Published by Nick McCullum on June 16th, 2017
Master Limited Partnerships – or MLPs, for short – are phenomenal investment vehicles for investors who are seeking to generate current portfolio income.
They are the most tax efficient vehicle for returning money to investors because they avoid the double taxation (corporate and personal) that corporations experience. MLPs are not taxed at the organizational level.
With that said, MLPs are avoided by the majority of self-directed investors. This is likely for two reasons.
First, MLPs have more complicated tax reporting (though not necessarily higher taxes) than their corporation counterparts.
Secondly, many MLPs are in the energy sector, a segment of the stock market that is out of favor right now.
These two factors are presenting compelling buying opportunities for those investors willing to own MLPs. Many are trading at attractive valuations and elevated dividend yields.
Sunoco LP (SUN) is an example of this. The MLP is currently trading at a dividend yield of 11.2%, making it a member of the short list of stocks with 5%+ dividend yields.
As with any high dividend stock, Sunoco should be thoroughly analyzed before investing to ensure that its dividend is sustainable, even during economic downturns.
This article will analyze the investment prospects of Sunoco LP in detail.
Sunoco is an MLP that operates retail fuel sites and convenience stores.
The company also distributes wholesale motor fuel to other convenience stores, independent dealers, and commercial customers.
More specifically, Sunoco owns ~1,355 retail fuel sites and has distribution arrangements with ~7,825 third-party sites located in more than 30 states.
Sunoco’s general partner is a wholly-owned subsidiary of Energy Transfer Equity (ETE). ETE owns a 2% LP interest in Sunoco, and Energy Transfer Partners (ETP) – another Energy Transfer entity – owns a 46% LP interest in Sunoco.
More details about the company’s current business model can be seen below.
Source: Sunoco LP May 2017 Investor Presentation, slide 3
Sunoco benefits from a resilient business model, particularly considering it operates in the energy sector.
Sunoco is a distributor of end products, which means that it is in the business of fuel transportation, not exploration or refinement. Sunoco collects its cut of fuel costs while being somewhat insulated from the price of the underlying commodity.
The company collects stable cash flows based on long-term fee-based wholesale distributions policies. We will see later in this analysis that Sunoco’s wholesale segment is about to become the largest part of the partnership’s business.
Source: Sunoco LP May 2017 Investor Presentation, slide 4
Sunoco has a relatively convoluted corporate history.
In 1920, the company opened its first service station and became listed on the New York Stock Exchange.
After decades of steady growth, Sunoco because the official fuel of NASCAR and was eventually acquired by Energy Transfer Partners in 2012.
Later in 2012, the current Sunoco L.P was spun-off from Energy Transfer Partners as Susser Petroleum Partners and changed its name to Sunoco L.P. (and ticker to SUN) in October of 2014.
The company’s long corporate history can be seen in detail below.
Source: Sunoco LP May 2017 Investor Presentation, slide 5
Sunoco is executing a major strategic change right now that its current and prospective investors should definitely be aware of.
Earlier this year, Sunoco entered into an agreement for the sale of the majority of its convenience stores. The acquirer is 7-Eleven.
The transaction will leave Sunoco with approximately 200 convenience stores in North & West Texas, New Mexico, and Oklahoma, for which a second sale marketing process is already underway. Sunoco has 54 locations in Hawaii which it plans to retain for the foreseeable future.
The proceeds of the transaction total $3.3 billion in cash plus fuel, merchandise, and other inventories. The transaction will see Sunoco enter into a 15-year take-or-pay fuel supply agreement with 7-Eleven, under which the partnership will deliver approximately 2.2 billion of gallons of fuel annually.
Sunoco’s current restructuring means the company will likely look dramatically different in a year’s time. Instead of being a retail fuel distributor, it will now be primarily a wholesale fuel distributor, using its existing presence in the market and its new arrangement with 7-Eleven to drive the segment’s growth.
Wholesale fuel is attractive in many ways, benefitting from reliability of demand, less capital-intensive operations, and long-term contracts with creditworthy counterparties.
However, investors should acknowledge that this restructuring comes with substantial execution risk. Sunoco is a large organization and a change of this magnitude is not guaranteed to succeed.
Sunoco’s growth will be largely driven by M&A.
The company is very willing to make bold portfolio transactions when it sees a strategic or financial benefit. The company’s offloading of its convenience store locations to 7-Eleven is a perfect example of this.
Sunoco has built up expertise in M&A over time. Since December of 2014, the company has closed on more than $700 million of diversified mergers & actions. This can be seen below.
