Introduction

Several months ago during the mists of the initial Covid-19 selloff, I published an article regarding Sunoco (SUN) and the likelihood of their distributions being reduced in the short term. Whilst I always endeavor to make correct judgments regarding the future, no one is perfect and to my surprise their earnings held up better than envisioned. It may seem that this means their still very high distribution yield of 12% is quite attractive for income hungry investors, risks still remain even after updating this analysis.

Executive Summary and Ratings

Since many readers are likely short on time, the table below provides a very brief executive summary and ratings for the primary criteria that was assessed. This Google Document provides a list of all my equivalent ratings as well as more information regarding my rating system. The following section provides a detailed analysis for those readers who are wishing to dig deeper into their situation.

Image Source: Author.

*There are significant short and medium-term uncertainties for the broader fuel retailing industry; however, in the long term, they will certainly face a decline as the world moves away from fossil fuels.

Detailed Analysis

Sunoco cash flows

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Sunoco notes 1

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Instead of simply assessing distribution coverage through distributable cash flow, I prefer to utilize free cash flow since it provides the toughest criteria and best captures the true impact to their financial position. The main difference between the two is that the former ignores the capital expenditure that relates to growth projects, which given the very high capital intensity of their industry can create a material difference.

When looking at their historical cash flow performance from 2017-2019 it can easily be seen that almost half of their distribution payments have been debt-funded, given their average distribution coverage was only 53.74%. My original analysis theorized that their earnings and thus distribution coverage would suffer due to the severity of the Covid-19 lockdowns and the resulting economic downturn. Interestingly, this initially was the case during the first quarter of 2020 with their operating income collapsing, but to my surprise not only did it recover but it surged higher in the second quarter as their margins expanded; see the financial statement extracts included below.

Sunoco income statements

Image Sources: Sunoco’s Q1 2020 10-Q and Q2 2020 10-Q.

I was quite surprised that they could endure their fuel sales plunging 26.3% year on year during the second quarter of 2020, as per their second quarter of 2020 results announcement. When looking ahead, the guidance included in this same announcement forecasts their 2020 capital expenditure to total $105m, which is a very large decrease of 44.44% year on year. Suffice to say that this is likely towards the lowest that they could possibly continue indefinitely into the future and thus provides an optimistic basis for assessing their ability to cover their distributions going forward.

When their capital expenditure forecast is combined with their annualized distribution payments of $352m from the first half of 2020, it indicates that they require operating cash flow of $457m to remain cash-flow neutral and thus provide at least adequate distribution coverage. Given their historical operating cash flow from 2018-2019 of $447m-435m, this may prove possible following their surprisingly strong performance during the second quarter of 2020. Even if this eventuates, it nonetheless highlights that they will have minimal cash remaining after distribution payments, which in turn is where the risks continue to lie.

Sunoco capital structure

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Throughout the recent years their capital structure has remained essentially unchanged, which is neither positive nor negative since their debt far exceeds their equity and they also sport a relatively small cash balance. Similar to most situations, the extent that this impacts the sustainability of their distributions will depend upon their broader leverage and liquidity.

Sunoco leverage ratios

Sunoco notes 2

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When reviewing these financial metrics it quickly becomes apparent that their leverage is very high, as primarily evidenced by their net debt-to-EBITDA of 6.65 sitting well above the minimum threshold of 5.00. This is further supported by their gearing ratio sitting well above 50% at a staggering 83.06% and their interest coverage fluctuating between 1.55 and 3.06 across the years, indicating that their ability to safely service more debt is very limited.

Whilst this level of leverage may not pose any immediate threat to their distribution or ability to remain a going concern due to their surprisingly solid recent performance, it, nonetheless, still reduces their scope to navigate any unexpected tough situations. Given their almost non-existent free cash flow after distribution payments, they have minimal scope to deleverage if required without reducing their distributions.

Sunoco liquidity

Sunoco notes 3

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When looking at their liquidity it appears adequate with a current ratio of 1.07; however, their relatively very low cash balance is their main weakness. This unfortunately leaves them reliant on their credit facility, which is not ideal but thankfully it still retains an undrawn balance of $1.3b. It should always be remembered that these are reviewed periodically and contain covenants, which increases the risks if they were to face a sudden crisis.

It was positive to see that they do not face any material debt maturities until 2023, as the table included below displays. This should provide them with ample time to refinance, which is especially important since they have zero scope to actually repay over $1b of debt in only a few years.

Image Source: Sunoco’s 2019 10-K.

Conclusion

In certain situations their thin distribution coverage would not be risky, but given their very high leverage this is sadly not the case. Perhaps some investors are not fearful of such leverage. However, I am not one of those since it provides them with minimal scope to navigate any unforeseen negative events. Whilst I am softening my stance on the probability of their distributions being reduced in the short term, given their very high leverage and minimal scope to deleverage, it remains risky and thus I still believe a neutral rating to be appropriate.

Notes: Unless specified otherwise, all figures in this article were taken from Sunoco’s Q2 2020 10-Q (previously linked), 2019 10-K (previously linked) and 2017 10-K SEC Filings, all calculated figures were performed by the author.

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.