry:  Retail)
  • ARO Tangible Book Value per Share:  $4.32
  • Industry-Implied Fair Value of ARO:  2.55 * 4.32 = $11.01  (33.45% upside to current price of $8.25)
  • Assumed Conservative ARO Price to Book Ratio:  1.60
  • Conservative Estimate for Fair Value of ARO:  1.60 * $4.32 = $6.91  (-16.24% downside to current price of $8.25)

Valuation Based on Median Free Cash Flow of the Past 7 Years

  • Industry P / FCF Multiple:  11.13  (Source:, Industry:  Retail)
  • ARO Median FCF per Share Over Last 7 years:  $1.11
  • Industry-Implied Fair Value of ARO stock:  $1.11 * 11.13 = $12.34  (49.52% upside to current price of $8.25)
  • Assumed Conservative ARO  P / FCF Multiple:  9.0
  • Conservative Estimate for Fair Value of ARO stock:  9.0 * $1.11 = $9.98  (20.91% upside to current price of $8.25)

Valuation Based on LTM Revenue and Median EBIT Margin Over Past 7 Years

  • LTM Revenue ($M):  $2309.93
  • Median EBIT Margin Over Past 7 Years for ARO:  13.2%
  • Discounted EBIT Margin to be Conservative and Comparable to Peers over Last 7 Years:  10%
  • Normalized EBIT ($M) = $2309.93 * 10% = $230.99
  • Median EV / EBIT Multiple for ARO Over Past 5 Years:  5.22
  • Total Implied Enterprise Value for ARO ($M) = 5.22 * $230.99 = $1204.91
  • Plus Cash & Short-Term Investments ($M):  $100
  • Minus Long-Term Debt:  $0
  • Divided by Number of Shares (m):  78.49
  • Equals Fair Intrinsic Value for ARO Common Stock:  ($1204.91+$100-$0)/78.49 = $16.63  (101.52% upside to current price of $8.25)

Our three valuation measures provide estimates ranging from $6.91 to $16.63 for the intrinsic value of Aeropostale’s common stock, which is definitely skewed to the upside.

Potential Catalysts

  • The retail sales environment may not disappoint as badly as some analysts may be predicting.
  • Aeropostale may be able to adapt to “fickle” teenager’s tastes and new fads quickly.
  • Aeropostale’s stores aimed at 12-14 year old kids, called P.S. from Aeropostale are a growing chain, and over time will gain more share of that segment of the market.
  •, owned by Aeropostale, is an online women’s footwear & apparel website that is growing sales.  Despite ARO’s overall net sales decreasing by 6% in the second quarter of 2013, net sales from the e-commerce business of ARO including, increased by 22% to $39 million.  ARO’s e-commerce business may continue to become a bigger piece of the sales pie, which may stimulate an increase in ARO’s share price.
  • Sophisticated activist investors are on the scene.  Sycamore Partners has taken a nearly 8% stake in Aeropostale, calling ARO “an attractive investment.”  This makes it the third largest holder of the stock.  Communication with the company’s management and board about Aeropostale’s business and strategy may force the company to take steps that enhance shareholder value more quickly.


  • Competition from lower-cost retailers such as Forever 21, H&M, Zara, and others may continue to erode market share from Aeropostale, causing them to lower prices in order to compete, resulting in lower margins.
  • The retail environment may continue to suffer from low demand as young adults choose to spend the bulk of their money on things such as electronics.
  • High teen unemployment will result in less disposable income to spend on apparel.
  • Despite the stock reaching new lows, the lack of insider buying of Aeropostale stock is a concern.


Overall, I think Aeropostale’s stock is a good value at this level.  A good amount of the fear may already be priced into this stock, and the concerns about a weak retail environment lasting for a long time may be overblown.  The presence of activist investors taking an 8% stake in the company gives us additional confidence.  ARO’s low valuation statistics as compared to its peers, and its debt-free balance sheet and cash position also make this stock worth considering as a contrarian play.


I do not have a position in ARO, however I may initiate a position in the next 48 hours.  I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Murphy USA: A Bargain Spin-off Stock With 45% Upside Potential


What follows is an article I wrote on Seeking Alpha about Murphy USA common stock, which was spun off from Murphy Oil in August 2013.  Based on a relative valuation to comparable companies, and a free cash flow valuation model, I concluded that Murphy USA had potential for about 45% upside to the then-current price of $38.43.