Source: Sunoco LP May 2017 Investor Presentation, slide 6
Investors should note that in the diagram above, a clear transition can be seen from purchasing retail-only businesses to purchasing wholesale or hybrid locations. Thus, we can reasonably conclude that Sunoco has been eyeing a more wholesale-focused business model for some time.
The company also has plenty of room to grow by expanding into unpenetrated geographies. Sunoco’s current geographic footprint can be seen below.
Source: Sunoco LP May 2017 Investor Presentation, slide 7
After the divestiture of Sunoco’s retail locations, the company’s geographic footprint will be similar, but much less dense. The company has meaningful opportunities to grow by expanding into the heartland or the northwestern United States.
Competitive Advantage & Recession Performance
Sunoco’s large size in the fragmented fuel distribution industry gives it a scale-based competitive advantage over its smaller peers.
With that said, the company is a more risky investment than many of the other securities analyzed on Sure Dividend.
The MLP had an unsustainable distribution coverage ratio of 0.74 in its most recent quarter and 0.88 over the trailing twelve months. Further, Sunoco’s debt to adjusted EBITDA ratio is 6.31, high even for an MLP.
The company also has a significant exposure to rising interest rates. 46% of Sunoco’s outstanding debt is floating rate, meaning that the partnership’s interest expense will increase as market interest rates rise.
Importantly, the Federal Reserve increased its benchmark interest rate on June 14, which was its 4th interest rate increase in 18 months. The markets widely expect another interest rate hike this year and three more in 2018.
For Sunoco shareholders, this poses a significant risk.
The company also has significant debt maturities in 2019, just in time to refinance at higher rates.
More details on Sunoco’s debt maturity profile and interest rate exposure can be seen below.
Source: Sunoco LP May 2017 Investor Presentation, slide 13
Sunoco’s poor distribution coverage and debt structure are unappealing for conservative investors.
However, the partnership is taking measures to improve its capital structure.
In the first quarter, Sunoco completed a private placement for $300 million of preferred equity, sold to GP owner Energy Transfer Equity. The company is also receiving a significant cash infusion after the divestiture of its convenience store business. Some of this capital will likely be used to shore up Sunoco’s balance sheet.
Source: Sunoco LP May 2017 Investor Presentation, slide 12
All said, Sunoco is a riskier investment than most companies covered on Sure Dividend. Investors focused on risk-adjusted returns (rather than just absolute returns) should take this into account before investing in this company.
Valuation & Expected Total Returns
Sunoco’s future shareholder returns will be driven by valuation changes, dividend yield, and growth in the company’s distributable cash flow.
As an MLP, Sunoco is difficult to analyze using the traditional price-to-earnings ratio. A practical alternative is to compare the company’s current dividend yield to its long-term average dividend yield.
Sunoco currently pays a quarterly dividend of $0.8255 which yields 11.2% on the company’s current stock price of $29.60. Sunoco’s current dividend yield is compared to its long-term historical average in the following diagram.
Sunoco’s average dividend yield since its spinoff is 7.4% and its current dividend yield is 11.2%. Based on dividend yield, the company appears meaningfully undervalued.
With that said, the markets are pricing Sunoco at a pessimistic valuation likely because of its poor distribution coverage ratio. Concerns about a dividend cut are weighing on this company’s stock price, pushing its dividend yield higher.
The remainder of the company’s total returns will come from profit growth.
Estimating future profit growth for Sunoco is difficult because of the execution risk associated with its transition to a wholesale-first business model.
Accordingly, the company presents a binary investment opportunity with two distinct outcomes:
- The execution is successful, distributable cash flow increases, and the company returns to steady dividend growth
- The execution does not go as planned and the company potentially experiences a dividend cut
Sunoco investors will likely realize outstanding total returns or poor total returns (but likely not somewhere in between) depending on which of these hypothetical scenarios materializes.
Sunoco is a high risk, high reward stock. The partnership merits further research and potential investment based on its strong track record in mergers & acquisition transactions.
As mentioned in this article, Sunoco is a member of the shareholder-friendly Energy Transfer family of companies.
If you’re interested in gathering more information on the Energy Transfer group of companies (which all have more sustainable dividends than Sunoco LP), the following Sure Dividend articles will be of interest:
- What Can Investors Expect From The New Energy Transfer Partners
- Energy Transfer Equity: Undervalued MLP With a 7% Yield
- Sunoco Logistics: The Highest Yielding Dividend Achiever
Note: Sunoco Logistics recently merged with Energy Transfer Partners to form the ‘new’ Energy Transfer Partners. The legacy Sunoco Logistics article listed above will still be helpful for understanding the business model of the pro-forma company.