Description

Description:

SUN L.P. is primarily a wholesale auto fuel distributor, with customers in 30 states.  (While now primarily a wholesaler, Sun still has a few smaller businesses such as two strings of convenience stores called APlus and Aloha).  SUN’s general partner is owned by ETE.  With the recent reporting of two quarters of solid gross margins/gallon and the conummation of two recent acquisitions, SUN's new business startegy is now de-risked and we believe that the stage is now finally set-- 16 months after the announcement of a transformative divestiture-- for SUN units to appreciate from its current low-end valuation.  When combined with a 12% yield, we see a path to a one-year return of at least 30%. There are two prior VIC reports on SUN over the past four years (one in 2015 and 2017) which provide a good overview of 1) the partnership’s history and 2) the transformative divestiture announced in the spring of 2017 (& completed in early 2018), respectively. This report will outline the new wholesale-focused SUN, and how the stability of it's new platform, the more flexible balance sheet and the acquisition opportunity in front of it should result in a re-rating, on top of the sizable distribution.

Brief 1H2018 overview and near-term outlook:

Q1: Q1 was messy, with the divestiture occurring mid-way through the quarter.  The encouraging thing though was that the gross margin/gallon came in slightly above the high-end of the company’s (recently increased) guidance range of 9-10 cents. 

Q2: The second quarter, a seasonally average quarter (approximately 25% of annual volumes), was the first full quarter post-divestiture and had many positives, and in our opinion, is an inflection point:

·         1)     Gross/margin/gallon reported at the high end of guidance (9.9 cents).

·         2)     Gross margin/gallon long-term guidance range increased to 9-10 cents/gallon.

·         3)     Adjusted-EBITDA reported at $147M, above street forecast of $133M; even the adjusted ebitda number contained an additional 3.5M of wind down costs, so true adjusted ebitda would be $150.5M.

We now also have a look at the post-divestiture balance sheet. Prior to the 7-11 divestiture, SUN was highly levered, with debt/ebitda running around 6.65x.  With the closing of the transaction midway through 1Q, debt/ebitda has come down to approx. 4.33x run-rate ebitda, below  management’s target range of 4.5-4.75x.

With the lower leverage and two quarters demonstrating the stability of gross margins at the high-end of management’s guidance, along with distribution coverage of close to 1.30x, there appears to be much less risk to the units.

Near-term margin outlook: with margins at the high-end in 1H, one concern could be that SUN is “over-earning.”   But, even if you hypothetically re-cast SUN’s ebitda using the midpoint of gross margin gallon guidance (9.5 cents), the $150.5 M would only drop to approximately $142.5M, putting (run-rate) debt/ebitda at 4.6x, still within management’s target range. 

Moreover, we think, that it is more likely that management is being conservative with their guidance and is likely to continue to report high-end margins, and may end up actually raising their margin guidance again.  We believe this will be the case because:

1)      Trailing 12 months margins are now 9.8 cents;

2)      Management has stated that they consciously began shifting their strategy about 6 months ago to one where they are now turning away lower-margin volumes.  Here’s what management said on the Q2 call with regard to this somewhat new approach:

“First, our Q2 volumes rose seasonably from Q1, in line with our expectations. And the other biggest point to remember is that margin and volume are not independent variables. I mean, as we look at our business and we manage it -- we’re managing it for both short-term and long-term gross profit dollars. So over the last half a year or so we’ve taken a fresh look at how we manage that margin and volume relationship and there’re some times and places where we’ve traded up volume for margin with overall positive results. Specifically for Q2, as you think about it, we could have easily sold more gallons but then not put out the gross profit number that we did.”

So, in 3Q (and longer-run for that matter), we believe margins will continue to land in the high-end of guidance for the two reasons above and also because on the recent call, margins quarter-to-date appear likely to be in the 9.5-10 cents range give management commentary.  On the Q2 call, management said the following with regard to Q3:

“The underlying business is strong, and we expect it to continue. Looking forward, the third quarter is off to a good start. In July, our margins were strong and our volumes continue to grow.”

Later, in response to a question, management repeated, “so far in the quarter both volume and margins are looking strong.”

Near-term volume outlook: The short-run volume outlook also appears good.  Management provided an outlook for sequential volume growth “throughout” the balance of the year:

“total fuel volume in the second quarter was approximately 2 billion gallons, a 6.5% increase over the first quarter. We anticipate that volume will trend higher throughout the second half of the year, driven by growth in our organic fuel business, our recently acquired businesses and typical seasonality.”

Medium/longer-term volume growth, highlighted by roll-up strategy:

With the balance sheet concern behind SUN, we believe investor psychology will gradually re-focus on the stability of the new platform (over three years of annual margins in the 9-10 cent range), the potential for solid volume growth and, ultimately distribution growth.  We believe this shift has just started and will result in a re-rating to at least the middle part of the group on valuation and perhaps even the high-end.   