Here is the link to my Excel valuation spreadsheet.

MUSA Free Cash Flow Valuation


Spinoffs are generally underfollowed by analysts and can often see undue selling pressure caused by shareholders of the parent company looking to dump the stock.  This can lead to enterprising investors being able to pick up some great bargains if they’re willing to read through an SEC Form 10.  These are not the glamour stocks you hear everyone talking about, but the less the following, the better chance we have of picking up a great bargain.  As Joel Greenblatt said in his book, “The Little Book that Beats the Market”:  “Over the long run, the market gets it right….and is a very rational fellow.”

Murphy Oil (MUR) has just completed the spinoff of its retail fuel product and convenience merchandise subsidiary, Murphy USA (MUSA).  I will show that Murphy USA (MUSA) is exactly what we look for as value investors:  A great business at a cheap price.  I will do both a comparable company valuation and a free cash flow to equity valuation to show that MUSA is underpriced by at least 40%.

Key Highlights

  • 1179 retail fuel stations in 23 states
  • Majority of sites are company-owned, about 90% of them
  • Most of locations are adjacent to Walmart stores.  The strategic relationship with Walmart expected to be a key driver of growth over next several years.
  • Announced expansion plan for approximately 200 new sites with Walmart over the next 3 years, with total locations by 2015-2016 reaching 1408.



The proximity of Murphy USA (MUSA) locations to Walmart stores generates a significant amount of customer traffic.  MUSA’s focus is on low-priced convenience products complementary to Walmart’s products.   Also, a fuel price discount program is in effect for over 950 locations if customers use Walmart gift cards or Walmart MoneyCards.  This lowers the price of fuel by about 0.10 to 0.15 cents a gallon for those customers participating and becomes an incentive to stop by and fuel up at a Murphy USA location.

Murphy USA also has the lowest relative fuel cost among the selected competitors below, which will drive high fuel volumes and gross profit.


In addition, they have a low cost operating model due to the fact that most of their stations are 208 or 1200 square-foot kiosks with very low capital expenditures and maintenance requirements.  Many stations require only one or two attendants to be present.  Add to that the fact that the majority of their locations are company-owned and there isn’t any rent expense, and you have the makings of an efficient Walmart-like low-cost operation.

Another advantage that Murphy USA has is supply optionality for their fuel.  They have a wide array of midstream assets (pipelines, terminals) in the Midwest and the South that they use to distribute fuel.  They have access to numerous terminal locations, and a distribution system that allows them to send trucks to the terminal that has the most favorable prices, reducing their fuel costs, and enhancing their margins.


Also, they expect to increase revenue by selling “Renewable Identification Numbers (RINs)”, which are numbers attached to a batch of biofuel, created by blending ethanol and bio-diesel.  Murphy USA can source the fuel directly at their terminals and blend it, allowing them to generate RINs that they can sell in the market.  (Since 2005, the EPA set annual quotas dictating what percentage of motor fuel consumed in the U.S. must be biofuel blended into fossil fuels.  A certain amount of RINs must be submitted to the EPA yearly for companies to remain in compliance.  Companies that can’t create enough RINs are obligated to purchase from a company like Murphy USA, hence the opportunity for additional revenue.)

Opportunity for Expansion

Below we see the existing Murphy USA network in blue dots.  As we can see, their operations are mostly focused in the Midwest and South to Southeast.  The yellow dots represent Walmarts in MUSA’s adjacent and core areas, so there is plenty of room to expand MUSA’s network of locations.


Comparables Valuation

Murphy USA’s competition:  Susser Holdings (SUSS), CST Brands (CST), Casey’s General Store (CASY)

Company Enterprise Value (Millions) EBIT/EV(Last 4 quarters EBIT) ROIC=NOPAT/Invested Capital P/E (most recent 4 quarters) P/EBIT (most recent 4 quarters) Price per Share
MUSA $2411.15 9.79% 11.68% 15.13 7.64 $38.43
SUSS $1572.98 8.37% 7.5% 18.25 7.77 $48.44
CST $2971.34 7.40% 9.85% 17.57 10.22 $29.74
CASY $3314.53 6.34% 7.68% 23.28 12.16 $66.59

NOPAT = Net Operating Profit After Tax = EBIT (1-T)

Invested Capital = Total Equity + Total Liabilities – Current Liabilities – Excess Cash

Excess Cash = Cash and Equivalents – Max (0, Current Liabilities – Current Assets)

As we can see in the above table, MUSA is relatively cheap compared to its peers at an EBIT / TEV yield of 9.79%, and also has a more attractive ROIC (Return on Invested Capital) than its peers at 11.68%.  Its P/E is also the lowest of the group.

