Description

Misunderstood transaction leads to highly compelling deleveraging and value creation opportunity.

Sunoco LP is still priced as a distressed MLP despite a highly compelling transaction with Seven & I Holdings.  The opportunity exists because there is significant confusion over the terms of the agreement with Seven & I Holdings.  Much of the market is assuming a 10-12x LTM EBITDA transaction multiple, but I calculate the multiple is over 15x LTM EBITDA.  This multiple is more in line with the cyclically depressed EBITDA levels in ’16 with the retail business EBITDA falling by nearly 21% y/y and likely the significant cost cutting and synergy opportunity for Seven & I Holdings. 

The source of the confusion is that management, for whatever reason, has been super cagey about this deal in the press release and the conference call that followed.  However, management did highlight a 2.2bn gallon wholesale long-term take or pay contract that SUN will benefit from as part of the transaction.  Management also highlighted this take or pay agreement is north of any internal margin given from retail to wholesale (which could be as low as 0 or even negative).  From our understanding of the 10-K and management commentary, we can assume that there is a 4c per barrel uplift to wholesale EBITDA (i.e., SUN’s retail assets benefitted from very beneficial COGS).  

This value discrepancy is significant as it de-levers SUN from 6.7x LTM EBITDA (unadjusted for the recent ETE preferred) to just 3x LTM EBITDA. 

I assume $200mm of taxes are paid on this transaction given management commentary and the likely built in gain and solve to a $3.1bn reduction in net debt to $1.34bn (unadjusted for preferred).  I estimate LTM EBITDA falls from $665 to $453mm with $300mm of lost Retail EBITDA offset by $88mm of wholesale EBITDA.  EV multiple has compressed from 11.3x EBITDA to 9.8x EBITDA, while business has gotten better through the disposal of the more cyclical retail, convenience store business.  Business will be primarily wholesale fuel supply which benefits from long-term fixed margin contracts. 

Management has committed to maintaining the distribution yield and solving to 1.1x coverage. 

I can solve to $3 LTM DCF if excess cash is used to either buyback stock or if company re-levers to 4x EBITDA.  However, this is based on LTM and street estimates have EBITDA increasing by $60mm due to cost savings program, which management believes has more firepower as a result of the disposal.  Also management appears to be conservative on capex requirements for the wholesale business, with that business just consuming $112mm of capital in 2016 (vs guided $140mm). 

On conservative estimates by using LTM math (vs. the incorporation of cost savings) and using $300mm (out of $330mm of total retail EBITDA despite Seven & I buying just 1,110 of the 1300 stores, we solve to a FCF yield ex. Excess cash of 13.9% at a leverage ratio of just 3x.  I can easily see management supporting the $3.30 dividend through the greater than $75mm cost savings program, capital allocation through buyback or M&A and through the sale of the incremental assets at a multiple north of the 9.8x LTM it is currently trading at. 

As the market digests the transaction, I believe the multiple will go to 11x EBITDA for near term upside to $34 or 19% on top of the $3.30 annual distribution worth an annualized 12%.  As Seven Eleven closes, the 200 other stores are sold, management comes clean about numbers and capital plans, I believe there is upside to $44 at a 7.5% distribution yield within a year.  Combined with the distribution itself, that’s 67% upside with your downside protected by a de-levered balance sheet and an 11% FCF yield (ex. Excess cash).

Key quotes from transcript to support my case:

First, the divestiture proceeds will allow us to reduce our leverage ratio. We expect to be in the 4.5 times to 4.75 times range. Second, after the debt reduction, we expect to have a coverage ratio in the neighborhood of 1.1 times. I should point out that these ratios won't be achieved in year one, as we will incur a significant deal related cost.

We expect our combined maintenance and growth capital expenditures to be around a

$150 million annually upon completion of these transactions.    

As we look at it, it'll probably be somewhere around $50 million on the maintenance side and about a $100 million on the growth side

Again, in February we talked about cutting operating expenses and G&A by $75 million. Once we complete this transformation, we expect to reduce G&A by significantly more than our $75 million target. 

By the end of the year, we expect to be a focused, streamlined, MLP qualifying business

the 15-year fixed margin take-or-pay fuel supply agreement provide stability of income with the ability to grow the business moving forward. We will continue to pursue supply agreements with fixed margins.

all you smart people on the phone will continue to try to approach this differently and we're not

going to answer the question here this morning, we'll give more detail as time goes on, but remember, all these metrics will change depending on the results. We still got a lot of work to do selling the remaining assets. I think Tom said it exactly right. When we exit the retail business, our EBITDA will be lower. I told you, we're going to have a 1.1 coverage ratio. There are a couple of ways we can get there, we can reduce the divisor in terms of the outstanding shares where we can do M&A activity and we will do what we believe is optimum for all our – all our unitholders. So, I would encourage people to talk with Scott as time goes on as you guys refresh your models, but we're going to frustrate you here this morning with and not give you any additional specifics.

I think just in terms of clarity, this is not going to be billions of dollars of tax, but it's going to be hundreds of millions of dollars of tax, based on the basis. The base, we have in the assets that are being sold versus the proceeds.

<Q - Eric Genco>: Good morning. I was wondering if you could tell us historically when these – when some of these assets were affiliated the – the per gallon margin that you had agreed to was in the $0.03 to $0.04 range, can you tell us where that was before this transaction? Is that the right number to be thinking about?

<A>: No, remember these were company operated and the right number to think about here would be the $0.23 to $0.25 a gallon that came with retail gallons. Remember with retail gallons, two things, that those gallons are – the retail margin is not qualified. Secondly, we had the employee cost associated with it.

but in order to avoid intercompany eliminations, you just had – you just reported the retail

gallon.

So essentially, whatever math we do on this, if we say 2.2 billion gallons now supplied to 7-Eleven, we apply some margin and we add that to whatever we were – we had originally for wholesale as a pro forma, is that the correct thought process behind doing it?

<A>: Yes, I would say, if you look at the range that we talked about before, that would be a total. And so that you don't double count it, subtract your $0.03 to $0.04 of gallon from. Yeah.

<Q>: Right. And so then if we really think about this from a perspective of like what are you – what theoretically you gave up, you have – if we start with $0.24, we would assume that the buyer then would have to take out whatever this assumed number is, $0.03 to $0.04 out of that and that would be an incremental expense to them that wouldn't have necessarily showed up in your accounting, is that fair?  <A>: Well, I think that you – I'm not sure that any buyer would enjoy the same position that we enjoy in terms of cost of goods sold, so I don't think – this is not a zero-sum game here, in that regard.

<Q>: Okay. So, then you – okay, so essentially, we're thinking these are probably – this agreement probably comes somewhere north of $0.03 to $0.04?

<A>: Well, I think, Tom mentioned that it was within the – to think about it in the range that we've given people around wholesale and both he and I said this is a market related price, we think it's attractive for both parties given what their normal options would be and the different position that we're in as owner of the Sunoco brand for example, right

Catalyst

Managment PF numbers

Transaction for 200 more additional stores

Sell Side Awareness

Seven & I transaction closes

Maintenance of distribution