When Sunoco LP (SUN 0.69%) reported its fourth-quarter results last month, those numbers likely sent a chill down the spine of the company's income-focused investors. That's because the company published atrocious coverage and leverage metrics, which all but seem to ensure that the payout has nowhere to go but down. Here's a look at why those numbers are so worrisome.
Missed it by a country mile
During the fourth quarter, Sunoco LP's adjusted EBITDA was $153.6 million, down a disappointing 18.6% year over year. Driving down earnings were lower gasoline fuel margins in both its retail and wholesale segments as well as lower profits from merchandise sales. Meanwhile, distributable cash flow plunged even more deeply, cratering 30.5% to $62.6 million due to those same issues as well as higher interest, income tax, and maintenance capital expenses.
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As a result, the company didn't even come close to covering its distribution to shareholders. With a 0.61 times coverage ratio, it only made $0.61 for every $1 it paid out to investors. That unimpressive result pulled its full-year coverage ratio down to 0.98 times, meaning it paid out more than it earned for the year. That's an unsustainable level, which is why the yield has risen to more than 13% in a signal by the market that it expects Sunoco LP to slash its payout.
In over its head in debt
Another impact of Sunoco's earnings slide is that the company's leverage ratio has grown out of control. As of the end of the fourth quarter, its net debt-to-adjusted EBITDA ratio had ballooned to 6.5 times, even after the company sold $71.4 million units to pay down some debt. For perspective, a leverage ratio below 4.0 times is typically considered a safe one for a master limited partnership, though that's if it can rely on relatively secure cash flow from fee-based contracts, which isn't the case at Sunoco LP.
Sunoco LP's leverage has also spiraled out of control because of its acquisition binge over the past few years. In November 2015, it completed a $2.226 billion dropdown transaction with its former parent company, Energy Transfer Partners (ETP). Under the terms of that deal, Sunoco LP paid Energy Transfer Partners $2.2 billion in cash and $194 million of its units. That deal capped $5.7 billion of transactions between Sunoco LP and Energy Transfer Partners, resulting in a stunning rise in its leverage as it borrowed heavily to finance these deals.
The company has completed a steady diet of third-party transactions as well. In December 2015, it paid $57 million for a fuel distributor in the Northeast, using its credit facility to finance the deal. Meanwhile, the company completed a string of deals last year, including buying Emerge Energy Services' (NYSE: EMES) wholesale fuel distribution and terminalling business for $167.7 million, again funding the deal, and several others, with its credit facility. While it would go on to issue new units and long-term debt to pay down its credit facility, these deals haven't generated a consistent earnings stream, which is why the leverage ratio has grown to such a concerning level.
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Limited options at best
Sunoco LP is working on several options to de-lever its balance sheet and stabilize its distribution. For example, the company hired an advisor to help it generate some cash. It's looking to sell company-owned retail locations, undeveloped sites, and other real estate. However, it's unlikely to produce enough money from this process to address all its issues.
Among the other potential solutions that analysts have put forth is a preferred equity offering or an incentive distribution rights (IDRs) waiver from its parent company, Energy Transfer Equity (ET 1.97%). The IDR waiver is something Energy Transfer Equity has done for Energy Transfer Partners several times in the past. Another possibility is the outright elimination of the IDRs by trading them for more units, which is a solution that has worked for several other MLPs because it cuts cash outflows and lowers the cost of capital. That said, Sunoco LP's biggest problem is that its underlying cash flow isn't stable because that's the nature of the businesses it operates. Because of that volatility, the company probably has no choice but to cut the payout down to a level that it can sustain in good times and bad.
Investor takeaway
Due to challenging market conditions, Sunoco LP's earnings tumbled last quarter, which is putting tremendous pressure on its finances. While the company is working on a variety of solutions to reduce debt and gain some more breathing room, it has a huge mountain to overcome. As a result, there's plenty of reason for investors to worry that the company might have no choice but to cut its payout so it can get back on solid ground.