I have taken EBIT and Net Income from the most recent four quarters of data available for each company.  If I would take MUSA’s 2013 results as of the end of June 2013, and annualize them the numbers for MUSA would look even more attractive.

Free Cash Flow to Equity Valuation Assumptions

Current Number of Stores:  1179

Square Footage Breakdown

  • 208 square-foot stores:  77%
  • 1200 square-foot stores:  4%
  • Large-format 2400 square-foot stores: 7%
  • Other:  12%

Of the approximately 200 new sites with Walmart over the next 3 years, a little less than half will be 1200 square feet, and the rest will be 200-800 square foot kiosks.   We can see in this the company’s desire to build more of the higher earning 1200 square foot stores. Of these new 200 locations, I assume 40% will be 1200 square feet, 40% will be 200 square feet, 10% will be 500 square feet and 10% will be 800 square feet.   In calculating new sales per share, we assume annual sales of $4744 per square foot, which is given in the company presentation.

Effective tax rate for 6 months ended June 30, 2013: 39%

Number of Stores expected by end of 2013: 1240

Number of Stores expected by end of 2016: 1408

This is about a 4.5% store growth rate over the next 3 years.  I assume after that, the store growth rate slows down to 1% a year from 2017 onwards to be conservative.

Annual Merchandise Sales Dollars by Square Foot:  $4,744

In approximating sales per share for each year, I did the following:

For 2013, I just annualized sales by taking revenue for the 6 months ended June 2013 and multiplied by two.  For 2013, the company says in their investor presentation: “2013 includes upside from a number of factors which may not repeat year on year.  E.x. Strong contribution from midstream, and unusually high RIN sales prices.”  Therefore, for the years 2014 and onwards, I assume the company’s EBITDA margin will revert to an average of their past EBITDA margins from 2012, 2011, and 2010.

To get annual merchandise sales in 2014 for the 208 square foot stores:

(208 sqft.)*($4744)*(0.77)*(1240 stores) = $942.15 million annual merchandise sales for 208 sqft stores

To get annual fuel and ethanol sales, I simply took the $8330 million in fuel and ethanol sales in the 6 months ended June 2013 times 2 to annualize, giving us approximately $16.66 BN and divided it by the number of stores in 2013 of 1179 to get about $14.13 million in per store fuel sales per year.  For valuation purposes I assume this number would hold relatively constant over the next few years.

So, the total annual sales for all 208 square foot kiosks in 2014 would be $942.15 M + ($14.13 M)*(0.77*1240stores) = $14,433 M = $14.43 Billion.  In the same way, I calculated the annual sales of all the different sized stores.  Adding all this up, I approximated sales per share for each year based on number of locations, assuming the relative mix of square footage stores would remain constant.

I then assumed an EBITDA margin to come up with EBITDA per share for each year.  EBITDA margin is estimated using the average of EBITDA margins from 2010 of 1.71%, from 2011 of 2%, from 2012 of 1.58%, and from the 6 months ended June 2013 of 2.04%, which comes out to 1.83% on average.  Management sees the opportunity to enhance margins as this quote from their Form 10 explains:  “We source fuel at very competitive industry benchmark prices due to the diversity of fuel options available to us in the bulk and rack product markets, our shipper’s status on major pipeline systems, and our access to numerous terminal locations. In addition, we have a strong distribution system in which we utilize a “Best Buy” method that dispatches third-party tanker trucks to the most favorably priced terminal to load products for each Murphy USA site, further reducing our fuel product costs.”

I assumed depreciation and amortization expense as a percentage of sales will be similar to its average value over the past few years.  For 2010: 0.36% of sales, for 2011: 0.33% of sales, for 2012: 0.39% of sales, and for 6 months ended June 2013: 0.42% of sales.  Averaging this gives us depreciation and amortization expense of 0.375% of sales on average, from which we are able to get EBIT per share.