SUN’s current run-rate volumes are approximately 8.0 billion gallons/year. They have three avenues to grow this over the next few years:

1)     1)     SUN has some built-in growth through a take-or-pay contract which was negotiated as part of the 7-11 divestiture.  (Note that this take-or-pay contract is about 25% of SUN’s overall volumes, giving Sun even greater stability). In 2019, this contract will add 200 million gallons and then an additional 100 million in each of the subsequent two years.

2)     2)     They have enough excess cash flow above their distribution plans and maint capex requirements to fund a small amount growth capex.  In 2018 that growth capex will be approximately $65m and should result in about 125+/- million gallons of volume growth.  We can expect a similar amount in subsequent years.

3)     3)     SUN has articulated that they would expect 4-5 acquisitions per year.  They are completing these at about 5x EBITDA, while their units are trading at 8.3x EBITDA and their cost of debt at only 5.1%.  This arbitrage will provide the lion’s share of their volume growth and will likely be what ultimately drives both the re-rating of the units as well as distribution increases.  The first two acquisitions, Superior Plus and Sanford, completed over the past four months, were done at 5-6x and “less than 5.0x” ebitda, respectively and the pipeline for acquisitions is strong.  Here's some fo the commentary around acquisitions which gives us confidence that there are many more like this ahead:

w  "What we’re executing this year is that we think that there is a long runway of growth for these smaller type of acquisitions. And if you kind of take the example, the first half, we’re talking about 100 -- little bit over $100 million to acquisitions, and one of things we talked about is: as we bring in our scale and our buying power and our infrastructure, we think that we can do these at a synergized multiple in the mid-single digits and both of those are achieved. With that said, we think there we’ve a robust pipeline and we think there's more out there....we think they’re going to be highly accretive." 

     Given the size of the first two acquisitions (approximately 150 million gallons on average), we can expect approximately 600-750 million gallons added each year.

So, overall, we should see high single digit or possibly even double digits volume growth over the next few years.  Despite some concerns about an equity raise, there does not appear to be the need for that at all and management said there would be no equity raise forthcoming.  Here was their response on the call to that:

“We feel very comfortable with where we are right.…we don't need to issue equity this year and any -- I would be speculating if you want -- you said how far out we can go? It would depend on size and cash flow. But we don't see any of that right now.”

In fact, with 3 issues of senior notes not due until at least 2023 and with the $1.5B revolver ($1.1B available, following the two acquisitions completed in April and August), the stage is set for a roll-up of 4-5 acquisitions per year of similar size with no equity issuance necessary for as many as 4 years, if not longer.

Valuation:

SUN is cheap relative to its both of its closest comparables:  Crossamerica (CAPL) & Global Partners (GLP):

·         SUN is trading at 8.2x run-rate ebitda and at a 12.1% distribution yield;

·         CAPL is trading at 10.5x ebitda and at a 11.1% yield;

·         GLP is trading at 9.2x ebitda and a 9.2% yield;

Sun at a 12% yield is also at the lower end of its range relative to its (brief) 16-month trading range post-divestiture announcement.  That range has been 13.5% to 10%

Summary:

Given the reduced risk/greater stability of the new platform, the opportunity to scale up through a roll-up strategy that contributes to a solid volume growth story, we see SUN re-rating to at least a 10% yield or $33/unit.  Combined with the 12% yield, we are expecting a 30% total return.  We also see the possibility for a re-rating to a 7-8% yield should the company’s margins stabilize at the high-end of their range over a longer period of time (or should the range get raised again) and/or if we see distribution increases, and/or if acquisition activity accelerates. Given this set-up, we see little downside over the near/medium term and can simply collect the 12% yield should the re-rating not occur.

Risks:

ETE does something unexpected to destroy LP value.  While this is a possibility given management at ETE, recent acquisitions such at PTXP & ETP have been done at premiums and have treated LP interests reasonably fairly.

Significant uptick in interest rates could put pressure on all yield instruments.

Significant recession causes gasoline consumption to falter.

Catalysts:

Additional roll-up acquisitions

Sell-side upgrades

3Q eps report confirms margin and volume trends

Evidence of moderate organic volume growth

Several more quarters of high-end margin performance beyond 3Q

Distribution hike in 2019

Buyout at premium by ETE

Catalyst

Additional roll-up acquisitions

Sell-side upgrades

3Q eps report confirms margin and volume trends

Evidence of moderate organic volume growth

Several more quarters of high-end margin performance beyond 3Q

Distribution hike in 2019

Buyout at premium by ETE