Businesses are inherently risky. One of the primary risks of any business is the reduction in demand for its products. For businesses operating in the cost leadership domain, a shift in the demand curve for its products/services will lead to reduction in product prices and eventually company profits. However, recent performance of Sunoco LP (SUN) suggests that its business model is well insulated against this risk. Thus, at its current price, the share is a definite buy, yielding a very healthy dividend yield of approx.13%. In this article, I have discussed the mechanics behind the solid business model of Sunoco LP, and why the share is a great buy today.
Middle Man Benefits
Sunoco LP is a middle man in the petroleum industry, which is characterized as a perfect competition in economics. In a perfect competition, the products are not differentiated in any way, and the product prices are driven by demand and supply forces. Fundamentally, motor fuel from any fuel station is same. By operating in the transportation and distribution phase of the petroleum industry, Sunoco LP either passes or absorbs the effects of changing crude oil prices.
During times of rising crude oil prices, Sunoco LP can pass the higher petroleum product prices to the retailer, thus reducing retailer margin. When crude prices are low, retailers keep their margin high to recoup their previous losses, and Sunoco LP can absorb part of this increased margin. Thus, Sunoco LP will always be on the winning side irrespective of the crude oil price. This is evident from the historical data of gross motor fuel margin (company 10-k) and crude oil prices over the past five years shown in Figure 1. Ignoring the minor quarterly variations in crude oil prices, we can see that crude oil prices jump from the $40-$50 range in 2015-2017 to $60-$70 range in 2018-2019 and a simultaneous but opposite change in the gross margins for Sunoco LP.
Figure 1 (Source: Chart created using data from 10-K & Macrotrends)
Of course, there are caveats to this argument, and a major one is the shift to renewable energy and the advent of electric vehicles. Electric vehicles, as a product, has the potential to shift the demand curve of petroleum products to the left. I am talking about the end of need for refined petroleum products, and I believe it is safe to say that that day is at least a decade away.
Stable demand for Sunoco LP’s services
It is obvious that the demand for transportation and distribution services of petroleum products is highly dependent on the demand for petroleum products. Figure 2 shows the consumption of motor gasoline and distillate fuel oil in the USA for the past 5 years. We can see from Figure 2 that the consumption of motor fuel and distillate fuel oil is not affected by crude oil price volatility. Motor fuel and distillate fuel oil account 70% of the total consumption of petroleum products in the USA, the rest 30% is accounted by Jet Fuel (8%), Hydrocarbon Gas Liquids (15%), Residual Fuel Oil (1.5%) and other oils (10%).
Transportation of goods and services is the backbone of any economy. The choice of fuel for transportation may change in the future from non-renewable sources to renewable sources but, it can be interpreted from the chart that the demand for the fuel will remain steady. Sunoco LP operates in this field, and hence enjoys a stable demand for its services that results in stable revenues and better business terms while renewing debt.
Minimum guarantee of return per quarter
Having established that reduction in demand for Sunoco LP’s service is highly unlikely in the near future, it can be deduced that, at the current share price, Sunoco LP unitholders can expect anywhere between 6.7% (distribution of $0.4375/quarter) to 12.7% (distribution of $0.8255/quarter) returns per year from their investment. Sunoco LP operates as an Master Limited Partnership (NYSE:MLP), meaning it has to distribute almost all of its cash balances at the end of each quarter. The target distribution level is decided by Energy Transfer Operating LP (NYSE:ETO), which owns 100% of the Incentive Distribution Rights (IDR). The following table shows the waterfall payment arrangement for distributions.
Source: 2019 Sunoco 10-K
The minimum quarterly cash requirement to achieve the different target levels of distribution are:
Source: Calculated by author from Sunoco’s distribution policy
In the past five years, the lowest ever cash flow from operations for the whole year was $ 303 M in 2017. Still, that year Sunoco LP paid distributions of $0.8255 per common unit for all four quarters. This shows that ETO, which owns 100% of IDR, intends to distribute cash at the top target level, even if Sunoco LP needs to borrow money for the required distribution. This situation is pointed out as a conflict of interest in the business risks section of the annual report. ETO owns 100% of Sunoco General Partners and may force Sunoco LP to increase leverage to pay distributions to IDR holders. However, ETO also owns 28.6% of common units of Sunoco LP, and hence, it is in ETO’s best interest to take fiduciary decisions in the best interest of the company unitholders.
The business of transporting petroleum products is less risky because the demand for petroleum products is neither expected to reduce in the near future nor is it affected by changing crude oil prices. This perception allows Sunoco LP to replace their existing credit with newer credit and rotate their debt without paying back the principal. Thus, Sunoco LP can concentrate on generating enough cash to give distributions and cover the interest payments, and not worry about future repayments of loan principal. However, rise in interest rates, better fuel efficiency and growth in market penetration of electric vehicles are factors that can shift the demand curve, and Sunoco LP may not be able to rotate its credit at beneficial interest rates resulting in higher interest payments, lower CFO and eventually a distribution cut. Till that time, investors can be assured of a guaranteed return on their investment.
Prior to the global pandemic, the share was trading at a price of around $30, and post-recovery from the share price dip during April 2020, Sunoco LP’s share price has recovered to around $26. Fundamentally, the business has not changed. In reaction to the pandemic, the management has shown quick adaptation by massively reducing the planned capital expenditure for 2020 and improving the operating efficiencies. As a result, we see an increase in operating income from 42% (as a percentage of gross income) in Q3 2019 to 59.8% in Q2 2020. I have chosen this metric because this excludes any effect of the changes in crude oil prices, product margins or inventory valuation adjustment. The approx. 18% increase in operating income is directly attributable to the improved operating efficiency of the company.
Improved operating efficiency, reduced capital expenditure and a positive short-term outlook by the US Energy Information Administration that motor fuel oil consumption will recover by 2021 are the reasons I believe that, qualitatively, Sunoco LP’s shares are under priced and have the potential to reach pre-COVID share price levels ($30) by the end of 2020. Usually, the objective of investment in an MLP is not capital gains through increases in share price, but any additional returns from an increase in share price is a cherry on top.
Sunoco LP is a cash generating asset that has middle man benefits in a volatile industry, has stable demand for its services and is being managed by an agile and active management team. For the past 17 quarters, Sunoco LP has paid cash distributions of $0.8255/unit and for the past 22 quarters at above the 3 rd target level. Before the global pandemic, the share of Sunoco LP was trading at a price of $30 while earning approx. $16 billion revenue at an EBITDA of $ 647 million. As per the latest quarterly report, the H1 revenue for 2020 is just over $5 billion with EBITDA of $218 million. However, due to reduction in crude oil prices, Sunoco LP is now enjoying a gross profit margin of 13.5 cents per gallon as compared to 9 cents per gallon in 2019. YoY, the increase in margin (48%) offsets the decrease in motor fuel gallons sold (-26%), resulting in an increase in motor fuel oil gross profit compared to Q2 2019. These points prove that recovery of share prices of Sunoco LP is incomplete and it has potential for upside, making it a solid buy for now.
Crude oil prices, demand for motor fuel oil and operating efficiency of Sunoco LP are the key parameters to keep an eye on for its unitholders. Till the time demand for petroleum products does not reach back to its pre-COVID levels, any unexpected change, especially in the crude oil prices, will result in constricting the cash generated by the company and may demand a re-look into the investment.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.