Description

Thesis:

Sunoco LP (SUN) represents an attractive risk/reward opportunity to invest in one of the premier distribution growth stories in the master limited partnership (MLP) universe. Benefiting from the partnerships consolidation in 2014 into the Energy Transfer family of MLPs, Sunoco LP unitholders are positioned today to benefit from related party acquisitions, the ever-increasing scale of the business and an unrivaled rollup opportunity. Given Sunoco LP’s opportunity set, the roadmap to a +$4.30 distribution as compared to the partnerships current distribution of $2.18 is fairly straightforward. With a current unit price of ~$48 and a yield of 4.5%, the units offer significant upside given the partnership’s distribution growth trajectory. At a $4.30 distribution, Sunoco LP is worth between $61 and $71 at a yield of 7% to 6%. Plus, you’ll get paid distributions along the way. Given the involvement of Kelcy Warren’s Energy Transfer, unitholders can feel good about the prospects of the distribution ramp happening quickly and occurring in a manner that establishes the fourth large scale limited partnership in the Energy Transfer family.

Background:

Sunoco LP, formally Susser Petroleum Partners LP, was previously managed by publicly traded Susser Holdings Corp. Susser Holdings was the first and as of yet only company to take public an MLP (now Sunoco LP) devoted to the holding of wholesale and retail motor fuel distribution assets. The initial IPO unlocked tremendous value for Susser Holdings as the MLP established the mechanism through which the parent company could sell assets to Susser Petroleum Partners and recycle that capital into new fuel stations in the high growth markets of the southwest.

The success of Susser likely captured the imagination of Kelcy Warren and his team as it presented a roadmap for how Energy Transfer Partners LP (ETP), an entity controlled by Energy Transfer Equity LP (ETE) could monetize the firm’s significant fuel distribution assets that were acquired as part of the 2012 purchase of Sunoco Inc. These fuel distribution assets were essentially gravy for the Energy Transfer family as Warren’s primary target was the general partner of Sunoco Logistics Partners L.P. (SXL) and its premier crude and NGL transportation franchise. With Energy Transfer Partners purchase of Susser Holdings, the partnership gained a vehicle (eventually renamed Sunoco LP) through which Energy Transfer Partners could raise cash for itself via the sale of non-core assets while at the same participating in the roll up a fragmented industry through its ownership in the incentive distribution rights (IDRs) and limited partnership interest in the Sunoco LP.

Company & Industry Dynamics:

At the time of Energy Transfer Partners purchase of Susser Holdings, Susser Petroleum Partners controlled approximately 527 company operated retail stations and dealer/distributor operated fuel stations. Since that time and after a name change to Sunoco LP, the partnership has added an additional 418 locations through a related party purchase (dropdown) of ETP owned Sunoco stations and a 3^rd party transaction. Sunoco LP is set to grow considerably via the large remaining inventory of dropdowns held by Energy Transfer Partners, which totals 5,650 locations.

Given the effects of Sunoco LPs first third party acquisition and dropdown while under the control of Energy Transfer Partners and the firm’s recent secondary offering, Sunoco LP has a market cap of ~$1.68B and net debt of ~$0.42B for an EV of ~$2.1B against pro forma EBITDA of ~$180M valuing the company at roughly 11.6x on a Q1 2015 annualized run rate. It is management’s goal to grow Sunoco LPs EBITDA to $1B via the various levers in their toolkit. In doing so Energy Transfer Partners will free up capital for other investment projects while at the same time creating an IDR stream to use in its various deal makings with its own parent Energy Transfer Equity LP.

