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Faith was fading fast. Sunoco LP (NYSE: SUN) had lost 20% of its equity value through the first three months of 2017.
As recently as last week, Sunoco units were trading down enough to lift the SUN distribution yield to 14%. When energy partnerships find their units priced to offer such tempting distribution yields, one takeaway is clear to the battle-worn investor: The unit price is dropping because investors are bracing for a distribution cut.
Investors weren’t wholly unreasonable in strolling out the exits. Sunoco’s distributable cash flow ̶ the cash used to service the distribution ̶ had failed to cover the SUN distribution for most of the past year. It really failed to cover the distribution in the fourth quarter. Sunoco reported that distributable cash flow covered the quarterly distribution by 0.61 times, thus leaving a significant deficit. (You want multiple of one or above.)
There were mitigating factors, or Sunoco’s shares would likely have been priced in the low teens instead of the low twenties at the end of March.
Equity Transfer Equity (NYSE: ETE), Sunoco’s sponsor and general partner, was the most mitigating of the mitigating factors. Equity Transfer has deferred claiming any incentive distribution rights since the second half of 2015. The deferment has freed hundreds of millions of dollars that Sunoco has used to support the SUN distribution. Equity Transfer contributed an additional $300 million to Sunoco’s cause by investing in a preferred equity private placement in February.
Despite the parent’s willingness to support its progeny, investors kept their distance . . . until last week.
Sunoco units soared like a superball spiked into 12-inch concrete after reporting that it would sell its convenience stores and retail gasoline outlets ̶ 1,110 in total ̶ to Seven & iHoldings (OTC: SVNDY), owner of the 7-Eleven convenience-store chain. Seven & iHoldings agreed to pay $3.3 billion to take the stores and outlets off Sunoco’s hands.
Reassurance on SUN Distribution
When the deal was announced after the market close on April 5, Sunoco units were priced below $24. The next day, April 6, they were priced at just under $29. Investors rightfully felt assured that Sunoco’s $0.8255 quarterly distribution per unit would be maintained.
Who would argue otherwise? The $3.3 billion will enable Sunoco to retire a significant chunk of its $4.5 billion of outstanding long-term debt. Long-term debt, having quadrupled to since 2014, elevated Sunoco’s leverage multiple to a covenant-busting 6.5 times equity in the fourth quarter. Sunoco plans to drop the multiple to a more-normalized 4.5-4.75 range. With less debt to service, the distribution-coverage ratio rises to 1.1 times.
When the facts change, so should your opinion. My, how the facts have changed, and so has the opinion.
This time last year, the investment thesis centered on Sunoco’s convenience-store presence. Sunoco’s gut-busting debt had been incurred to expand its convenience-store girth to 1,340 convenience stores and retail fuel sites, a 40% increase over the previous two years. Investors were enthralled by the prospect of Sunoco further dominating the convenience-store market.
Today, the investment thesis centers on the prospect of Sunoco leaving the convenience-store market to dominate the wholesale-fuel-distribution market (the business Sunoco was diversifying with the convenience-store splurge). Sunoco’s goal is to supply fuel to a network of over 8,900 locations, consisting of third-party dealers, distributors, and other commercial customers.
A Lighter Business Model
By switching to a distribution-mostly model from a distribution-retailing model, Sunoco tells us that it is switching to a “lighter” business model. Capital needs will be reduced 50% going forward. Capital needs will be reduced $290 million in 2017 alone.
After the convenience-store sale was announced, three investment firms — Baird, Jefferies, and Barclays — raised their respective investment rating on Sunoco. Baird and Barclays raised their respective price targets as well. Baird sees Sunoco units changing hands at $36 a year from now; Barclays sees them changing hands at $36. Wall Street obviously likes the deal with iHoldings and the concurrent directional change. Faith has been renewed.
I confess that my faith has also been renewed. I also like the directional change. Sunoco is a High Yield Wealth recommendation. The deal with iHoldings buttresses the all-important distribution and will likely lead to a higher unit price and further yield compression.
With that said, I have the uneasy feeling that investors are rewarding Sunoco for selling assets for $0.80 that cost it a dollar. But as long as they are willing to reward, why should we care?