Sun Shine or Sun Burn?

by Brian Graney (TMFPanic@aol.com)

ALEXANDRIA, VA (Feb. 25, 1999) -- The next company up for examination in our ongoing study of the oil and gas industry is Sunoco Inc. (NYSE: SUN).

Description: Sunoco has a very colorful and interesting history. The business traces its roots all the way back to 1886 and a company co-founded by Joseph Newton Pew. Pew's name might sound familiar -- his progeny went on to establish The Pew Charitable Trusts, one of the nation's largest philanthropic organizations. Those trusts were initially capitalized in 1948 with shares of stock from Papa Pew's company, which by that time had already been listed on the New York Stock Exchange for 23 years under its new name, Sun Oil Co.

Over the course of this century, Sun found itself involved in all aspects of the oil business, from exploration and production, to refining and marketing, to pipelines and oilfield equipment. For awhile, the company was even involved in the shipbuilding and real estate businesses. That all changed in the 1980s when Sun started shedding business units, starting with its shipbuilding and oilfield equipment subsidiaries. Between 1988 and 1996, the company also disposed of its domestic oil and gas E&P business (which eventually became Oryx Energy), its international E&P units, its real estate business, its Suncor Canadian subsidiary, and a mining affiliate.

Today, the company is divided into five main businesses: petroleum refining and marketing in the Northeast and Midwest; lubricants (including the Kendall motor oil brand); petrochemicals; oil pipelines and terminals logistics; and coke production, which is used by the U.S. steel industry. In 1990, the company moved its headquarters to Philadelphia (a town near and dear to this Fool's heart) and in 1998 officially started doing business as Sunoco.

The company's five domestic refineries process about 730,000 barrels of oil daily, mainly into gasoline, jet fuel, home heating oil, fuel oil, and petrochemical feedstocks. On the marketing side, Sunoco branded gas is sold through more than 3,700 outlets in 17 states. In 1998, refining and marketing accounted for 51% of combined earnings. The remaining slices of the earnings pie looked this way: chemicals (12%), lubricants (4%), logistics (16%), and coke (17%). While Sunoco is not quite a downstream pure-play, the refining and marketing business will be the focus of our glance at the company.

Financials: As we have throughout this study, we will initially focus on only a few key elements: 1) How does the market value the company? 2) How profitable are its operations? 3) How does the company finance those operations? 4) And what does management do with the money that it earns?

Valuation: It's time to ask the Fool's resident mathematician, Spanky the Wonder Pooch, to crunch some numbers for us. Sunoco's most recent average diluted sharecount was 94.2 million shares and its shares were last changing hands at $31 9/16. With that information, Spanky figures the firm's market capitalization is $2.97 billion. See, this stuff isn't so hard. If Spanky can do it, so can you. Good dog, Spanky. Go back to gnawing on Jeff's shoe.

As of Sept. 30, the company had $81 million in cash and $840 million in long-term debt. Adding the debt to the above market capitalization and subtracting the cash gives us an enterprise value of $3.7 billion. That's roughly the same size as Apache and yesterday's featured company, Ultramar Diamond Shamrock.

Profitability: This is where things get interesting. Profits at a downstream-focused company such as Sunoco are going to look very different from those achieved at a major integrated firm, where E&P operations are usually the profit driver. As we have seen, E&P profits rise when oil and gas price levels climb and evaporate when prices head south. For Sunoco, however, the economics are reversed. Oil can be viewed more as an input, rather than an end product. So, when oil prices are low (as they are now), Sunoco's relative profitability can rise since its main input is cheaper. There's more to this story, but that is essentially what is happening at Sunoco right now.

Even though Sunoco's economics are topsy-turvy from most of the other companies we have looked at so far, we are still going to use return on capital employed (ROCE) as our main profitability gauge. (If this ratio still seems bizarre to you, hang in there. We'll have more about how to derive ROCE in tomorrow's column.)

In its 1998 earnings press release, the company said it achieved ROCE of 13%, which it believes was "the best in the industry." Which companies Sunoco includes in "the industry" is left to the reader to figure out. However, that is the highest level we've seen so far, so we'll take management's word for it. ROCE was lower in 1997, when average oil prices were higher. We've calculated a figure of 10.7% using the numbers in the firm's 10-K report for 1997.

Leverage: At the end of Q3, Sunoco's debt-to-capitalization ratio (total debt divided by the sum of total debt plus shareholders' equity) was 36%. That's not going to win any awards from debt-adverse investor groups, but it's not too shabby either. The long-term debt-to-equity ratio is 0.52.

Use of Cash Flow: Sunoco's current dividend yield is 3.17%. Believe it or not, that is toward the low end of the yield spectrum for the oil and gas companies we have looked at so far. That's probably because Sunoco's share price wasn't trashed last year quite as badly as the shares of many of the other companies on our list. In 1998, Sunoco's shares lost "only" 14% of their value.

The company is doing a good job repurchasing shares at a consistent clip, buying back 3.8 million shares last year (or 4% of its shares outstanding). Sunoco's board also recently authorized an additional buyback of up to $150 million in stock. That's something that we like to see. At this point, we also must mention how well the company has streamlined its operations over the past two years. By modernizing its refinery system, Sunoco has been able to get rid of bottlenecks and improve efficiency. These improvements helped Q4 operating income rise 79% year-on-year, even though revenues declined 16% during the period.

Snapshot: Click here for Sunoco's financial snapshot.

Conclusion: Sunoco seems to be heading in the right direction and its business is chugging along right now, but we do have some concerns. First, the company has absolutely zero exposure to the natural gas industry, an area where we feel the future prospects are quite bright. Also, the firm's past share price performance hasn't been up to our standards. With dividends reinvested, Sunoco's annual return has averaged 8.5% over the past five years, 6.2% over the past ten years, and 9.3% over the past fifteen years. That's not exactly an earth-shattering track record during the longest bull market of this century.

So, what should we do? Should Sunoco become the fourth company to make it to our second round of consideration, or should we nix it as quickly as Liz Taylor drops husbands? Give us some Foolish feedback on the Drip Companies message board over the next few days. We'll be back next week to share the results.

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