While 5,650 locations may seem like a lot it amounts to less than 4% of the market which encompasses over 151,000 convenience stores. The market is highly fragmented which can be seen in the following data set which displays the percent of the convenience store market controlled by entities with various store counts: 58% of stores are controlled by 1 store operators, 14% by 12-50 store operators, 6% by 51-200 store operators, 6% by 201-500 store operators and 16% by +501 store operators. The smaller operators have a significant disadvantage to the larger players primarily in their lack of purchasing power. An example of this can be seen when Energy Transfer Partners acquired Susser Holdings, despite Susser’s size, at the time it was acquired the a pro forma synergy number of $70M was put out by management with 75% of the synergies coming from increased purchasing power. It should be noted that management believes further additional synergies are available in the G&A/IT arena but as of yet these have not yet been broken out. To give an idea of the value of these synergies to the deal, Susser Holdings was pacing through the first six months of 2014 at +$160M in adjusted EBITDA for the year.

On a consolidated basis (combining Sunoco LP and Energy Transfer Partners assets) the mix of the fuel volumes on a per gallon basis breaks out as follows: 55% third party wholesale, 30% company operated retail, 13% commercial wholesale, 2% consignment. On a gross profit the various segments break out as follows: 36% merchandise & other, 28% wholesale fuel, 27% retail fuel, 5% rent, 4% other fuel. It’s important to note the wholesale volumes to company operated retail locations skews the retail fuel percent higher as the company puts this gross profit into the retail fuel category. Wholesale fuel volumes are important to a fuel distribution MLP as they are much more stable on a margin basis when compared to retail volume margins. It is also important to note that a disproportionate share of gross profit in the merchandise segment is coming from legacy Susser assets. In the first six months of 2014 as a standalone entity, Susser Holdings gross profits broke out as follows: 57% merchandise, 35% motor fuel, 8% other. Historically legacy Sunoco assets (those controlled by Energy Transfer Partners) have been smaller and more fuel centric providing a tremendous organic remodeling opportunity for Sunoco LP going forward. This smaller retail footprint also shows up in the size of the average station based on fuel volumes. The legacy Susser Petroleum Partners averaged approximately 3.3 million gallons of fuel sales vs 2.6 million gallons when including the most recent acquisitions and 0.9 million gallons for the average remaining stations held at the Energy Transfer Partners level.

Value Creation for Sunoco LP Unitholders:

There are four ways in which distributable cash flow will grow and value will be created for Sunoco LP unitholders. The first revolves around the dropdown of assets from Energy Transfer Partners to Sunoco LP. These assets are composed of the 5,650 wholesale and retail convenience stations described above. Assuming just over half of the merger synergies related to the Susser Holdings deal accrue to Energy Transfer Partners, I believe that Energy Transfer Partners can dropdown 550M of EBITDA. While the initial drops will almost surely be at higher multiples, I believe that over the life of the dropdowns that the drops will occur at an average multiple of 11x. The initial drops can be at higher multiples given the low relative IDR burden on Sunoco LP. Energy Transfer Partners has stated that it intends to use the proceeds of these dropdowns to help finance various new midstream projects. These projects provide credence to the partnerships statement at the company’s analyst day in November that the firm intended to drop all fuel distribution assets into Sunoco LP within the next 18-30 months. This pace of dropdowns, to be financed 50/50 debt/equity, when compared to Sunoco LP’s current EBITDA of around $180M on a pro forma basis implies a top tier distribution growth rate at the partnership over the next three years.

Going forward it should be clear that Sunoco LP well have a tremendous opportunity as it revamps the dropdown assets given their smaller volumes and retail footprints. In Susser Holdings 2013 analyst day the company suggested that new stores could deliver 25% unlevered ROIs and 88% levered ROIs after 36 months. This compares nicely to comments made during Sunoco LPs 2014 analyst day delivered by Energy Transfer management where they suggested that new stores typically produce 2-3x the cash flows of legacy locations. These new to industry stores as Sunoco LP identifies them are typically significantly larger on a footprint basis allowing for more fuel pumps, have larger and more inviting retail faces that lead to merchandise purchases in +70% of transactions and typically include restaurants that are company owned. While remodels will clearly have lower returns compared to new builds, significant operational upside/improvement likely remains within the legacy stores currently located at the Energy Transfer Partners level.  These stores will provide organic growth opportunities for Sunoco LP for years.

