Sunoco LP's Most Brilliant Move in 2017 So Far

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Sunoco LP (NYSE: SUN) entered 2017 on shaky ground. Due to lower fuel margins in its retail business as well as smaller contributions from merchandise sales, its earnings and cash flow declined. Because of that, the company distributed more to investors than it pulled in last year, causing its coverage ratio to fall below 1.0 times. Meanwhile, after an expansion binge in prior years caused debt to rise, its leverage ratio ballooned to an unsightly 6.5 times net debt to adjusted EBITDA when earnings fell.

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Because those metrics aren't sustainable over the long term, the company launched several strategic initiatives earlier this year to raise cash. These included retaining an advisor to assist with finding strategic alternatives for more than 100 real estate assets and securing a $300 million preferred equity injection from its parent Energy Transfer Equity (NYSE: ETE). While these were smart moves, none were as brilliant as its decision to jettison the bulk of its retail assets to 7-Eleven. Here's why that move was such a good one for the long-term sustainability of the company.

Solving all its problems in one deal

In early April, Sunoco LP signed a deal to sell 1,110 of its 1,355 convenience stores to 7-Eleven for $3.3 billion in cash. That cash infusion will enable the company to repay a significant portion of its debt and get its leverage metrics down to a much more manageable level. In fact, since it had more than $4.3 billion of debt outstanding at the end of the first quarter, it can potentially pare that down to about $1 billion after closing the transaction. Meanwhile, after adjusting for the lost earnings, the company's leverage ratio will decline to 4.5-4.75 times debt to adjusted EBITDA, which is within its target range.

Furthermore, Sunoco LP was able to recoup some of the lost earnings by signing a 15-year take-or-pay agreement with 7-Eleven to supply it with 2.2 billion gallons of fuel per year. That deal will provide Sunoco LP with predictable cash flow over the life of the contract as well as built-in upside as volumes rise by half a billion gallons over the first four years of the deal. As a result, the transaction Sunoco will accelerate the strategic shift toward expanding its industry-leading fuel supply business, which has become its biggest moneymaker.

Say goodbye to volatility

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By shedding the bulk of its retail assets, Sunoco LP will rid itself of a business that didn't generate as predictable a cash flow stream as the company had hoped. In 2015, for example, its retail business made $411 million of adjusted EBITDA after selling 2.49 billion gallons of fuel and $2.18 billion worth of merchandise. However, adjusted EBITDA slumped to $328 million last year despite selling 2.52 billion gallons of fuel and $2.27 billion worth of merchandise. The culprit? Lower margins after its retail margin per gallon fell from $0.264 in 2015 to $0.24 last year, which was a 9.1% decline.

Contrast this result with its wholesale business. Last year, it made a $0.098-per-gallon margin, which was up from $0.094 a gallon in the prior year, good for a 4.3% jump. That increase in margin, when coupled with higher volumes, helped drive adjusted EBITDA in the wholesale segment up to $337 million last year, an improvement from $304 million in 2015. Meanwhile, the underlying earnings stability of the business will improve in the future thanks to the long-term supply agreement it signed with 7-Eleven. According to the company's projections, roughly 87% of its wholesale volumes going forward will come from long-term fixed-fee contracts that should provide it with stable cash flow.

That stability should enable the company to pay a sustainable distribution going forward that it could grow as it expands its fuel distribution business and by adding other MLP-friendly assets to its portfolio, such as expanding its storage terminal business. That's good news not only for Sunoco investors but for its parent company Energy Transfer Equity, which will be able to earn higher incentive distribution rights as Sunoco grows.

Investor takeaway

Sunoco LP's decision to sell its retail business was a brilliant move because it fixes the company's balance sheet while adding another stable source of income for its growing fuel distribution business. That puts the company's finances back on solid ground, enabling it to focus on further expansion, which is the key to driving an eventual increase in shareholder distributions.

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Matt DiLallo has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.