From EBIT per share, I then calculated earnings per share for each year and assumed an effective tax rate of 39% as reported in Form 10 and outstanding debt of $650M with a weighted average interest rate of 5.49% as reported in their Form 10, leading to an interest expense of .0549*650M = $35.685M for 2014.  It’s still unclear as to what percentage of debt the company wants in their capital structure, so I assumed yearly interest costs would remain constant for the foreseeable future.

Capital Expenditures

MUSA’s capital expenditures for the next few years according to company presentation:

2013 CAPEX: $204 million ($168 growth and $36 maintenance)

2014 CAPEX: $165 million ($135 growth and $30 maintenance)

2015 CAPEX: $149 million

I assume CAPEX is approximately $149 M for 2016 and onwards as well since the rate at which stores are built will eventually decrease, so growth CAPEX will decrease as well.

Working Capital Investment

There was actually a net decrease in operating working capital for the 6 months ended June 30, 2013 of $39.597 million, but since I don’t expect this to recur, I won’t add it to free cash flow.  I assume working capital investments from 2014 onwards will be 5% of the sales increase from year to year.

Free Cash Flow to Equity Formula

FCFE = Net Income + Depreciation/Amortization/Noncash Charges – Fixed Capital Investment – Working Capital Investment

Stock Value = FCFE_1/(1+r) + FCFE_2/(1+r)^2 + FCFE_3/(1+r)^3 + …. FCFE_n/(1+r)^n + [ FCFE_n+1/(r-g) ]/(1+r)^n

Where “r” is the required rate of return, “g” is the assumed growth rate.  The last term in the equation above is the terminal value representing an assumed growth rate of free cash flow equal to “g.”

I assumed a beta of 0.8 for MUSA.  The competitors CASY and SUSS have betas of 0.65 and 0.51 respectively according to Yahoo Finance, so I’m being relatively conservative.  Lowering MUSA’s beta to that of its competitors would result in an even larger potential upside.

Below is the valuation spreadsheet.


The free cash flow to equity model gives a value of $55.85 to Murphy USA (MUSA) common stock, which represents about a 45% upside to the 9-5-13 closing price of $38.38.

Potential Risks that Could Affect the Intrinsic Value Given Above

  • Oil price increases may reduce the gross margin per gallon of fuel earned (currently $0.13) and passing cost increases down to the customer may be difficult.
  • A general slowdown in the economy might reduce travel, recreation, and construction activity, which could result in declining fuel and merchandise sales.
  • The interest expense on the current long-term debt of $650 million may reduce cash flows that may be needed for working capital requirements and capital expenditures.  A reduction in credit rating could increase MUSA’s cost of borrowing.
  • Interest rate increases will increase the cost of debt service further eroding cash available for capital expenditures and day-to-day operations.
  • Murphy USA’s (MUSA) ability to grow and generate revenue depends on their continued relationship with Walmart.  It that relationship ends or deteriorates, cash flow will decline and the business will suffer.
  • MUSA has midstream assets such as pipelines and product distribution terminals that supply their retail fueling stations.  If there is an interruption of supply or an increase in cost related to delivery of fuel to the market, or disruptions due to weather events or accidents, sales will be adversely affected.
  • MUSA currently has only one principal supplier for over 80% of their merchandise.  Any disruption in supply could have an adverse effect on their business.
  • The free cash flow model given above may understate capital expenditure requirements and working capital requirements, reducing the cash flow available to the shareholder.  Also, if the number of locations assumed over the years does not materialize, cash flow and sales will be less than what the model predicts.  If the future EBITDA margin is less than the historical one assumed, or if interest rate expenses are higher than assumed, cash flow and share price will be less than what the model predicts.


Overall, I think Murphy USA (MUSA) is a great opportunity for investors to participate in an under-followed spinoff due to their great relationship with the biggest retailer in the world, Walmart.   Along with that, I like their plans for expansion, and their high volume, low-cost model of business.  The fact that MUSA is priced cheaper than its competitors and earns a higher return on invested capital, makes this stock a strong buy with about 40% upside to the current price.

Disclosure: I am long MUSA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.