Third party acquisitions in what is clearly a fragmented space will also be a driver for unitholders. Given the fragmented nature of the fuel distribution business, Sunoco LPs scale will give it a strong structural advantage when it comes to acquiring smaller third parties, especially when coupled with its status as the largest publicly traded fuel distributor. With the firm’s large wholesale network, Sunoco LP will likely have a structural advantage in acquiring terminals as well as wholesale and retail distribution locations. The company’s first third party transaction involved the purchase in Hawaii of just under 100 locations, 47 of which will be company owned (the remainder being wholesale) and 6 fuel terminals for approximately $240M at a 7x multiple. Assuming a 7x multiple on future third party transactions, Sunoco LP will likely be on the hunt to purchase $2B worth of assets to hit the company’s goal of $1B in EBITDA at Sunoco LP.

Finally unitholders can potentially benefit from any restructuring of Sunoco LPs real estate assets as well as any real estate assets that get dropped down as a part of larger dropdowns by Energy Transfer Partners LP. Management believes that there is ~$700M of real estate value inside of Sunoco LP pro forma for the last two transactions and ~$1.8B of real estate value inside of Energy Transfer Partners LP’s fuel distribution business.  

Valuation & Upside Walk:

While returns on an investment in Sunoco LP will be driven by the degree to which Energy Transfer Partners pulls the various value creation levers outlined above, I see several return scenarios – both of which potentially understate the impact of the company’s real estate holdings and organic growth opportunities.

Scenario 1: Assuming 550M in dropdowns at 11x over three years, no organic EBITDA growth (e.g. remodels), no third party transactions and a 50/50 debt/equity funding split one could generate an IRR over the next 3 years of 26% assuming a 6% exit yield or a 17% IRR assuming a 7% exit yield which equates to a value of $80 and $62 a share with an ending distribution to unitholders of ~4.30-4.80 by the end of year 3.

Scenario 2: Assuming 830M in dropdowns/asset purchases (to account for potentially $2B in third party deals) at 10x (to account for lower third party acquisition multiples) while holding all other variables as outlined above constant one could generate an IRR of 36% at a 6% exit yield or an IRR of 25% at a 7% exit yield which equates to a value of $98 and $75 a share with an ending distribution to unitholders of 5.30-5.90 by the end of year 3.

Note distributions are included when calculating the potential IRRs. In order to calculate more accurate IRRs I am assuming 1.0 coverage on distributions, in reality this will not happen. Given the nature of the funding of the dropdowns and asset purchases the price at which stock is sold during the three year time period in question plays a significant role in the IRR of the opportunity as one would expect.

Key Risks:

The primary risks around owning Sunoco LP revolves around the rate at which Energy Transfer Partners will drop assets into Sunoco LP. Given the various historical precedents involving Kelcy Warren and his willingness to attempt value creative corporate actions the risk that it will take a prolonged period of time to transfer these assets is low. However, market conditions may impair the ability of Sunoco LP to access the necessary capital markets. Additionally, fuel distribution focused MLPs like Sunoco LP with retail fuel exposure have an increased risk for tax leakage due to certain types of non-qualifying MLP income. To date within Energy Transfer Partners, management has been able to mitigate this tax risk. Macro specific risks relate to industrywide MLP risks (interest rates, taxes, etc.) whereas industry specific risks relate to the various headwinds within the refined product market in the United States.

Catalyst

Sunoco LPs current distribution of $2.18 on an annualized basis is reflective of the company’s financial state at the end of the third quarter of 2014. This distribution sets the stage for a dramatic ramp in the distribution during the first part of 2015 as the distribution of the partnership rises to reflect the ~$1B in accretive transactions executed in Q4 of 2014 and the impact of the partnership’s portion of the $70M in synergies achieved by the Susser Holdings/Energy Transfer Partners merger. Given these tailwinds and the potential for further transactions one can see a scenario where the partnership’s distribution easily rises to somewhere above $3 by the end of 2015.