Source: Sunoco Logistics Partners.
Every long-term income investor knows that the best way to achieve fantastic long-term returns is to be greedy when others are fearful. Unfortunately, the recent oil crash has caused most energy stocks to trade at extremely low levels. This makes determining which investments are worth your hard-earned money far more challenging.
Take, for example, Sunoco Logistics Partners (NYSE: SXL), which has been punished worse than most of its peers over the past year.
Is this a classic case of a market that's irrationality mispricing a good business? Or a warning that something is wrong with Sunoco Logistics' business model?
To help long-term income investors decide whether this high-yield MLP deserves a place in your diversified income portfolio, let's look at three key questions dividend investors need to ask to determine just how good of an investment Sunoco Logistics might make over the next few years.
Just how undervalued is it?
| Yield | 5-Year Average Yield | Price/Operating Cash Flow | 13-Year Average Price/Operating Cash Flow |
|---|---|---|---|
| 8.6% | 4% | 9.0 | 10.3 |
Sources: Yahoo! Finance, Fastgraphs.
From a yield perspective, Sunoco Logistics Partners seems extremely attractively priced. The same can be said about its price-to-operating cash flow, considering its fast growth rate. For instance, management just announced a its 43rd consecutive quarterly distribution increase, 5% quarter over quarter and 20% year over year.
In fact, this is the 15th consecutive quarter of 20% year-over-year distribution growth, an impressive feat for any midstream MLP.
However, a high and fast-growing yield can also be a double-edged sword if an MLP isn't growing fast enough to sustain it in the long-term.
Does the payout profile justify the valuation?
| Metric | Sunoco Logistics Partners |
|---|---|
| Q1-Q3 2015 distribution coverage ratio | 1.2 |
| Q1-Q3 2015 excess distributable cash flow | $105.7 million |
| 5-year analyst projected CAGR payout growth | 23.4% |
Sources: earnings presentation, Fastgraphs.
Sunoco Logistics Partners' payout appears to be rather sustainable, at least in the short term. In addition, analysts are projecting that its payout growth will accelerate through 2020. So that means Sunoco Logistics is an obvious buy, right?
Not so fast. To determine whether the payout can achieve these optimistic growth rates, and more importantly remain sustainable in the long term, Sunoco Logistics needs to be able to grow distributable cash flow at least as fast as its distribution.
However, for the full year 2011 through 2014, the MLP only grew DCF at a 17.9%.What's worse for the first three quarters of 2015, DCF grew only 10.6%.
So unless Sunoco Logistics Partners has a major growth catalyst up its sleeve, such as a large backlog of organic growth projects or a giant dropdown pipeline from its two general partners, Energy Transfer Equity (ETE 0.36%) and Energy Transfer Partners (ETP +0.00%), its coverage ratios (and thus sustainability and growth potential) likely to fall over time.
Source: Sunoco Logistics Partners.
While 2016 is likely to be another solid growth year for Sunoco Logistics because of five projects coming online, 2017 and beyond shows possible trouble ahead. With cash flow growth already slowing, the only way for management to continue its aggressive payout growth strategy is to let the coverage ratio decline closer to 1.0, the bare minimum for a sustainable distribution.
The problem with this strategy is that Sunoco Logistics would end up retaining precious little cash to internally fund its growth efforts, thus relying completely on debt and equity markets for capital.
As for dropdowns from Energy Transfer Equity and Energy Transfer Partners, while this is always a possibility, the fact is that Energy Transfer Equity owns no midstream assets itself, and Energy Transfer Partners is struggling to maintain a coverage ratio of 1.0.
Thus, Energy Transfer Partners might not have any assets it can afford to drop down to Sunoco Logistics.
Does Sunoco's access to growth capital allow for future growth?
| Metric | Sunoco Logistics Partners |
|---|---|
| Debt/EBITDA (leverage) ratio | 7.1 |
| Operating income/interest (interest coverage) ratio | 3.94 |
| Average debt cost | 2% |
| Historic funding sources | 36% debt, 64% equity |
| WACC | 7.23% |
| ROIC | 2.83% |
Sources: Morningstar, GuruFocus.
Sunoco Logistics has historically relied on equity markets for two-thirds of its capital needs. Yet with its unit price almost cut in half over the past year, it will probably have to rely on debt to fund its planned $2.5 billion in capital expenditures in 2016.
The problem with this is that, as Sunoco Logistics' latest $1 billion senior debt offering shows, the interest rates it will have to pay because of its highly leveraged balance sheet are much higher than what its been paying up to now.
This will only raise its weighted average cost of capital, which is already much higher than its return on invested capital, meaning that future growth is likely to be even less profitable. This could further weaken the long-term growth and sustainability prospects of its distributions.
Bottom line
Sunoco Logistics Partners' current payout is sustainable, and its growth prospects for 2016 seem good. However, given management's aggressive distribution growth policy, my concern is that its coverage ratio will decline over time.
When combined with limited growth prospects in 2017 and beyond, low and declining profitability, and a high debt load that is only likely to grow in 2016, I would say that the long-term risks justify the market's current valuation.
